By Gary Paulin is Global Head of Integrated Trading Solutions at Northern Trust.

Outsourcing, initially of the back office, and subsequently of the middle office, has been a feature of the asset management industry for some years. More recently, in the third wave of outsourcing, managers began to outsource non-core front office functions, and the pace of change has grown rapidly to the extent that the industry has passed the tipping point of this transition.

For example, in our survey taken during Q1 2020 of 300 heads of investment operations from global asset management firms with assets ranging from $10 billion to $500 billion, 85% of respondents said they were already outsourcing their trading capability or were interested in doing so within the next two years.

What started as simply a cost-efficiency endeavour has evolved. The outsourced trading model has moved from being a largely defensive strategy – a response to cost pressures – to a proactive move that can de-risk and streamline operations and enhance governance and operational resiliency while also responding to very real and relentless margin progression.

In short, outsourced trading is increasingly viewed as a more optimal state for asset managers, and as the timing of the Northern Trust survey shows, this turn in thinking predates the onset of the Covid-19 pandemic. The pandemic in our view is an accelerant of change, but not the catalyst. We can see its origins more than a year ago, well before the economic cataclysm and office shutdowns of 2020.

Recent years have seen increased deal flow in the asset management industry, along with significant restructurings and increased investment in technology, as firms sought to gain scale, cut fixed costs and automate functions. These are classic responses to margin pressure, which has persisted even during the recent bull market in equities.

In fact, the drivers of change are global and go far beyond simple margin pressure. They include aspects of competition, the ability to leverage economies of scale, business resilience, changing economic models, variable costs, demographics, technology and regulation – drivers no longer hidden under the veil of strong markets. Critically, this past year has marked a significant change in the economics of the industry, as margins for many asset managers fell despite assets under management going up.

Margins are not expected to fall in a bull market like that of 2019 – when the S&P 500 gained over 28% – yet according to investment market analysts this, for many, is what happened. The long-held assumption that strong market returns correlate with asset manager financial performance broke down. Strong markets failed to mask the structural drivers underneath and, we believe, this was the tipping point for the industry.

As economics change so must operations. The pandemic brought new urgency – and opportunity – for managers to undertake an internal review of their whole office. The question at the bottom of such a review is whether a range of front office functions, historically perceived to be core to a successful asset management operation, actually deliver value. If not, these functions must be considered a cost and susceptible to outsourcing to a more cost-efficient platform. Meanwhile, the extended work from home protocols of 2020 have undermined some of the core objections to outsourcing, such as the assumption that portfolio managers need to work in close physical proximity to their trading desk.

Beyond the value/cost equation, however, there is increasing recognition that front office outsourcing – whether whole or in part – is directly beneficial. For example, outsourcing to a global service provider has enabled a range of firms to expand their investment horizons internationally without concern about governance issues as apply to passing overnight trading to third-party brokers who will almost certainly be under the same pandemic pressure as all the rest of us. Other firms have seized the opportunity of moving to a variable pay-as-you-go cost dealing structure to offer a broader slate of investment strategies or to develop their inhouse research capabilities.

These and other opportunities are new, and underline our view that front office outsourcing leads to an optimal state for investment managers; one where the playing field is levelled enabling medium and smaller firms to compete on the basis of pure alpha with large scale players.

But today, it is not just the smaller or medium managers who are outsourcing front office functions; many of the ‘big players’ are also in active transition. Why? Because the benefits of outsourcing apply to the whole asset management industry, but a hyper-scale manager requires a hyper-scale global service provider to work with. These used not to exist, now they do and both sides are riding the wave.