What Is Step-Out Trading?
Step-out trading is the execution of a large order by several brokerage firms that are each assigned portions of the trade by another brokerage firm. In step-out trading, one brokerage executes a large order and then gives other brokerages credits or commissions for the share of the trade that it executes. Although different brokerages are executing different blocks of the trade, each block will be executed at the same price.
Step-out trading can also refer to an order that is executed entirely by one brokerage that simply gives credits or commissions to other firms for portions of the trade, which it might do if those firms provided research and analysis. The firms that are the recipients of the stepped-out trade execute the other side of the equation—what is sometimes called a stepped-in trade.
Step-Out Trading Explained
Step-out trading typically involves trades placed by investment advisers on behalf of their clients. It can involve an investment manager making a decision to execute a trade with a third-party broker-dealer other than the company that they normally work with.
With this kind of step-out trade, investment managers of separately managed accounts place certain orders with another company. The purpose is to help the investment manager in meeting their obligation to seek what is called best execution for the particular trades. Best execution requires that an investment manager must place client trade orders with companies that the manager thinks are capable of providing the best execution possible for their clients' orders.
The qualifications the manager looks at when seeking the best execution include finding the best opportunity to get a trading price beyond what is currently being quoted and finding a company that can execute the trade quickly.
Managers need to be completely transparent with advisors and clients and provide additional details regarding these trades, so as to allow them to have as much information as possible insofar as the manager's trading practices. It is also critical that managers divulge what, if any, additional transaction costs will be passed on to the advisors and clients as a result of the step-out trade.
Because the manager is using a third party to execute a trade other than their normal brokerage, there is often a fee associated with the trade, which the investor must pay.
Regulatory View on Step-Out Trades
The SEC has raised concerns that step-out trades may not result in best execution, which brokers are legally required to provide, and may have disclosure issues. Rule 10b-10 provides some protection against these potential problems by requiring the different brokerages participating in the step-out transaction to provide certain material information about the trade in their trade confirmations.
On the other hand, step-out trading can also facilitate the best execution and can be a good way to compensate different brokerages for their research and analysis activities.
- Step-out trading is the execution of a large order by several brokerages that are each given a portion of the trade by another firm.
- Step-out trading can also refer to trades placed by investment advisers with third-party broker-dealers on behalf of their clients.
- Step-out trading can include additional fees for clients, but such fees can be seen as a reasonable trade-off if they enable managers to provide their clients with the best execution possible of their trades.
Real World Example of Step-Out Trading
A recent report from fund manager Ameriprise Financial (AMP) showed that in the first three quarters of 2018, a number of the equity investment managers that they work with performed step-out trades, typically resulting in either no fee or a fee of up to 3 cents per share.
For example, Ameriprise said that ETF manager Invesco (IVZ) stepped-out 76.4% of client trades in its U.S. Real Estate Securities Fund, in the first quarter of last year. In the second quarter, it stepped-out 57% and in the third quarter, 46%. However, it was able to do this without passing on any additional fees to clients.
By contrast, a number of firms did pass on fees. For example, Legg Mason (LM) stepped-out 28.6% of client trades in its Dividend Strategy Balanced Fund in the first quarter of 2018 and charged clients 1.61 cents per share. In the second quarter, it stepped-out 32.4% and charged clients 1.58 cents per share. In the third quarter, it stepped-out only 0.2% of client trades and charged 1.68 cents per share.
On the higher end of the spectrum, Lazard (LZD) stepped-out 47% of client trades in their Emerging Markets Equity Select ADR, but just in the first quarter of 2018. In exchange, they charged clients three cents per share.