By Matt Dundas
Technology and lax regulations have transformed the stock market from an honest, capital-allocating machine into a smoke-and-mirrors carnival game – at least that’s what Michael Lewis claims in his latest book, Flash Boys: A Wall Street Revolt. Lewis’ emphatic assertion that “markets are rigged” has once again thrust the issue of high-frequency trading (HFT) into the national spotlight. What exactly are HFT traders up to and, perhaps more importantly, how does HFT activity affect portfolios of Versant clients and of other long-term investors?
Picking Up Pennies
Perhaps the most comprehensive definition of HFT is the use of high-speed trading technology to exploit evanescent opportunities to make a quick profit in the markets. The faster one’s hardware, software, and internet connection, the more likely one is to find and exploit an opportunity before his competitors. HFT transactions vary in nature, but most take the form of either arbitrage or order front-running.
An arbitrage opportunity occurs whenever an asset can be bought at one price and sold at a higher price at the exact same time. Have you ever searched for the same item on both Amazon and EBay? You might notice that the price for the item is lower on one site than on the other. Since all members of the public are free to buy and sell goods on these websites, you could engage in an arbitrage transaction and make a quick buck: buy the item from the site where the price is low and sell the item on the site where the price is high (assuming, of course, that the difference in prices is sufficient to cover any selling fees you might incur).
Some HFT traders seek profits by engaging in the same routine described above not with clothes, DVDs, antiques, and other EBay treasures, but with stocks, bonds, and derivatives. Consider a simple case in which shares of stock XYZ trade on two different exchanges. On one exchange, there are 100 shares for sale for $10.01 each, while on the other exchange, traders will gladly pay $10.02 each for the same 100 shares. The HFT trader with the fastest technology will see this opportunity, buy for $10.01 in one market, instantaneously sell for $10.02 in the other market, and enjoy his $1 of risk-free profit (100 shares times $0.01 profit per share). This profit is earned for essentially matching a willing buyer with a willing seller. If you are not impressed by the $1 figure, keep in mind that HFT firms might easily engage in thousands of these trades per day.
Front-running takes place when a market participant knows that another participant is about to purchase something. Armed with this information, he buys it first and then flips it to other participant at a marked-up price. Suppose you live near the coast and have seen on the weather report that a hurricane is about to make landfall. You believe that after the storm hits, there will be huge demand for clean drinking water, so you “front run” that demand by driving to every Costco in the area and buying all of the water bottles you can get your hands on. After the storm hits, you sell those water bottles to your thirsty friends and neighbors for a premium, locking in a nice profit. Sounds a bit less innocent than arbitrage, doesn’t it?
On Wall Street, HFT firms turn to special, high-speed data feeds from exchanges to get the “weather report” they need in order to anticipate large buy and sell orders on a particular stock. HFT firms might have arrangements with exchanges to be able to access “flash orders”, or orders that exist only for the blink of an eye (literally) before being made available to all market participants. This effectively affords an HFT trader an opportunity to scan the market for a way to profitably fill the order before the other, slower traders get that chance. For example, a mutual fund might submit a large sell order of 10,000 shares of XYZ to Exchange A with the stipulation that it will sell for no less than $10.05 per share. Exchange A would then “flash” this order to its HFT clients for about a half a second before sharing the order information with the broader (slow) market. During that half second, the HFT firm uses its technology to find a buyer on Exchange B who will pay $10.07 for 2,000 shares and a buyer on Exchange C who will pay $10.06 for 1,000 shares; the HFT trader promptly acquires the aggregate 3,000 shares from the mutual fund for $10.05 and sells the shares to the buyers at the higher prices. Once the half-second flash order expires, an order to sell the mutual fund’s remaining 7,000 shares is relayed to the broader market. After the dust settles, the HFT trader has essentially pocketed a commission for exchanging a large block of the mutual fund’s shares for instant cash.
Critics of HFT do not view these arbitrage and order front-running activities as honest games of matchmaking. Instead, they argue that HFT has created a two-tiered “fast vs. slow” market structure in which technology is used as a cloak to obscure market manipulation and exploitation of the public. Critics claim that HFT firms are middlemen who jump in between “slow” buyers and sellers who would otherwise find one another, thus raising the cost of trading by marking up share prices. In any case, how could it possibly be necessary to conduct business in micro-second increments, right?
Supporters of HFT view the increased speed and automation of trading as an innovation that has reduced trading costs for all market participants. They claim that hardware and software has replaced the less-efficient, more expensive human traders that used to match buy and sell orders. Further, they argue that HFT has increased liquidity by efficiently matching disparate groups of buyers and sellers. HFT fans also excuse HFT traders’ “marking up” of share prices as being no different than paying brokers for access to the market in days past. Defenders of HFT tell those wary of having their orders front-runned to simply avoid using market orders (orders that accept
whatever the current price of an asset is) and to instead use limit orders (orders that specify an acceptable price for the trade).
Meanwhile, In Phoenix…
Versant’s investment beliefs naturally preclude Versant from extensive trading of stocks and funds in our clients’ accounts. Further, a great deal of our trading involves mutual funds, where shares are priced once per day and where our clients are trading directly with a fund company. Consequently, the fervent dance of ultra-fast trading occurring around us should be of little to concern to our clients when Versant places trades in their accounts. That being said, the fund companies managing the funds our clients are invested in, while generally fairly passive in style, are constantly trading. Portfolio managers must trade often in order to satisfy liquidity needs of the funds they manage and to mirror performance of benchmarks, whose underlying holdings are ever-changing, making the topic of HFT quite relevant to portfolio managers.
The fund managers that manage funds recommended by Versant collectively manage several trillion dollars. Portfolio managers at companies like the Vanguard Group and Dimensional Fund Advisors lose sleep over basis points. For managers charged with replicating a particular index in a fund, the pressure to manage the portfolio efficiently is particularly intense – the difference between success and failure might come down to whether the fund deviated from its benchmark by margins as small as a handful of basis points over the course of a year. Trading costs directly impact fund performance and tracking error. If you think that these managers would sit quietly while HFT firms steal even a fraction of a penny per share off of a trade, think again. So, what do these managers have to say about HFT? Their answers may surprise you.
Joe Brennan, global head of Vanguard’s equity investment group, said in a recent interview with Bloomberg that the majority of HFT traders are improving market liquidity and not harming investors. In fact, in a 2010 letter to the SEC, the Vanguard Group estimated that HFT activity reduced its transaction costs by 100 basis points for every “roundtrip” (buy and subsequent sell) transaction over the 2001-2010 time period – a savings that is passed directly on to fund share holders. Dimensional Fund Advisors responded to Versant’s request for feedback on the HFT issue by stating flatly that “[HFT front-running] doesn’t generally apply to the Dimensional trading approach”. Dimensional cited the fact that it has a “patient trading” methodology in which it trades at its leisure using limit orders rather than demanding instant liquidity using market orders. Finally, Cliff Asness, managing and founding principal of AQR Capital Management, said in his April 1, 2014 Wall Street Journal Op-Ed that “[AQR] devote[s] a lot of effort to understanding our trading costs, and our opinion, derived through quantitative and qualitative analysis, is that on the whole high-frequency traders have lowered costs”.
Proceed With Caution
Advances in technology have vastly altered the way in which trading takes place in the financial markets. At this point, the evidence suggests that, at least for long-term investors, HFT is at worst an inconsequential distraction and at best a cost-reducing innovation. Nevertheless, there is certainly nothing to be lost from continued investigation of the impacts of HFT, whether it be by private asset managers or the SEC. As for Versant, we will continue to monitor the HFT debate to ensure that our clients are playing a fair game.
Disclosure: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Versant Capital Management, Inc.), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Versant Capital Management, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Versant Capital Management, Inc. is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. If you are a Versant Capital Management, Inc. client, please remember to contact Versant Capital Management, Inc., in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. A copy of the Versant Capital Management, Inc.’s current written disclosure statement discussing our advisory services and fees is available upon request.
