High-frequency trading has been getting a lot of coverage since the release of Michael Lewis' book Flash Boys and his talk on 60 Minutes about speed traders rigging the stock market for average investors.
To gain a better understanding of what high-frequency trading has meant to the markets and long-term investors since it was introduced more than 20 years ago and what the pros and cons might be today, we asked a long-term value investor and an alternative investments specialist to share their diverse views.
For Rowsell, it is fascinating to see the spotlight return to the high-frequency trading (HFT) topic. "One will recall that the Securities and Exchange Commission spent considerable time researching whether and how the 'flash crash' of 2010 was affected by HFT," said Rowsell.
Rowsell points out that computer-based trading and technology failures severely hurt Knight Capital and, separately, the Facebook IPO in the summer of 2012, prompting another discussion of how to manage the vulnerabilities introduced by the speed and capacity of computerized trading. Now, Michael Lewis' description of how fast data feeds and special exchange order types have enabled HFT computers to execute trades in microseconds and get ahead of other market participants is once again sparking a healthy debate.
"The debates between certain exchange participants and Mr. Lewis are becoming highly charged but, indeed, informative. We think it is good that discussions about these issues are putting the spotlight on market health and functionality," said Rowsell.
Advanced trading tools critical today
Over the years the traders at Harris Associates have worked diligently to navigate a technologically advanced landscape of broker algorithms, liquidity sources and evolving market structure. "The tools they have cultivated assist us in accessing the additional liquidity in electronic markets without revealing too much about the nature of our trades," said Rowsell. The customizations Harris Associates has implemented, including using price limits and minimum fill quantities, as well as accessing dark pools and block trading venues, she believes, have helped reduce the firm's exposure to predatory HFT strategies.
"We regularly review broker algorithms, order routing data and venue performance so that we can constantly adjust and improve how our orders are handled. Although we can never be perfectly insulated from HFT exposure, our practices appear to help," said Rowsell, adding that Harris' trading costs compare favorably to other investment managers. In fact, in December 2013, Institutional Investor's Transaction Cost Analysis survey* ranked Harris Associates sixth overall in the Elkins/McSherry universe of asset management firms for exhibiting trading costs below market averages.
Benefits of greater trading competition
Overall, Rowsell says she welcomes the chance for market participants to gain a better understanding and to have access to more transparency regarding trading behavior. However, she believes there are two important elements of context long-term investors should remember. "All investors have benefited from the narrower spreads and enormous drop in commissions that markets have seen over the past decade. Trading commissions that once cost seven to ten cents per share – or more – can now be as low as fractions of a penny. The proliferation of algorithmic trading models and dozens of alternative trading venues has made trade execution hugely competitive, delivering benefits to all who own stocks," said Rowsell.
Rowsell notes that her firm does not actively trade in and out of stocks in any portfolios. "Our turnover of stocks is relatively low, implying that we typically hold securities for years at a time. Further, our interest in a company's stock is not driven by trading dynamics. We look for stocks trading at a substantial discount to our estimate of intrinsic value. Our focus on identifying a stock's true economic value and our willingness to patiently own it until that value is realized means that the penny-perfect purchase or sale price does not contribute meaningfully to the total return of the stock for our shareholders," said Rowsell.
Harris Associates does eagerly follow all developments in the trading arena, such as broker behavior and technological tools. But, in Rowsell's view, market phenomena such as HFT are unlikely to contribute to or detract meaningfully from her firm's success.
*Ben Baris, Institutional Investor, December 2013 / January 2014. "Transaction Cost Analysis, Shaving Pennies Amid the Boom." The Transaction Cost Analysis survey conducted by Elkins/McSherry compared investment firms' trading costs relative to the volume-weighted average price, based on a universe of approximately 1,400 managers. Any reference to a ranking, a rating or an award provides no guarantee for future performance results and is not constant over time.
Kristi Rowsell is President and Partner at Harris Associates. Joining the firm in 1995, her previous roles at Harris Associates included Chief Financial Officer, Tax and Accounting Manager and Treasurer of The Oakmark Funds. Previously, Ms. Rowsell was vice president and treasurer at Calamos Asset Management and a senior tax specialist at KPMG Peat Marwick. She is a graduate of Virginia Tech University with a BS and a Master of Accountancy – Taxation. She is also a Certified Public Accountant.
PhD, CFA, Senior Research Scientist, Portfolio Manager
According to Lüdi, advances in computer and telecommunications technology in the past 25 years have had a profound impact on everyday life and disrupted most industries – with financial markets being no exception. "It is undisputed that computerized trading has brought vast benefits to the wider investment community, including lower transaction costs, increased liquidity, and broader access to markets, as well as improved dissemination of relevant information," said Lüdi.
Lüdi points out that participants in any competitive activity have generally competed based on skill and speed and it is widely accepted that the more skillful and faster players merit their rewards, as long as they were earned fairly. "Whereas electronic low-latency trading is, in my opinion, not harmful per se, there are mounting reports of alleged manipulative behavior and other activities prohibited by laws and regulations," he said.
Lüdi believes the use of fast communication and computing infrastructure represents a natural progression in market adaptation and firms employing these technologies have typically been protective of their operating secrets. Possibly provoked by this secrecy, he says, media coverage of high-frequency trading has lately taken on an air of conspiracy and controversy, often blurring the differences in technological objectives and methodologies of participants.
Broader range of investor types today
According to Lüdi, modern financial markets are the habitat of many different types of participants, with different objectives evaluated over vastly different time scales. At one extreme are the long-term value investors, fundamentally driven, with an outlook measured in years. At the other extreme are market makers, for whom the tiniest fraction of a second is crucial, as they aim to earn the difference between the price at which a security can be bought or sold, while minimizing their exposure to overall market risk.
Controversial practices of HFT
Many of the controversial activities attributed to high-frequency trading are generally linked to market making and can be grouped into two categories: front-running other orders and "quote stuffing." "The former may be facilitated by preferential arrangements between exchanges and certain clients, whereas the latter can be interpreted as market manipulation. Both can have the consequence of higher transaction costs or missed opportunities for other participants, but I think that in the majority of cases, these techniques aim at other algorithmic traders, and much less at retail investors," said Lüdi.
The extent to which the benefits of improved liquidity and reduced transaction costs for long-term investors may be mitigated by the effects of potential manipulations remains a topic of debate among both academics and the public, according to Lüdi.
Is greater regulation on the horizon?
For market regulators, and possibly lawmakers, the debate about preferential arrangements and market manipulation will likely lead to a renewed focus on enforcement and possible refinement of existing rules and regulations. However, Lüdi warns that regulators should beware of the unintended consequences any new regulations may bring, as it has been suggested that the success of some high-frequency trading strategies has been facilitated by well-intended rules initially drafted to protect investors and to end front-running. "Investment managers, and the clients for whom they have fiduciary responsibility, will likely benefit from more computerized execution methods, rather than less, as they all derive gains from increased competition and reduced transaction costs," said Lüdi.
Lüdi also believes long-term investors would do themselves a grave disservice by abandoning investment in financial assets because of an emotionally charged debate and should instead focus on a diversified portfolio that is in line with their long-term objectives. But of course diversification does not guarantee against a profit or protect against a loss.
"Within AlphaSimplex, we see ourselves confirmed in our core philosophy. We focus on some of the most liquid markets, such as futures and currency forwards, which structurally may be less susceptible to manipulation, and we design our investment process to adapt to changes in financial markets. For example, by adjusting our strategies’ investment horizons or by developing state-of-the-art trading technology to fulfill the best execution requirements with respect to our clients," said Lüdi.
Mark T. Mueller, PhD and Scientific Consultant at AlphaSimplex Group, also contributed to the views above on high-frequency trading.
Philippe Lüdi, PhD joined AlphaSimplex Group in 2006 and currently serves as a Senior Research Scientist, focusing on global macro and global tactical asset allocation strategies. He has also served as a Co-Portfolio Manager since May 2010. Dr. Lüdi received the equivalent of an MA in molecular and computational biology from the University of Basel in 2000, followed by an MS in statistics in 2002 and a PhD in bioinformatics in 2006, both from Duke University. He is a CFA® charterholder.
Dark pool is the trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is represented by block trades facilitated away from the central exchanges.
Flash crash refers to the quick drop and recovery in securities prices that occurred shortly after 2:30 p.m. Eastern time on May 6, 2010.
Front-running is the unethical practice of a broker trading an equity based on information from the analyst department before his or her clients have been given the information.
High-frequency trading (HFT) is a program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions. Typically, the traders with the fastest execution speeds will be more profitable than traders with slower execution speeds. As of 2009, it is estimated that more than 50% of exchange volume comes from high-frequency trading orders.
Intrinsic value is the value of a company, based on the net present value of forecasted cash flows such as future earnings or dividends.
Market makers refers to a broker-dealer firm that accepts the risk of holding a certain number of shares of a particular security in order to facilitate trading in that security.
Quote stuffing refers to the tactic of quickly entering and withdrawing large orders in an attempt to flood the market with quotes that competitors have to process, thus causing them to lose their competitive edge in high-frequency trading.
Value investors employ the strategy of selecting stocks that trade for less than their intrinsic values.
Volume-weighted average price (VWAP) is calculated by adding up the dollars traded for every transaction (price multiplied by number of shares traded) and then dividing by the total shares traded for the day.
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This material is for information purposes only and should not be construed as investment advice. Any economic projections or forecasts contained herein reflect subjective judgments and assumptions, and unexpected events may occur. The statements and opinions expressed are those of the representative of the Natixis Global Asset Management subsidiary referenced. Opinions are subject to change at any time and there can be no assurance that developments will transpire as forecasted. The opinions and information referenced are dated as indicated and cannot be relied upon as current thereafter.