High frequency trading: Fact vs. fiction

“Pay no attention to that man behind the curtain” — the Wizard of Oz

Much has been written about High Frequency Trading (HFT) since Michael Lewis’s 60 Minutes appearance and his new book Flash Boys has created a major buzz within the industry.

HFT is the rapid-fire, electronic execution of extremely large buy and sell orders at various stock exchanges, and it has been blamed for the sudden “flash crash” of 2010. Lewis says the technology has created a “rigged” stock market.

Lewis is a great writer, and his description of a million dollar hand of Liar’s Poker played on the bond trading desk of Salomon Brothers in the 80’s was clearly a career-changing event. But the question remains: Are retail investors really disadvantaged from HFT?

How Does HFT Work?

Although the claims of the market being “rigged” have elements of truth, it doesn’t affect true investors that much in my opinion. There is an obvious defense to this type of trading: increased overall market liquidity that creates more competitive market pricing for all.

Whether you buy this argument or not, you should recognize investing is not a daily or even weekly event. The theoretical increased cost of say 2 cents when purchasing 250 shares, raises the cost of your investment by $5.00.

Clearly not great, but if you are really investing in a business, spending thousands of dollars, and $5.00 is your make or break point, you should just not be buying. The only way this type of cost increase really matters, is if you are a day trader, a gambler, or purchasing a 100,000 shares.

Some facts: a $300 million fiber optic line was built by private firms to speed up the connection from traders in Chicago to the stock exchange computer servers in New Jersey. The New York Stock Exchange is no longer a busy open outcry market, with traders battling crowds at their respective posts. It’s more of a theater for cable tv financial programs more than anything else.

This new fiber optic pipeline became the quickest route to execute a stock order and certain traders paid millions to gain access to this private electronic superhighway. The exchanges themselves actually sold high-speed connections to the traders willing to pay extra. Soon complex computer-driven algorithms were designed to send a series of orders along with rapid-fire cancellations to test market depth and balance.

Often these traders quickly reversed course after discovering large institutional orders. Once these orders were discovered, these “algo traders” won the electronic foot race between a New Jersey consolidation midpoint and the actual exchange server somewhere else in New Jersey.

This “strategy” effectively allowed bigger and faster (hence high frequency) traders to “front run” any potential large orders by taking a position ahead of them.

That’s not so retail friendly. However, similar types of situations have long been a part of the stock market. Back when actual humans made a market in a stock 1/8th of a point wide (12.5 cents), smaller orders often didn’t get the best execution.

Ultimately, under competitive pressures, the New York Stock Exchange narrowed the difference between its buying and selling price to just pennies, and that’s when the business model of a typical floor trader collapsed, soon after the machines took over.

Now, let me explain what this all means to you. Chasing higher returns, is the bane of the average investor’s existence. In my opinion, mutual fund holders often do worse than their actual fund’s average return. Why? Because they get out too early or buy into a fund too late.

In short, investors often chase hot trends and trying to time the market. A five-year study by Morningstar, reported in the Wall Street Journal, showed investor performance trailed their actual funds average by 1.17 %, compound that difference over a period of 20 years and you really miss a lot of upside.

It’s also worth remembering, according to S&P Capital, of all bear markets since 1945, those down between 20-40%, the average time to recovery is just 14 months. The lesson here, work with an advisor, establish an appropriate and comfortable “risk” position and don’t try to time the markets. I personally believe that’s just gambling, ultimately a loser’s game, not investing.

DISCLAIMER: All opinions included in this material are as of May 7, 2014 and are subject to change. The opinions and views expressed herein are of the portfolio manager and may differ from other managers, or the firm as a whole. All investments involve risk (the amount of which may vary significantly) and investment recommendations will not always be profitable. Past performance does not guarantee future results.

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