Rekenthaler Report

About That Rigging Claim

By John Rekenthaler | 04-01-14 | 08:00 PM | Email Article
High Dudgeon
Michael Lewis has taken the high moral ground. In publicizing his new book on
high-frequency traders, Flash Boys: A Wall Street Revolt, Lewis has dominated this
week's investment news, first with Sunday's 60 Minutes interview and then with a
long excerpt in The New York Times. In both the interview and the Times article,
Lewis claims that the U.S. stock market is "rigged."
Uh-huh.
To judge from the Times excerpt (I have not yet read the book), Flash Boys is
Lewis at his mesmerizing best, detailing how high-frequency traders, or HFTs,
burrowed into the marketplace, operating so quietly and surreptitiously that even
investment giants like T. Rowe Price and hedge fund giant David Einhorn did not
realize what was occurring. They knew that their trades were not getting processed
as they expected and that something odd was happening, but they did not
understand why.
We learn that HFTs profit through an information advantage. Even if
simultaneously placed on every stock exchange, trade requests do not arrive at
each exchange at precisely the same moment. The length of the data transmission
wiring between the broker who places the order and the exchange varies, which
gives the HFT its feeding opportunity. In the very short amount of time that it
takes light to travel the extra distances between the exchanges, HFTs pounce.
As an example, consider a large buy order for Microsoft (MSFT) at $41.50 that
arrives at the first exchange. An HFT will read that order, will anticipate that this
buy request will temporarily boost Microsoft's stock price, and will place its own
buy order for Microsoft at $41.50 at the remaining exchanges. A micro-fraction of
a second later, the initial buy order arrives--but can no longer be filled. There is no
remaining Microsoft stock selling at $41.50. It now costs $41.51 or $41.52.
Is that rigged?
It is in a trivial sense, in that HFTs extract profits from the system in a way that
you and I cannot. In that aspect, however, HFTs are neither new nor unique. Stock
market makers, who profit by supplying liquidity, in a fashion that you and I
cannot match, existed long before HFTs were invented. So, too, did retail stock
brokers, who were protected from stock commissions until 1975, and who even for
decades after that served as unavoidable toll collectors. Want to buy a stock? Pay
the toll.
Thinking Small
However, there is a difference between HFTs and previous profit extractors: The
HFT effect is smaller.
Indeed, for the retail investor who holds stocks directly, it's not clear that there are
any effects at all. HFTs don't care if you place an order for 100 shares of Microsoft
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or even 1,000 shares. They care about larger orders, of the size that typically
come from institutions. So, if you purchase a stock directly, at the usual individual-
investor levels, you're probably not triggering an HFT response.
Even at the institutional level, the bill is very modest. Lewis cites the test case of a
trade of 10 million Citigroup (C) shares. The savings from eliminating HFTs from
the trading process was $29,000--less than a penny per share. Not all that long
ago stock prices were quoted in 8ths, or 12.5 cent increments. In every trade,
market insiders extracted that spread. Now stock prices for large, liquid companies
are quoted by the penny, with perhaps another penny or so captured by HFTs. If
that is a bad thing, by all means let's have more bad things.
In fact, many fund managers tell Morningstar researchers that HFTs are a good
thing. As with traditional market makers, HFTs provide liquidity in exchange for a
fee. However, the liquidity that HFTs provide is very high, which has helped to
enable the shrinkage of stock spreads, and their fees are relatively low.
Thus, setting aside the trivial case, HFTs might well be an improvement on
tradition--a de-rigging of the stock market, so to speak.
The Little People
There is one party, though, that appears to have been significantly hurt by HFTs:
hedge funds. Hedge fund performance has plummeted since the mid-2000s, when
HFTs came to prominence. There are several reasons why, including the possibility
that before HFTs were hatched, hedge funds were the de facto micro-traders, using
their superior resources and technology to beat retail day traders.
In the 60 Minutes story, Lewis cites a hedge fund manager who claims to have
suffered a 3.3% annual loss at the hands of HFTs--$300 million in leaked profits on
a $9 billion fund. Now that is a real loss; given such an example, it's easy to see
why hedge funds would be unhappy.
That said, it's a bit rich, to say the least, to see hedge funds leading the charge in
the cry for stock market equality and against the system being set up to reward
insiders. All right, it's more than a bit rich, it is corpulently so. It's also rich that
Lewis' lead sources for Flash Boys are the principals at a new brokerage firm (IEX)
that was created to outflank HFTs. That company benefits if investors believe: a)
HFTs are bad; b) HFT effects are big; and c) those who are opposed to HFTs are on
the right side of truth, justice, and the American Way.
Those are the parties speaking for the everyday investor in alleging that the stock
market is rigged--hedge funds, a new brokerage firm, and an author who relays
their story. On the opposing side, former Vanguard chief investment officer Gus
Sauter wrote in 2012, "Net-net we're better off with HFT than without. Individual
investors have benefited more than institutional money managers." I mean, really.
Deciding whom to believe is not a difficult call.
Don't let that deter you from reading the book. It is sure to be entertaining as well
as instructive about the abstruse world of stock trading. And IEX may indeed be a
useful invention that further squeezes stock trading costs. But rigging? To
paraphrase Peter Lynch, 10 minutes per year thinking about that is five minutes
too many.
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Final note--Felix Salmon of Reuters shares many of my views on this topic. The
ideas are independently derived, as I read his column after completing this one,
but there certainly is overlap--and as Salmon published first, the overlap should be
noted.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for
Morningstar.com and a member of Morningstar's investment research department. John is quick
to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his
views are his own.
John Rekenthaler is Vice President of Research for Morningstar.
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