Considerable waves were made when 60 Minutes’ Steve Kroft interviewed Michael Lewis about his new book on high frequency traders (HFT). Lewis’ contention is that investors are being taken advantage of by high frequency traders who are able to front run their trades. High frequency traders can see an investor’s signal to buy and can get their order to the exchange before the investor—meaning they can then turn around and sell the stock to that investor at a fractional mark-up.
For example, let’s say you wanted to buy 100 shares of Microsoft. The stock is currently trading at $40.00. Let’s say that the bid/ask spread is currently $40.00 by $40.01, meaning it would cost you $40.01 to buy a share at the best offered price, or you would receive $40.00 if you were selling a share at that moment. An investor may place a market buy order for 100 shares. If they place this as a market order this goes into the system and during the time it takes to reach the exchange it may be viewable by others who may have a faster route to the exchange. In this example, an HFT could theoretically buy the 100 shares of Microsoft right before you (at $40.01) and then sell them to you at a higher price, perhaps $40.02. In this case they would then be able to profit $0.01 per share, or a total of $1.00, while that investor ended up paying a total of $4,002 instead of $4,001 for their 100 shares.
However, what if that investor placed a limit order instead of a buy order? The limit order mandates that the investor does not pay more than a stated price for the security. In the example above the investor can decide that owning Microsoft stock right this instant is not the most important priority, but instead they would like to buy it soon but are willing to pay no more than $40.01. If they place this as a limit order there is no arbitrage opportunity for the HFT because if they were to buy the 100 shares before the investor and try to mark it up to $40.02, the investor is no longer willing to buy them and the HFT would then be stuck with the position.
Let’s take that idea a step further and assume that the investor is still interested in owning Microsoft, but has decided to be a patient trader and let the market come to them. Let’s say they now place their limit order at $39.99, meaning they are willing to pay no more than that for the stock. The investor has prioritized the expediency of owning the stock right away below the opportunity to acquire the stock at a lower price. Their order may not get filled right away, but when a large sell order comes along that seller may sell the first few shares at $40.00 and the next shares would go to the investor waiting at the $39.99 mark. While mere pennies, these costs — or savings — add up over time and can make a real difference in returns.
If an investor is dealing only with mutual funds, they do not have to contend with a bid/ask spread or worry about the speed at which their order is getting to market, since mutual funds trade only once a day at their net asset value. The trading decisions are then passed on to the portfolio manager.
Back to the 60 minutes story — at one point when discussing how analysts are addressing the problem, interviewer Steve Kroft replies, “You beat speed by slowing it down”. Kroft was referring to new algorithms institutions had created to ensure all orders were arriving at markets at the same time. Yet we know in practice that patient trading and maintaining low turnover may also act to help reduce all of the fees associated with trading.
One aspect of HFT which was not mentioned in the 60 Minutes segment was the potential positive impact HFT has on the market by increasing liquidity. Due to increased competition, spreads on securities have fallen over time, lowering the cost of investing for everyone in the marketplace.
At the end of the day, the issue raised in this segment is one of many issues that an advisor should consider when determining implementation options. Higher turnover funds will incur higher transactions costs, both explicit (such as taxes and fees) and implicit (such as the potential to move market prices or be affected by the HFT).
Having a well-thought-out, sustainable approach to investing is one of the best ways to try and mitigate the risks brought up by Mr. Lewis.
Source: 60 Minutes: Is the U.S. Stock Market Rigged? March 30, 2014
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IRN R 14-165 (Exp 4/16)