Frank Thoughts: The Imaginary "Investor"
Dave Canal
July 21, 2017

Imagine that you could make millions in the stock market with little risk, yet know nothing about stocks.  You don’t even have to care about the direction of the market.   That doesn’t matter because you hold stocks for just a nanosecond.   A fact that makes it irrelevant whether the market is going up or down.   Sound perfect?  It is.  You’re a member of what was a large - now much smaller – group of high-frequency traders.  Profits go to those with the fastest technology.   This speed race creates a maelstrom of activity totally unrelated to a company’s business.  It’s all about taking advantage of slower computers.  In the real world that’s called front running an order.  If a human does it, it is illegal. When a machine does it, it is legal.  Explain that?  Regardless, it has nothing to do with price discovery.

In the tech world, this faster speed experience is called lower latency.  Latency means the delay in signal processing by automated trading platforms.  The lower the latency the faster a signal is processed.  The more that happens the more competitive you are.  As you can imagine, knowing ahead what other computers are programmed to do is a license to make money.  But there is a limit to it … the speed of light.  The good news is, we are approaching that speed.  The closer we come to it, the less advantage anyone has.  As it unfolds, the market will get back to price discovery and that favors active managers.

 HFT started in 1995 and grew exponentially.  At its peak in 2009, it represented 78% of all trading volume obliterating the significance of market volume.   Now 10-12 billion shares of daily trading has become meaningless as most of it has no basis in price discovery.  That is the single reason active managers have lagged the S&P 500 for the past six years.  This useless trading has created a consistent 70%+ correlation among stocks.   Furthermore, when HFT is combined with ETFs (and increasingly it is)   you have the potential for major disruption in a future declining market.   With yearly turnover running 880% in ETFs, high-frequency turnover is clearly involved in the pricing of these “passive” investments.

Markets exist for the purpose of price discovery … not speed of order execution.   Buyers and sellers come together to determine what something is currently worth.  Some investors are smarter, others are luckier, while some are better informed or more knowledgeable in a given subject.   Others may even have inside information.  None of this “discovery” is involved in high-frequency trading.   In fact, HFT disrupts price discovery by its predatory execution of thousands of trades a second.

My awareness of this expanding technology began 1998.  My friend, Joe Galluzzo, and I were going to share a new Russian secretary named Ivanka.   “Very, very bright,” he told me.  By way of being sociable, I asked about her husband.   “What does he do for a living?” With a big smile she said “He’s a computer engineer at Goldman Sachs.”  Startled I asked, “How does he know about the stock market?”  “Oh, he doesn’t know anything about it,” was her honest answer.  “But he knows computers.  And they pay him a lot of money,” she added proudly.   At the time, Goldman had 600 traders.  They now have two.   As of this year, the firm had 27,000 employees; 9,000 are computer engineers.   As latency decreases, price discovery increases.   As that process evolves, the performance of active managers will increase as well.

Francis Patrick Boland

 

Request Your Free Guide

Ensure your advisor is responding properly to changing market conditions.







Read more