The world of active investment management was dramatically and negatively impacted on March 6, 2006.   On that day, the New York Stock Exchange became a for-profit organization.   The impact of the event would be disruptive to active management for years, yet the impending impact was missed by everybody.   After all, who would hurt their best customers?  

But as a for-profit organization, the exchange’s entire business model had to change.  You cannot make money from a “concept” of price discovery, but you can from paid transactions.   This change would create an unintended consequence.  The Dow Jones organization recently reported the consequence, “… almost all (emphasis mine) actively managed US, global and emerging market funds had failed to beat the market since 2006.”The reported number of active managers who underperform was 99%. 

The change ended 214 years of nonprofit status.   As a nonprofit, the customer base was individual and professional investors.   They shared the common purpose of seeking price discovery.   An exchange was central in doing this.  In price discovery, everyone contributes.   Some investors are smarter than others; others may have more knowledge about a particular business; some are luckier or even have inside information.   It all comes together in determining what something is worth at a moment in time.

None of this occurs with high-frequency trading.  It contributes nothing to price discovery; in fact, it directly impedes it.  This has been a major cause of active managers’ under performance for the past seven years.   As HFT trading started to interfere with price discovery, discouraged individual investors started buying passive ETFs.   The two inadvertently created a positive feedback loop for passive investing – it’s grown exponentially - and a seven year negative loop for active managers.   HFT trading is, conservatively, estimated as 50% of NYSE volume; ETF passive trading at 30%.   With 80% of trading having nothing to do with price discovery, it has overwhelmed price discovery for active managers.

When the NYSE became a for-profit company its customer base had to change because its mission changed.  It became making money for its own stockholders.   Thus collocation was born.   HFT firms are allowed to place their computers on the floor of the exchange in order to cut latency.  Latency is the speed at which computer instructions are passed on.  Speed of execution is EVERYTHING.  Even a few feet can make a difference.  HFT computers are starting to approach the speed of light which is 671 million miles per hour.   At that speed, you can go around the world 7.5 times … in a second!   As a public company, the NYSE has been in a position to charge economic rent.   That’s a term dating back to the middle ages.  If you owned a bridge you could charge whatever anyone was willing to pay to cross it. 

To approach the speed of light is very expensive.  This “bridge” hit its peak usage in 2009.  At that time, HFT volume on the exchange was 78%.  Profit for HFTs was close to eight billion; now it’s less than eight hundred million.   Moreover, many firms are going out of business.   You may have noticed how S L O W exchange trading has become.   Price discovery is coming back because capitalism has come full circle.   

Francis Patrick Boland