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Perspective on High-Frequency Trading

I have received a number of questions since “60 Minutes” ran a piece on high-frequency trading (HFT) on March 30 (lest we forget, this is the same “60 Minutes” that ran a piece in 2010 that predicted the municipal market would implode in 2011, and we all know how that turned out). I’ll summarize what I think we know about HFT at this point, a viewpoint that runs counter to the perspective offered on “60 Minutes.”

What Is HFT?

Larry Harris, professor of finance at the University of Southern California, has spent an academic career studying trading in equity markets, and he categorizes high-frequency traders into three areas:

1) Market makers
2) Fundamentally driven traders
3) Front-runners

Market makers are simply traders who are ready to buy and sell specific stocks and therefore provide liquidity to the market. These traders are thought to have greatly reduced trading costs compared with the old system of market making that HFT has largely replaced. Further, these types of high-frequency traders appear to be the significant majority of the HFT market. So, in contrast to the “60 Minutes” piece, the majority of HFT has likely benefited individual investors by lowering the trading costs they pay or that their mutual funds pay.

Fundamentally driven traders try to gain an advantage by processing relevant market information (e.g., company earnings data, news about product sales, etc.) more quickly than other investors. To the extent they are able to do this, they are likely rewarded with better returns than other similar investors are able to achieve. So, who might be “harmed” by this activity? (Harmed is in quotation marks since it’s likely most of this activity is legal, and it’s hard to criticize firms that have spent significant capital and effort to improve how quickly they process information in an effort to deliver betters returns to their clients and themselves.) The most likely “victims” are money managers and investors who have not made an effort to improve information-gathering efficiency yet still invest in a manner similar to the high-frequency traders in this space. These firms and individuals likely are part of the more vocal group arguing that HFT should be curtailed without acknowledging the possibility that trading costs would increase as a result.

Widely considered to be the most distasteful aspect of HFT, front-runners try to anticipate or take advantage of the trades other investors intend to make by placing similar trades ahead of time. As a simple example, if you knew ABC fund manager planned to purchase a large quantity of a particular stock on April 15, you might purchase the stock on April 14 with the intent to sell it to the fund manager at a likely higher price on April 15. In practice, this type of trading takes place in fractions of a second compared with days. This activity is generally legal and was the primary focus of the “60 Minutes” piece. However, it is thought to be a minority of the total amount of HFT, and it’s not clear how this type of HFT can be regulated without detrimentally affecting the more positive aspects of HFT.

It’s worth noting that the commonality across each of the three areas is the technological capability to process either trades or information (or both!) extremely quickly. In this technological age, this is the new dynamic. Any regulatory activity almost certainly will not reverse this, and we should not want it to since indications are that, in total, HFT has benefited investors by lowering trading costs.

Have You Been Harmed?

While it’s impossible to say how each and every trade that is placed has been helped or harmed by HFT, keep in mind the big picture. HFT has almost certainly lowered stock market trading costs through its provision of liquidity and lowering of bid-ask spreads, which are a measure of how expensive it is to trade a given stock.

Further, for investors who hold well-diversified, low-cost and low-turnover portfolios, any negative impact associated with a particular trade you or a fund manager placed are secondary concerns at most (one indication of this is the relatively good returns such portfolios have generally earned during the era when HFT has come to dominate the market). We know the more important aspects are your allocation choice, a focus on broad diversification, total costs you pay, and the discipline to stick with your portfolio through good times and bad.

For those wanting to read more about HFT, I’d suggest the following pieces in addition to above links:

Jared Kizer is the director of investment strategy for the BAM ALLIANCE. See our disclosures page for more information. Follow him on Twitter.
 
 

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