How to Beat High-Frequency Traders

Posted on April 3, 2014 | Investor Update

Investor-Update
Author Michael Lewis ignited a debate within the financial community with his appearance on “60 Minutes” last Sunday. Lewis, the author of “Flash Boys: A Wall Street Revolt” (W. W. Norton & Co., 2014), called the stock market “rigged.” His reasoning? High-frequency traders are seeing what trades are being placed, jumping in line ahead of those investors who placed the trades and profiting at the expense of everyone else.

Brad Katsuyama, the man whose story Lewis tells in his book, used an analogy of buying tickets. Katsuyama described to “60 Minutes” a situation of placing an order to buy concert tickets for four adjacent seats on ticket exchange StubHub at $20 a ticket. A confirmation comes back saying only two tickets have been purchased. At the same time, the price of the other two adjacent seats has risen to $25.

The jump in prices described by Katsuyama, 20%, is a big exaggeration, but it clearly explains the allegation he trying to make: High-frequency traders are getting ahead of investors and are profiting as a result. High-frequency traders and their proponents counter that trading costs are being driven down and liquidity is being improved in the process.

Where’s the truth? The five-year 21.7% annualized return for the iShares Russell 3000 fund (IWV) as of March 31, 2014, shows good returns could have easily been realized by an individual investor who merely tracked the broad market’s performance. (A big reward for participating in the so-called “rigged” market.) Self-described long-term institutional investors Clifford Asness and Michael Mendelson of AQR Capital Management claimed in a Wall Street Journal op-ed that high-frequency trading is reducing their costs. On the other hand, if high-frequency trading firms weren’t making money, they certainly would change their approach.

It’s hard to discuss this subject without igniting emotions. It’s even more difficult to separate the facts from the hyperbole. What’s lost in the conversation is a focus on the market’s complexity. The digital structure underlying the market has become so complex, there isn’t a clear answer as what actual impact high-frequency traders are having on all other investors. Even Asness and Mendelson admitted not being “100% sure” as to whether high-frequency trading is actually reducing their costs. What we do know is that complexity not only can lead to problems such as the flash crash, but it can create anomalies and opportunities for malfeasance (legal, ethical or perceived).
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New Tax Rules for IRAs and Bitcoin

Posted on March 27, 2014 | Investor Update

Investor-Update
The Internal Revenue Service (IRS) recently issued announcements regarding individual retirement accounts (IRAs) and bitcoin. Since more of you have retirement savings than bitcoins, I’ll start with IRAs.

In the April AAII Journal, which will be on AAII.com early next week, we introduce you to Alvan and Elisa Bobrow. This couple is responsible for promoting a change in the rules regarding when you can and cannot rollover IRA. The rollover rules allow you withdraw and redeposit funds from a traditional IRA on a tax-free basis as long as you do so within a 60-day window. Patrick Gutierrez, a specialist in employee plans at the IRS, told me some people try to take advantage of this window to get what is in effect a free, temporary loan.

I can’t speak to the Bobrows’ reasons for doing what they did, but here is the short version of the events. Between April and September 2008, the couple moved money in and out of three IRAs. The IRS, which currently allows one rollover per IRA account per year, said the Bobrows violated the rollover rules with their actions. The tax court not only ruled in favor of the IRS, but further said the tax code limits aggregate IRA rollovers to one per a 12-month period.

I hope you read that last paragraph carefully. Currently, IRS Publication 590 says if you roll over funds from existing IRA #1 to new IRA #3, you cannot make any other rollovers from these accounts during a 12-month period. You can, however, make a rollover from existing IRA #2 to new IRA #4 at any time. Just after the April AAII Journal went to press, the IRS issued a new bulletin saying that in light of Bobrow v. Commissioner, IRA rollovers will be limited to one per person per year. The new rule will apply regardless of how many retirement savings accounts a person owns. It’s not certain when the new rule will take effect, but the tax agency’s current intention is to have it take effect on January 1, 2015.

The new rollover rule will not apply to trustee-to-trustee transfers. Both Sally Schreiber, the senior tax editor at the Journal of Accountancy, and Mark Luscombe, a principal analyst at CCH Tax & Accounting, confirmed that this means you can move your IRA accounts to as many brokers as you would like over the course of a 12-month period. The key is that you move the actual account, and don’t move funds from one IRA to another. (If that sounds like a technicality, realize it is a big one.)
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Coping with Randomness

Posted on March 20, 2014 | Investor Update

Investor-Update

I found myself struggling with my NCAA Basketball Tournament picks more this year than in the past. Partially it’s because of the parity that has evolved in men’s college basketball. Partially it’s because there are teams whose chances are tough to assess (e.g. North Carolina, Michigan State, my Kansas Jayhawks, etc.). Then there is the sheer randomness of the event that wrecks bracket picks.

The statistical odds of the tournament favor going with the top-ranked seeds, but upsets can and do happen. Fourth-seeded teams have lost during the first full round of play (now technically the second round of the tournament) more than 20% of the time since 1985. Seventh-seeded teams face nearly a 40% chance of not making it to the round of 32. Top-seeded teams may look invincible with a perfect record during the round of 64, but it’s only a matter of time one is beaten by a 16th seed. (For those of you who don’t follow college basketball, the NCAA tournament has seven single-elimination rounds, whittling a field of 68 teams to just two.)

As the tournament goes on, unexpected teams gain momentum and win more games than anyone predicted. Wichita State, Butler, VCU and George Mason all surprised expectations and busted tournament brackets by making it to the Final Four in past years. I don’t recall any of the major college basketball commentators advising to take a chance on any of those teams. (This year, Wichita State is a #1 seed and is certainly not an underdog. The Las Vegas Sun listed the school’s odds of winning the national championship as 4-to-1.)

No amount of analysis can help you pick the correct outcome of every game. This is why Quicken Loans is able to run a contest with a $1 billion prize; the chances of picking a perfect bracket are astronomical. USA Today cited DePaul University mathematician Jeff Bergen as calculating the odds to be one in 9,223,372,036,854,775,808. Yet many have scrutinized their picks this week, including myself, in hopes of getting them right. It’s a reflection of our inability to cope with random events.

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The Challenge of Deciding When to Retire

Posted on March 13, 2014 | Investor Update

Investor-Update
One of the biggest decisions a person will make is when he or she will voluntarily retire. Though a great deal of emphasis has been made to encourage saving for retirement, arguably not enough emphasis has been placed on determining the “optimal” date for retirement or considering what one’s retirement lifestyle will be.

Two recent analyses looked at retirement date decisions and uncovered two different insights. The first, a poll by Gallup, found that finances play a significant role. The second, a study by the Michigan Retirement Research Center at the University of Michigan, said cognitive abilities play a role. Both considered different data and sought to answer different questions, which explains some of the difference between the conclusions.

Gallup surveyed over 85,000 working adults. The research firm found that nearly 50% of working baby boomers (those born between 1946 and 1964) do not plan to retire until at least age 66. One out of 10 predicted that they will never retire. Not surprisingly, those who strongly believe they have enough saved plan to retire earlier (age 66) than those who strongly believe they have not (age 73). Job satisfaction also played a small, but not significant, role in the desire to retire later rather than earlier.

The Michigan Retirement Research Center analyzed data from the American Life Panel (ALP). The ALP is run by RAND and the University of Southern California. It surveys more than 6,000 adults age 18 and older. These researchers found a link between cognitive scores and retirement expectations. Higher cognitive scores were associated with later projected retirement dates and more coherent retirement expectations. The Michigan researchers also found a correlation between longer expected longevity and postponing retirement.

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The Bull Market’s 5th Anniversary

Posted on March 6, 2014 | Investor Update

Investor-Update

This Monday, be sure to say “happy birthday, bull” as the current bull market will turn five years old. Since bottoming on March 9, 2009, the S&P 500 has gained nearly 200% on a total return basis. This is quite the reward for someone who braved the fear and pessimism that was occurring back then and bought a stock index fund, such the SPDR S&P 500 (SPY).

Also take time on Monday to reflect on your emotions, portfolio decisions and tolerance for risk during the last bear market. Yes, I realize it was a dark period you’d as soon forget, but this is a useful exercise. The level of pessimism and fear was very high: Bearishness in our weekly Sentiment Survey reached a record level of 70.3%. Banks were failing left and right, credit was extremely tight, and well-known financial firms were imploding. There was even speculation about General Electric (GE) going bankrupt.

What was your reaction to the negativity? Did you pull out of stocks and equity funds completely? Partially? Were you concerned the economy was about to fall into the abyss? Did you think further stock market losses were coming? Or did you open your wallet and start buying stocks?

If you were terrified, don’t feel alone. Many people were. A key problem with many economic theories is the assumption that humans are rational, profit-maximizing individuals. As behavioral science shows, we’re emotional, impulsive and overly focused on the short term. Our minds are programmed for survival, not Mr. Market’s ever-changing moods.

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Make Your Investment Expenses Count

Posted on February 27, 2014 | Investor Update

Investor-Update

Over the years, various surveys have shown that investors aren’t aware of what expenses their portfolios are incurring. Compounding matters, I’ve observed situations throughout my career where investors are focused on comparatively small costs without giving much consideration to the potential benefits that can be realized from incurring them. It’s important to be aware of both.

I’m bringing this subject up because in our March Stock Superstars Report, which will be published tomorrow, we discuss the costs of tender offers, offers to purchase some or all of shareholders’ stock in a company. If asked, I doubt many investors could articulate them. Yet, Helen of Troy (HELE) shareholders could be looking at a double-whammy of selling at a price below the current market value and incurring higher commissions. (Fidelity charges $38 for participating in a tender offer versus $7.95 for a traditional, open market trade). Granted, tender offers are not frequently made, but they do provide a good example of why it is important to pay attention to costs.

A far more commonly incurred cost is fund fees. Within the large-cap category of our 2014 mutual fund guide, one of the cheapest funds is Vanguard Total Stock Index (VTSMX). This fund has an annual expense ratio of 0.17%. In contrast, Marsico Flexible Capital (MFCFX) ranks among the most expensive funds with an annual expense ratio of 1.44%. This 1.27% difference equates to $127 extra per year for every $10,000 invested with MFCFX instead of VTSMX. That amount adds up. On a $100,000 investment, an investor will pay Marsico $1,270 per year more than he would pay Vanguard.

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Mutual Funds Probably Should Stay Open

Posted on February 20, 2014 | Investor Update

Investor-Update

Yacktman Focused (YAFFX), a fund we recently deleted from the AAII Model Fund Portfolio, is one of a relatively small group of value-oriented mutual funds to close last year. When a mutual fund closes, it either stops accepting investment dollars from new investors or stops accepting any new investment dollars, be it from new or existing shareholders. Some funds may partially close by removing themselves from broker networks and requiring new investors to directly go through the fund. The latter is what the Sequoia Fund (SEQUX), which I own, did for a while before completing closing its doors to new investors at the end of last year.

Mutual funds, like many other investment products, earn money based on a percentage of assets managed. In concept, a mutual fund manager would want his assets under management (AUM) to be as high as possible to maximize his profits. With the average domestic large-cap fund charging nearly 1% in annual expenses, every extra billion dollars’ worth of AUM adds up to a lot of profits.

In practice, there can be a limit to what level of AUM makes sense. A fund manager with a very targeted strategy can end up with more investment dollars than good ideas. This is particularly the case if a fund invests in a country with a comparatively small securities market or follows a restrictive strategy. It can also make sense to place a cap on a fund’s AUM to prevent it from becoming so large that it is difficult to do anything but essentially mimic an index fund, albeit at a higher cost.

Funds may close, however, because a manager simply believes the prevailing market environment doesn’t offer enough attractive investment opportunities. Investors may see a preliminary sign that this is occurring by monitoring the fund’s cash balance. For example, Yacktman Focused ended 2013 with a 20.8% cash allocation, up from 16.3% a year prior.

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Finding Winners in Last Year’s Bargain Bin

Posted on February 13, 2014 | Investor Update

Investor-Update

One of the most-cited value investing studies says stocks with low price-to-book ratios outperform stocks with high price-to-book ratios. Investment firm GMO’s Ben Inker says the study’s findings still hold, but work better when a one-year lag is used.

In “The Cross-Section of Expected Stock Returns” (The Journal of Finance, June 1992), Eugene Fama and Kenneth French published data showing an inverse relationship between returns and valuations. Average monthly returns ranged from 0.30% for the decile composed of stocks with the highest price-to-book (P/B) ratios to 1.83% for the decile composed of the lowest P/B ratio stocks. Fama and French calculated average returns for the period of July 1963 through December 1990 for their study.

Inker updated the data and shared his findings in the February 2014 GMO Quarterly Letter. He concluded: “If we just look at traditional value for stock selection—good old price/book as enshrined by Fama and French—the cheapest 10% of the market has outperformed the broad market by 2.5% per year since 1965. Sounds fine, but since the original Fama/French paper was published in 1992, the group has actually underperformed by 1.6% per year. The same group lagged one year outperformed by 3.5% per year since 1965, and since 1992 has outperformed by 2% per year. You can see similar patterns in sectors as well. In most cases lagged value either works better than portfolios based on current data or works almost as well.”

What Inker is referring to is buying the stocks whose P/B ratios ranked in the bottom decile one year ago (stocks whose valuations were lower than 90% of all other stocks last year), instead of buying those stocks that now appear in the bottom decile. His rationale for doing so is based on momentum. A stock becomes very cheap because of selling pressure (downward momentum), and the selling pressure may continue for a while. By using lagged valuation data, an investor allows time for the downward momentum to end.

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Two Notable Mutual Fund Trends

Posted on February 6, 2014 | Investor Update

Yacktman Focused (YAFFX), a fund we recently deleted from the AAII Model Fund Portfolio, is one of a relatively small group of value-oriented mutual funds to close last year. When a mutual fund closes, it either stops accepting investment dollars from new investors or stops accepting any new investment dollars, be it from new or existing shareholders. Some funds may partially close by removing themselves from broker networks and requiring new investors to directly go through the fund. The latter is what the Sequoia Fund (SEQUX), which I own, did for a while before completing closing its doors to new investors at the end of last year.

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No Tradable Signal From January’s First Five Days

Posted on January 9, 2014 | Investor Update

One indicator, the “First Five Days,” suggests the S&P 500’s full-year returns can be determined by how the index performs during the first five days of the year. If the first five days are positive, January’s returns will be positive and the calendar year will end with a 12-month gain. According to the Stock Trader’s Almanac, the last 40 up First Five Days were followed by full-year gains 34 times.

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