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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