Apparently, there is a group of market participants that don’t care about the true value of the companies they trade. They buy or sell without doing any analysis of fundamentals underpinning stock prices. They pay no attention to news of information flow. And they’re prone to exacerbating market trends (amplifying volatility). Left unchecked, these rogue participants will undermine efficient price formation to the detriment of all market participants, and ultimately weaken capital formation in the real economy.
Maybe you think I’m talking (again) about high frequency traders (I know, I’ve being doing so a lot recently, but there’s just so much being said on the topic that I don’t believe to be true). Actually, I’m talking about the buyside – and more specifically, index managers and momentum managers.
To quote a 2005 paper titled “Momentum and index investing: Implications for market efficiency” by Professor Ron Bird and colleagues;
- “The future outlook for market efficiency looks bleak. Arguably, index and momentum investors together represent a large segment of the investor universe, and both are responsible for pricing inefficiency. Perhaps policymakers can do something at the margins to induce more fundamental investing by lowering barriers to arbitrage. We, however, remain pessimistic, distortionary investing seems to have taken on a momentum of its own.”
Of course, fears that passive management would take over the world (often made by active fundamental-based managers trying to sustain higher fees) proved to be a little overblown. Predictions about a supposed threshold for indexed assets (as a % of overall market cap) beyond which price formation would break down proved groundless.
Why did I dismiss these arguments at the time?
- Firstly, I was never convinced that fundamental investors had a common view of ‘fair price/value’ – so even in a world of only active managers, it didn’t seem controversial to suggest we’d still see price swings in response to trading volumes. And if that weren’t the case, then there would likely be insufficient volumes to allow investors to enter/exit positions.
- Next, even if indexers or momentum investors were driving prices away from fair value, to me this seemed essential to creating opportunities for (supposedly) smarter value and contrarian investors/traders to provide liquidity at the margins. I figured that active managers should have seen (supposedly) dumb indexers and momentum investors as the sucker at the table.
- And lastly, at least with respect to index investors, it seemed odd to suggest, irrespective of the proportion of total assets indexed, that they could seriously impact price formation given their buy & hold (forever) strategy. Prices move in response to supply and demand, and if they don’t trade (except when stocks enter/exit the index), then they don’t influence price formation.
So is today’s debate simply history repeating itself? It’s certainly not that straightforward, but the comparison is amusing.
- Indexers invest, but don’t trade, whilst some HFT firms (who end the day flat) trade, but don’t invest. So indexers don’t really influence supply or demand at all, whist HFT firms influence supply and demand equally across the course of the day.
- I’m yet to see any solid statistical evidence that HFT firms exacerbate intra-day volatility. Equally, comparing the Spanish market (where competitive trading remains a pipe dream) to others in Europe, Cheuvreux recently reported (in their Navigating Liquidity paper, appended as annex here) that they found no evidence of HFT firms reducing intra-day volatility. This suggests to me that there is a balance between momentum-based HFT strategies (that amplify volatility) and reversion strategies (that dampen volatility). In other words, to the extent that HFT firms are amplifying volatility, there are institutional brokers and other HFTs developing trading strategies that exploit this.
- And despite the shrill nature of complaints about HFT in the blogosphere, most buyside firms and brokers I talk to are more sanguine. They recognise the improvements to market efficiency that competition amongst markets has delivered, and they fully understand lower trading costs have lead to a growth in high frequency strategies. They’re prepared to work with their brokers to evolve their trading strategies to cope with the new market context. The most thoughtful and informed article on the topic I’ve read of late is here on Institutional Investor.
In the highly competitive exchange/MTF environment in which we find ourselves in (both in the US and in Europe), it’s probably fair to say that, just as lower frictional costs have helped the growth of HFT volumes, so the growth of volumes from HFT firms have been an important factor in allowing markets to lower their tariffs. Any substantial reduction in volumes could force an increase in tariffs, with the danger of kicking off a vicious circle of lower volumes and higher costs – impacting brokers and investors alike. I think that would be a bad trade – although I’m prepared to listen to (coherent) arguments to the contrary.
As ever, I welcome your feedback.
P.S.
- Turquoise was the largest non-display midpoint MTF during the month of June, surpassing Chi-x for the first time. Thank you to those of you who helped us achieve this milestone. Our integrated (displayed) order book volumes are also increasingly often ahead of BATS in certain segments – particularly mid-cap indices such as the MDAX and FTSE250.
- We have now confirmed the timing of our migration to the Millennium Exchange trading platform. Please see the market announcement OP/271/10 under the ‘Operational’ section.
