Distortionary Investing

I’ve been catching up on some academic literature from some respected finance professionals (call me sad if you like, but you’re the one reading about somebody else who reads academic literature)…

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.

Luddites unite

I’m almost too tired to blog. Now you may ask “What on earth could leave Natan too tired to have an opinion?” Well, I have just finished reading a sixteen page interview with the principals at Themis Trading.

One again these self-proclaimed defenders of “fair markets” make dozens of claims about how exchanges, brokers and high-frequency traders are conniving to screw both retail and institutional investors. Here are some of my favourite excerpts:

• “But, let me be clear. We have no inside knowledge of these[HFT] firms. This is just what we hear in the market.”
  Dare I say that this could be a weakness in their position?
• “We have May 6 now to prove that HFT doesn’t increase market liquidity.”
  Strikes me that it also proved that the market isn’t particularly liquid when electronic market makers are forced out by stale data and unresponsive exchanges.
• “They provide it [liquidity] when they want to, not when the market needs them to. And only if their profit is virtually guaranteed… They are also liquidity demanders. Thesame guys who provide liquidity when they want to also demand liquidity when they need to. On May 6, they demanded liquidity.”
  Firstly, I imagine there are some HFT folks who will be delighted to know that their profits are virtually guaranteed. Secondly, what point are they making – that HFT firms trade for profit?
• “The basic problem, in our view, is the for profit exchange model, which is filled with inherent conflicts of interest… Traditionally, the exchange business wasn’t really very competitive, almost utility-like”
  Hang on, now I’m the one being blamed? They didn’t like exchanges when they were uncompetitive and slow, and they don’t like them competitive and fast. I know corrolation does not prove causation, but I think there might be an argument that a profit motive and competition amongst exchanges has spurred innovation, driven efficiencies and lower costs. I think their point is that because HFTs trade the most volume, exchanges are more likely to cater to their needs than to those of institutional brokers (or end investors) - which they support with...
• “Well, because we are not on the inside of these robots’ algorithms and their trading strategies to see exactly what’s going on, nor are we involved in the meetings in which we believe the exchanges are complicit in so much of what’s going on, it’s hard for us to come back with specifics when defenders of HFT say, “Oh, you don’t have the data to back it up.””
  So they’ve insulted HFTs, accused the exchanges of being complicit, what next – suggest that every other broker on the street is also involved in the great conspiracy?
• “Most institutional algos use a smart router to route orders in small pieces throughout the day. The pecking order of these routers differs depending on which broker sponsors the algo. But a common goal is to always route to the least expensive destination first. Most of the time this means routing to a dark pool before routing to a displayed liquidity venue."
  Aha, no surprise there then. Well, European MTF dark pools are more expensive than lit pools, so the argument that brokers use them to reduce costs doesn’t stack up. And in such a competitive environment, nor does the suggestion that the majority brokers act against their clients’ best interest – if that were true, Themis would be a large brokerage house rather than just “two or three guys”.
• On the OrderID and Side-of-aggressor data from dark pool data fees they say
  “By the way, they did get rid of them awfully quick overseas after we called attention to them. They were able, technologically, to do it in a heartbeat over there when some institutions started to boycott their European dark pools. Though, frankly, we’re a little skeptical that they took out everything we’d find objectionable if we had the regulatory power to comb through their records.”
  I’m sceptical they care about the truth – but it’s important to note that they don’t need any “regulatory power” – our public feeds are exactly that – public. So come and take a look.
• “Almost everyone else seems to have a vested interest”
  Really, I’m lost for words.
  

I guess an informed debate is too much to expect?

I'd welcome your comments...