High-Frequency Trading and Long-Term Investing

If you keep up with the financial news outlets, you’ve probably been exposed to the latest debates on high-frequency trading (HFT).  In Michael Lewis’ new book, “Flash Boys: A Wall Street Revolt,” he says that the stock market is rigged.  His reasoning for this incendiary statement is that high-frequency traders have the potential to see what trades are being placed and jump ahead of investors who placed the trades, profiting at their expense.  To be clear, these high-frequency traders are not human beings, but computers utilized by HFT firms.

Before I get to some of the more detailed nuances of this heated debate, let’s get right to the point and ask the question: “What impact does high-frequency trading have on long-term investors?”

In my opinion, almost none.  

It’s hard to tackle a subject like this without igniting strong emotions, no matter what side of the argument you’re on.  HFT firms and their proponents argue that overall trading costs are being driven down and liquidity has dramatically increased because of their participation in the market.  Opponents argue that HFT firms have an unfair advantage over most institutions and individual investors because of their superior speed and access to information.

Personally, I don’t like the idea of these firms having any advantage over the individual investor; but these arguments are not black and white. The global markets have become so complex and digital in nature that nobody has been able to provide a clear answer as to what actual impact HFT has had on investors.  We know that HFT firms have speed advantages over the individual investor and even most institutions, pensions and endowments.  They accomplish this speed in three ways:

1) Placing their computer servers next to those of the stock exchanges (expensive real estate)

2) Using ultra-fast digital pathways, including fiber-optic cables, microwave towers and even laser beams

3) Buying proprietary data feeds from the exchanges (not unique to HFT firms)

In “Flash Boys,” Lewis explains the effect of high-frequency trading by analogizing it with placing an order to buy concert tickets.  In the example, he explains that there are four adjacent seats available on the concert ticket exchange, StubHub, at $20 a ticket.  The concertgoer places the order to buy the four tickets for $20 a piece, but a confirmation comes back saying only two tickets have been purchased.  At the same time, the price of the remaining seats has risen to $25.  So, the insinuation is that the HFT firm has jumped in front of your stock order, thereby driving up the prices.  Obviously this is an exaggerated example – the price differential in stocks will be pennies, not dollars in share prices.  The HFT firm might get $25.01/share as opposed to $25.02/share.

HFT firms are looking to make moves in large trade blocks (like pension funds, banks, and endowments).  An individual investor placing an order is not going to run into a HFT firm.

And contrary to what’s been said in the media, the speed advantage alone is not enough for HFT firms.  Their software and algorithms don’t “know” for certain that the share blocks will be bought at an exact price, but they are essentially making a bet based on their information.  They win some, they lose some.  Inevitably some HFT firms are much more successful than others.

One of the most controversial arguments is that high-frequency trading is a form of insider trading in the digital age.  Insider trading means having access to material, non-public information before it reaches the rest of the market; like the announcement of a new product or acquisition.  This argument has merit, although their advantage seems to come more from networking speed rather than inside company information.

I am not in any way defending HFT firms;  I think that their practices and ethics should be investigated extensively.  There is so much that we don’t understand, and until we do, practical regulation is not possible.

So, now that we’ve waded through the weeds of high-frequency trading let me get back to my main point.  As long-term investors should we be concerned with HFT firms and their impact on the markets?  Only to the extent that they are found doing something illegal or unethical, just as a company executive engaged in insider trading would be convicted under the law.  Other than that it should have zero impact on a long-term investing strategy.

I’m not concerned in the least with fractions of seconds or $0.01/share price discrepancies.  I guess if I were an active trader jumping in and out of stocks all day maybe I’d be concerned.  But day trading was a loser’s game for most who attempted it before the advent of high-frequency trading, and the odds are probably even worse now for the individual investor.

I think Michael Lewis’ assertion (that the stock market is rigged) is ridiculous.  I know he’s trying to sell books, but that kind of statement could lead to uninformed investors abandoning the market altogether and missing out on long-term gains unlikely to be matched with other investments.  Since the bottom of the market in March 2009 stocks (S&P 500) are up over 200%.  That’s a pretty big payday for anyone investing in the so-called “rigged market.”  I’m confident that any young investor today could put money in a good stock mutual fund, fall asleep for twenty years, and wake up much wealthier.  And yes, in some form or other HFT firms will exist.

The market is just a vehicle to buy and sell shares in companies.  Good companies will always persevere over the long-term and reward patient investors, regardless of the exact share price you paid for it.

–Mike Minter, CFP®, CFS®