How Concerned Should You Be about a "Rigged" Stock Market?


Unless you have been hiding under a rock the past few days, you have doubtlessly heard about Michael Lewis’s new book, Flash Boys: A Wall Street Revolt. Perhaps you saw the Sixty Minutes interview of Lewis along with the primary protagonist of the book, Brad Katsuyama, or if you are an NPR addict, then you may have heard the even more detailed 37-minute interview. Needless to say, if you are CNBC watcher, then you got to hear both sides of the story and you may have even been waiting for them to have a go at each other with fisticuffs.

Putting aside Lewis's premise that with the advent of high-frequency trading, the stock market is now rigged, we do take issue with what he claims are the implications. In the NPR interview, for example, Lewis says, “Every time your retirement fund trades in the market, some high-frequency trader is skimming pennies from each trade, and it adds up to who knows, 10, 20—no one quite knows, many billions of dollars a year. It’s essentially a tax on your investment dollars. So you’re essentially being legally robbed from by the system.”

Well, if that’s not enough to make your blood boil and get you writing to your congressman, then we can’t imagine what is. And just who are these high-frequency traders anyway, aside from this evil cabal of the nightmare offspring of a marriage between software geniuses and Wall Street sharpies? As financial journalist Andrew Ross Sorkin points out, “Mr. Lewis argues that high-frequency traders, with their unfair advantages, are putting the little guy’s pension fund in jeopardy. That may be true, but only partly: Where do you think high-frequency trading firms are getting the money to invest? Pension funds. So it gets complicated very quickly.”

Yes, complicated it is indeed, which brings up a whole different worry about high-frequency trading—the potential systemic risk to the market as a whole. A commonly invoked example is the infamous Flash Crash of May of 2010 which began with a good-old-fashioned fat finger trade error. Lewis implies that the Flash Crash might have been just a taste of the calamity that could result from the on-going battle of the competing algorithms spinning completely out of control. Interestingly, when Fama and French were asked about the Flash Crash, they had this to say about it:

"We have yet to see evidence demonstrating that high frequency trading caused the Flash Crash. Apparently, many high frequency traders stopped trading when prices became erratic. To the extent that these traders are important liquidity providers, their withdrawal would have amplified the effect of unbalanced buy and sell orders. To go further and say they 'caused' the Flash Crash, one would have to argue that other liquidity providers were no longer around to offset unusual price pressure because they had been displaced by high frequency traders."

Getting back to the question of whether you should be concerned about the “billions” that are being legally skimmed from trades on a regular basis? Our answer is it depends on what kind of trader you are. In all the examples we have seen in the past few days of reporting on this issue, it is the seeker of liquidity who gets scalped and not the provider of liquidity. What we mean by “seeker of liquidity” is someone who is looking to buy or sell a certain stock at certain time and at a certain price. Specifically, it is someone who is willing to cross the spread between the bid and the offer price in order to get immediate fulfillment, and it is that person or entity that gets “front-runned” by the high-frequency traders.  Our point here is that neither you nor your “retirement fund” needs to be that person or entity.

Dimensional Fund Advisors (DFA) pioneered what they refer to as a patient and flexible approach to trading. When one of their funds has cash to deploy, the traders are given a list of dozens of names, any of which can be bought. They are considered substitutable. Furthermore, once a particular stock is chosen (which would include consideration of how favorably it is trading), there is no requirement to buy the whole position in a single transaction. It is this flexibility with respect to both securities and time that allows DFA to be a provider of liquidity to the market, and as such, its trades end up being a source of profit to shareholders. On a regular basis, DFA commissions a study of its trading operations by the Investment Technology Group (ITG). This study is not limited merely to explicit trading costs such as commissions and spreads, as it also considers implicit costs such as opportunity costs and market impact. Based on their analysis of DFA’s execution prices in light of the executed trades immediately before and after DFA’s trades, ITG estimated that value added by DFA’s patient and flexible approach to trading relative to its peer group. Please note that the numbers below refer to individual trades only and not to the overall returns of the funds.

Trading Costs (gain/loss) for Twelve Months ending 9/30/2013

Asset Class Median Peer Group Member DFA DFA Advantage over Median Peer Group Member
U.S. Large Caps -0.27% 0.20% 0.47%
U.S. Small Caps -0.61% 0.60% 1.21%
International Developed Markets** -0.47% 0.55% 1.02%
Emerging Markets -0.62% 0.72% 1.34%

*Source: Dimensional Fund Advisors
**This number includes the U.S. component of global funds.

In all four categories above, ITG found that DFA was at the top of its peer group. A question one may be tempted to ask is if DFA actually adds value through their trading, then why not increase the amount of trading they do in their funds to add even more value? The answer is that trading minimally is one of the keys to being a liquidity provider to the market. And that is what we advise for anyone who is not a high-frequency trader—to trade only when necessary. The market already has 52 weekends and ten holidays per year, so what is stopping any of us from giving it 364 days where we choose not to trade?

While we support all thoughtful efforts to end legalized front-running (including the establishement of stock exchanges with safeguards against it), we ask that legislators and regulators take extreme caution in how the new rules will be written, as even the most well-intended legislation and market regulation can engender unintended consequences. Lewis does a superb job of explaining how rules enacted after the crash of 1987 unintentionally created the environment for today's front-running. Furthermore, we absolutely oppose the repeatedly floated transaction tax as a costly and unnecessary friction in the market. To be clear, none of us wants to go back to the days of human market makers and “specialists” who regularly collected on 13-cent spreads (not to mention the 5% "industry standard" commissions collected by the brokers), making today's high-frequency traders look like pikers. With fully computerized trading, spreads and other trading costs are now far lower, which is a benefit for all of us. Like Lewis, we fully accept that our nostalgic vision of the market with the open outcry trading pits is gone for good. However, for those of us who understand how the market can work for us when we get invested properly using low-cost funds that trade minimally, stay disciplined in our investment program, and let the professional traders battle only each other over their milliseconds, microseconds, and nanoseconds, well, change is good.