market forces

Q&A with IFA: Front Running and Fair Pricing

market forces

Question: What is the relation, if any, between the practice of "front running" trades and the efficient market hypothesis?

Note: The question above was taken from DFA’s Fama/French Forum. Here is their response:

“First, if front running is profitable, there must be information in the trade that is not already in market prices. Thus, security markets must not be perfectly efficient. Second, if front running speeds up the rate at which a specific piece of information is brought into the market, we might even say it improves market efficiency. More generally, however, we have to consider how front running affects those who are gathering information and trading on it. If the threat of front running reduces their incentive to collect information, front running makes markets less efficient.”

To review, front running occurs when someone has advance knowledge of a large trade that is about to hit the market and profits by trading ahead of that trade. For example, if a broker knows that his high net worth client wants to buy 100,000 shares of Apple, then the broker could buy a few thousand shares for himself before placing the client’s order, and after the client’s order has moved the price up, the broker would sell his few thousand shares and pocket a tidy profit. That is traditionally what we think of as front running, and it is 100% illegal (and unethical to boot). In the wake of Michael Lewis’s Book, Flash Boys: A Wall Street Revolt, there has been a lot of chatter about high frequency trading and the potential for high frequency traders (HFTs) to engage in a sophisticated yet legal form of front running that is made possible by the HFTs ability to get ahead of everybody else by just a few milliseconds. In this article, we addressed the question of how investors should behave in a market that Lewis alleges is “rigged”.

There is no question that since Fama published his Efficient Market Hypothesis in 1965, advances in technology have allowed markets to become incredibly fast at incorporating new information. Even two seconds has been shown to be more than sufficient for the market to fully price in a widely followed report such as the Consumer Confidence Index compiled by the University of Michigan. Even when the market receives new information that was totally unexpected, it is fully digested in a few minutes.

The other important long-term trend that has occurred over the past few decades is the decline of the cost of trading. Gone are the days when brokers charged the “industry-standard 5%” and spreads of 13 cents (i.e., an eighth of a point) were perfectly normal. Also gone are the specialists and market makers who essentially operated a tollbooth where they collected from both buyers and sellers. The asset managers of those days would probably have sold their children to gain the opportunity to trade in a system where the biggest worry is HFTs collecting their penny (or fraction thereof) per share.  To be clear, the market has never been a level playing field, particularly for small investors who choose to speculate rather than invest.

In our opinion, the cost of HFTs legalized front running is simply not high enough to discourage people from analyzing securities to determine if prices are out of line with intrinsic values. Once a discrepancy between price and value exceeds the limits of arbitrage, market participants will act to eliminate it, and the limits of arbitrage are much lower today than they were in the days when trading was done in the pits via open outcry.