Friday, October 1, 2010

HFT: The Real Double Dip

I was misinformed. I guess the stock market is not about effective allocation of capital. It's about the search for a millisecond speed advantage or a smarter algorithm. Utilizing human capital, some of our most talented, for the development of sophisticated computer games that extract fractions daily from financial capital under the guise of adding liquidity.

Excerpts from a CNBC article:

The rapid-fire growth of high-frequency trading, HFT, has spawned a new breed of market mavens whose backgrounds are far different than the traditional suit-clad Wall Street titans. 

Their resumes are rich in rocket science and other non-financial fields and they may never have traded a stock, read an earnings report or scrutinized a balance sheet.

They are engineers, mathematicians and computer scientists...

The article later added this about new programs being offered at top universities. A masters degree in Financial Engineering is apparently available through NYU. Here's what Allan Maymin (a recent graduate now working as a quantitative analyst) said in the article:

"The future of Wall Street, in my mind, is computer on computer action...Humans come in, they check their stuff daily, and it's just computers battling intraday."

A masters degree in Financial Engineering? Computer on computer?


There's been lots of talk about the risks of a double dip recession but this situation is a real but very different kind of double dip. 1) A drop in the productive use of intellectual capital, and 2) a reduction in our financial capital as a larger than necessary portion of our savings and investment is converted into the additional frictional cost associated with all this useless activity.

Equities are investments in an uncertain future stream of cash flows, created by an entity over a long period of time, via productive tangible and intangible assets. Some involved in HFT have said their typical holding period is measured in seconds. Even if measured in minutes it's obvious that the fundamental outlook of a business does not change that often. So HFTs don't need to be informed or interested in things like the fundamental economics of what they are buying and selling. The time frame is too short to matter.

The question is: Why do we need 70% of daily volumes generated by participants uninformed and uninterested in the fundamental economics of the equities they are trading?

Isn't that likely to increase mispricing?

More importantly, increase the misallocation of capital?

Now, it turns out a highly temperamental Mr. Market that tends to misprice and misallocate creates opportunities that actually make investing long-term easier for the patient individual. A capable person with the stomach for it who knows how to value a business can do just fine with the current system. So what's the problem, right?

Well, I just happen to think the fact that an individual can still generate favorable returns misses the point.

To me, the question is does the advent of participants involved in things like HFT increase or decrease the effectiveness of our system of capital allocation overall. I maintain that you cannot have a good system with that many participants unaware of the underlying economics of what they are buying and selling. Larger than necessary distortions will occur. I am not suggesting that the temperamental nature of markets will be going away anytime soon. I'm just saying it's foolish to have a system of capital allocation with so many participants not anchored by the economics of the things they are buying and selling.

Also, as the article points out, many of the participants involved in these mostly non-productive activities are PhDs, physicists, engineers, mathematicians, and other scientists. Certainly this cannot be the best use of their talents.

I see little benefit and big costs. Not all these costs can be quantified but that doesn't make them unimportant.

"You've got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there's no precise numbering you can put to these factors. You know they're important, but you don't have the numbers. Well practically (1) everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they're taught in academia, and (2) doesn't mix in the hard-to-measure stuff that may be more important. That is a mistake I've tried all my life to avoid, and I have no regrets for having done that." - Charlie Munger in a speech at UC Santa Barbara

Some examples of those costs whether they can be measured or not:
  • Less effective allocation of intellectual and financial capital
  • Dollars, intended for capital formation, instead being converted into income (what Grantham points out is a "raid" of the balance sheet. )
  • Reduced confidence in the capital formation process
The capital formation center that is our equity markets should be driven by informed capital allocators who make/lose money based on the quality of their individual economic judgments. Rewards should come from dollars committed over a long period of time and the average holding period today of 6 months just doesn't cut it (and if the holding period is measured in seconds well that is just silly). Today, creating an algorithm or approach that can outrun/outsmart the other guy and committing dollars to very very short-term bets is increasingly the emphasis. I'm sure it's a blast and do not blame anyone who does it given the current rules. I just think changing the rules of the game to re-focus market participants on actual capital formation and allocation makes sense. Activities that facilitate providing capital to an existing business or some useful new idea should be the priority with an emphasis on longer term outcomes.

If it were my call I'd alter the rules and incentives at work here. It's a dumb use of talent and drain on capital as far as I'm concerned.


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