Friday, September 16, 2011

Capital Markets: An Overshadowed Servant to Traders?

"Unintended, yet permitted advantages within market structure have come to dominate and overshadow the true intent of the capital markets - to facilitate the allocation of capital from investors to businesses. The market has become a servant to short-term professional traders, in particular high-frequency traders ('HFT')." - Mason Hawkins of Southeastern Asset Management

With those thoughts as context, consider what John Bogle had to say in this The Motley Fool interview. In it, he explains why buying and holding is the winner's game and trading the loser's game.

Traders by definition bear the costs that goes to the intermediaries (croupiers) and achieve less collectively than the market return. Participants who buy and hold largely do not bear those costs and therefore capture the market return.

Now, check out this new survey on the impact of high frequency trading on the equities market:

Liquidnet's Institutional Voice Survey polled traders worldwide from Liquidnet's community of 630 institutional asset management firms.

Seth Merrin, Liquidnet's CEO said that:

"The survey reveals that there is strong conviction among the vast majority of long-only traders that HFT is a negative for institutional investors trading in large size..."

Merrin also said:

"Investors are clearly concerned that their long-term investment styles are at odds with the speculative, nano-second profit taking approach utilized by high frequency traders."

According to independent industry research analysts Aite Group and Tabb Group something like 75 percent of daily trading in equities comes from high frequency.

So we've got the machines trading back and forth all day. Even if most HFT practices are legit the question remains how is any of this useful? The SEC is, in fact, currently reviewing some of the high frequency trading practices that...

"...if executed in slower motion by conventional traders, would look a lot like front running, bid fishing or other practices that have long been banned by leading stock exchanges." - From the latest Davis Funds Semi-Annual Review

Below is a continuation of the excerpt I opened this post with from a letter to the SEC written by Mason Hawkins and colleagues regarding HFT (a letter well worth a full read for background):

"The market has become a servant to short-term professional traders, in particular high-frequency traders ('HFT').  As a result, the long-term  investor - whether an individual, mutual fund, or hedge  fund - incurs  unnecessary execution and opportunity costs when allocating capital to businesses. Unfair competition and structurally advantaged short­-term professional traders ultimately prevent the markets from reaching their  end goal.  If obfuscation clouds public debate and sidelines reform, many confidences that bona fide investors have in the capital markets may be irreparably harmed. 

The argument for change is predicated upon several fundamental premises: 

1. The markets do not exist as an end in and of themselves; 
2. The markets exist to facilitate capital allocation, transferring capital from investors to productive businesses that can provide a return on that capital; 
3. 'Trading efficiency' as defined by HFTs (e.g. increased speed, increased 'liquidity', price  'improvement') is not straightforward, nor is it an end, and has merit only if it improves the capital allocation process; 
4. Practices that implicitly 'tax' the allocation of capital or result in investing inefficiencies must be eliminated; and 
5. Markets should be fair, open, and accessible to all with the first obligation being  to uphold the interests of long-term investor."

How all this activity benefits anyone beyond high frequency traders and the exchanges is beyond me.

Charlie Munger says it best...

"Fancy computers are engaging in legalized front-running. The profits are clearly coming from the rest of us -- our college endowments and our pensions. Why is this legal? What the hell is the government thinking? It's like letting rats into a restaurant." - Charlie Munger

Charlie Munger's Thoughts on the World: Part 1

It's not exactly just some academic problem. These weaknesses are costly and will become even more so over the longer haul. It makes no sense to allow HFT and other short-term oriented behaviors to continue to tax and infect the capital allocation process.

Capital markets have historically been an advantage for the United States. It's too important to not reform.

Adam

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