Tuesday, October 11, 2011

The Disproportionate Role of ETFs and Algorithmic Trading

From this recent article by Doug Kass:

"The proximate cause of our so-sick and volatile market is not the eurozone crisis nor the ambiguity of our domestic growth trajectory; moves such as yesterday are made and exaggerated by intraday reweighting of leveraged ETFs and by the disproportionate impact price-momentum-based, high-frequency trading strategies."

Later in the article Kass added the following:

"I am convinced that, in the fullness of time, the SEC will recognize the damage that has taken place in our markets.

I am equally convinced that, by the time they do, it will be too late.

Kill the quants before they kill us."

Yesterday, Joe Saluzzi of Themis Trading had this to say about high speed trading on CNBC:

"What happened is we've gotten hijacked. Our equity markets are supposed to be a capital formation process to help small companies get bigger..."

Saluzzi asserts that high speed traders have taken over the markets and turned it into, more or less, a casino. If the bulk of the added volatility is in fact caused by some of these "innovations", then we are still making a big costly mistake not putting some safeguards in place.

We live in a world still influenced by flawed ideas like efficient market hypothesis (EMH). Even after decades of seemingly rather incontrovertible evidence refuting things like EMH, you'll hear statements spoken with confidence by market participants along the lines of:

"price is truth", and

"markets don't lie, people do."

I don't doubt that historically the market has been, at times, a better than average indicator of future economic outcomes. Yet, extending that to a belief that the market's price action provides a form of wisdom that always trumps all other judgments makes little sense.

Somehow, according to this thinking, a rather temperamental Mr. Market can reliably foresee the future.

Really?

With, at least by some estimates, 75% or more of trading volume now being driven by high frequency traders, how in the heck can market movements be providing reliably meaningful signals?

Now, even if you buy it has historically had some ability to anticipate, how does all this short-term oriented hyperactivity improve its ability to foresee? Any chance some of the recent changes make it less reliable and, more importantly, less stable? To me, it seems likely to provide lots more emotion driven false signals than it ever did historically.

Before the modern form of the capital markets came to be, Warren Buffett and Ben Graham have described the market and its participants with less than flattering words and phrases:

"The market is a psychotic, drunk, manic-depressive selling 4,000 companies every day. In one year, the high will double the low. These businesses are no more volatile than a farm or an apartment block [whose values do not swing so wildly]." - Warren Buffett at Wharton*

"...fractional-interest purchases can be made in an auction market where prices are set by participants with behavior patterns that sometimes resemble those of an army of manic-depressive lemmings." - Warren Buffett in the 1982 Berkshire Hathaway (BRKa) Shareholder Letter

"...Mr. Market suffers from some rather incurable emotional problems; you see, he is very temperamental. When Mr. Market is overcome by boundless optimism or bottomless pessimism, he will quote you a price that seems to you a little short of silly." - Benjamin Graham in The Intelligent Investor

The idea we want to take our cues from something that temperamental has always seemed hilarious to me. So, by its very nature, the market has never exactly been a stable beast. Yet, the amount of daily price movements we see in the modern iteration of capital markets makes the behavior Graham and Buffett were attempting to describe look rock solid by comparison.

These days, James Montier of GMO describes the situation as "the investment equivalent of attention deficit hyperactivity disorder".

We got by okay back then with a temperamental market so what's the big deal if it is a bit more volatile, and a bit more likely to misprice these days?

Well, we've obviously allowed some things to evolve, even if incidentally with the best intentions, that amplify the inherently temperamental nature of markets. The resulting feedback on the real economy is significant. It serves few, hurts many.

It's costly because businesspeople and consumers interpret the amplified market volatility in a way that can meaningfully affect investment and consumption behavior.

It's costly because hyperactivity inevitably drives unnecessary frictional costs within the system. These frictional costs from all the turnover certainly add up:

The "Invisible Foot"

It's also costly because the job of capital formation is likely to be done poorly. More mispriced assets, increased misallocation of resources.

Our markets operate below potential when it comes to their primary purpose: to facilitate the allocation of capital from investors to businesses.

Finally, why are we aspiring for our markets to function only as well as they have in the past? I know of nothing else like that. Shouldn't we be trying to improve them in terms of their primary purpose in life? I mean, Ford (F) isn't working hard to bring back the Model T nor is Apple (AAPL) going to bring back one of their "classic" computer designs anytime soon. As James Grant wrote in his book Money of the Mind:

"Progress is cumulative in science and engineering, but cyclical in finance."

Cyclical at best.

Some argue that our macro problems are now somehow worse than what we've seen historically and that explains the volatility. So I guess then one has to believe that the current macro problems are somehow materially greater than the things that happened in the past century?

Last I checked we had some pretty tough moments (a couple of world wars, the cuban missile crisis, and too many financial crises to list etc.) last century yet, during those times, volatility in the markets didn't even approach what we've seen this year.

Check out the so-called 'all or nothing days' in this post for some recent (the past 20 years) context.

High Frequency Trading: Tail That Wags the Dog

This situation certainly creates opportunities for the disciplined investor but that's not my focus here.

The economy already has some large challenges, to say the least, but these flaws in the capital markets are unnecessary, self-inflicted wounds that are likely making difficult problems even more so.

The capital markets serve us, not vice versa, and they can be redesigned to serve us better. There's no question, at least to me, that a 2.8 month average holding period is symptomatic of short-termism gone wild, computers or otherwise, with material consequences.**

There's little doubt that real damage is being done and many have an opinion of what's at the root of it. Yet, while it is likely that high speed trading and leveraged ETFs is part of the problem, until more unbiased analysis is complete, there is no way to know what's really the biggest contributor.

Time will hopefully tell, with some rigor and focus, what proportion of the damage being done is the direct result of high speed trading, leveraged ETFs, removal of the uptick rule, or some of the other recent financial "innovations" and market structure changes.***

Once we better understand the real root cause(s) it needs to be fixed yesterday as far as I'm concerned.

Adam

Long AAPL

* Based upon notes that were taken at a 2006 Wharton meeting.
** The average holding period has dropped to something like 2.8 months these days down from around 2 years in the 1980s and more like 4 to 8 years from the 1930s to the 1970s.
*** By experts with no material conflicts of interest, of course.
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