Welcome to the Machine: High-Frequency Trading Domination
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.Key Points
- Market volatility has spiked, starting with 2010's flash crash and culminating in this year's wild August, bringing asset-class correlations up with it.
- High-frequency trading and the use of leveraged exchange-traded funds (ETFs) are the primary culprits, but the impact isn't all bad.
- What are regulators doing and saying about the phenomenon?
The Flash Crash of 2010. The wild week in August when Standard & Poor's downgrade of US debt hit. Triple-digit last-hour moves becoming the norm. Turbocharged high-frequency trading firms are in the crosshairs of investors and the Securities and Exchange Commission (SEC). But are they really to blame? Over the past couple of months, it's become apparent that this new type of institutional trading is a big concern of individual investors—and it's a hot topic at client events at which I've spoken, so here's my take:
HFT defined
High-frequency trading (HFT) is a program-trading platform that uses high-speed and ultra-powerful computers to transact a large number of trades at very fast speeds. HFT uses complex algorithms to analyze multiple markets and execute orders based on market conditions.
Trading speeds are measured in milliseconds (thousandths of a second), and even more recently in microseconds (millionths of a second) and nanoseconds (billionths of a second). The twinkle in technologists' eyes is picoseconds (trillionths of a second) in a "race to zero." The goal, of course, is to make a (typically) small profit on each trade.
HFT firms are usually trading their own capital and rarely hold positions overnight. Some try to add "alpha" (outperformance relative to a benchmark) by using unique trading strategies, while others are more passive—often just trading the spread between a bid and an offer price.
Dominating trading volume…
According to several sources, including TABB Group, Aite Group and Thomson Reuters, HFT now accounts for between 55-75% of trading volume on average, with some days even higher. You probably remember the second week in August when the market had one of its wildest rides in history. I certainly remember, as I was on a vacation that turned into a non-vacation.
…and elevating volatility
On August 8, the Monday after S&P downgraded US debt, the Dow Jones Industrial Average fell by 635 points. Volume on the New York Stock Exchange was the fourth highest on record. TABB estimates record profits of $60 million that day for HFT firms. The bottom line is that any time trading firms are making millions while the majority of investors are either getting killed or simply watching market action with horror, it's going to generate attention.
Pros and cons
The proponents for HFT claim that it brings more liquidity to the market while keeping transaction costs low via narrowing bid-ask spreads, and a recent study by the Capital Markets Cooperative Research Centre of Australia supports that view. But there are plenty of studies that refute the aforementioned benign characterization of HFT.
One such study was completed last November by Yale Professor X. Frank Zhang, who found that "HFT is positively correlated with stock price volatility" and that it's "especially strong for the top 3,000 stocks in market capitalization and stocks with high institutional holdings." Zhang's most condemning find is that "the positive correlation between HFT and volatility is also stronger during periods of high market uncertainty."
You can see the latest increase in volatility in the chart below.
Volatility Elevated
Source: FactSet, as of October 14, 2011.
You can also see the unprecedented increase in asset class correlations, for which there's a longer history than volatility, in the chart below.
Correlation Elevated
Source: The Leuthold Group, as of September 30, 2011. Average 60-month correlation of monthly changes in S&P 500 with monthly changes in: Morgan Stanley EAFE, Gold, CRB (Commodity Research Bureau) Raw Industrials, 10-Year Treasury, one-Year Treasury-Bill Rate, Broad Foreign Currency Index.
Volatility and correlation are related
In times of high market volatility, stock movements tend to be more correlated and the link has grown increasingly strong since the mid-2000s. That was when regulatory reform encouraged financial exchanges to switch from floor-based trading to electronic trading.
Two things have happened since then that are coincident with the emergence of trading-platform fragmentation and HFT. First, as noted, volatility and correlations have both been higher. Second, the slope of the volatility/correlation curve is steeper, meaning that a rise in volatility today has a more pronounced impact on correlations than in the past.
HFT seems to have reduced bid-ask spreads (and thus transaction costs) in less-volatile times, making markets work more smoothly. But it appears to have done the opposite in more-volatile times, adding to market stress and amplifying volatility.
Diversification is dead …
This increase in correlations is throwing for a loop the notion of diversification in investors' portfolios as a way to minimize risk in volatile markets. If all asset classes are moving in tandem, the power of diversification is lost. This is the reason for the now-popular characterization of market action over the past several years as "risk-on/risk-off" trading, and HFT has undoubtedly been a factor in this phenomenon.
…long live diversification!
I'm often asked about this relatively new highly correlated market and whether it's a fixture of the future or a fluke of the unique environment we've been in since the financial crisis erupted three years ago. I lean toward the latter view and still believe that investing based on longer-term fundamentals will still be rewarded, and that diversification is not dead.
One of the things that high correlations do bring is the opportunity to find mispricings amid coordinated movements. It's simply the case that the fundamentals are very different among the riskier asset classes, and within asset classes among individual securities. When everything's moving in tandem, investors can look for securities, industries, sectors or asset classes whose movements aren't justified by underlying fundamentals. It may not be a strategy with an immediate reward, but should serve investors well in the longer term.
HFT and ETFs
The other facet of HFT dominance is its use of certain vehicles, notably ETFs. I'm a regular reader of TheStreet.com articles written about or by Doug Kass, founder and president of Seabreeze Partners Management. He opined recently on HFT firms' use of "leveraged" ETFs in particular, and it caught the attention of my friend Andrew Ross Sorkin, who penned an article on the subject in The New York Times.
Leveraged ETFs give investors the opportunity to bet on a basket of stocks, commodities or an overall index and have become very popular vehicles for traders generally and HFT firms in particular. It's estimated there's about $1 trillion invested in leveraged ETFs. Their attractiveness to HFT users comes from the fact that investors can bet long or short and leverage the bet, while also moving in and out during the trading day to lock in gains (or limit losses, which can be substantial). There are also "inverse leveraged" ETFs that go up when the price of the basket of goods goes down and vice versa.
Doug Kass calls these leveraged ETFs the "new weapons of mass destruction" as they've "turned the market into a casino on steroids." Leveraged ETFs have to rebalance their holdings each day to remain properly weighted, and they do so by buying and selling millions of shares within minutes. If a leveraged ETF made money that day, it has to reinvest the proceeds and leverage them again to remain balanced. This helps to explain many of the very wild, very large late-day swings we've seen in the market.
The view that HFT firms and their use of leveraged ETFs have wreaked havoc on markets has not gone unchallenged, though. William Trainor, a professor at East Tennessee State University, studied market volatility at the beginning and end of market days and concluded that ETF rebalancing had little to do with it. But Andrew Ross-Sorkin did his own (informal) poll of fund managers and virtually all agreed with the Kass view about both leveraged ETFs and the magnification of their impact from the use by HFT firms.
SEC et al. taking a look
In the meantime, I'm often asked whether there's any official scrutiny of the practices of HFT firms. In fact, US and European Union (EU) securities regulators are looking into whether ETFs and their use by HFT firms amplified August's wild swings in the market.
SEC officials are honing in on leveraged and inverse ETFs specifically, part of a broader look by regulators into exotic trading vehicles and HFT. In early September, prompted by August's market action, the SEC voted to open up a public dialogue about the use of derivatives by mutual funds and ETFs, among other things. The Dow Jones Industrial Average swung by at least 400 points on four consecutive days that month for the first time in its 115-year history. And as previously noted, many HFT firms posted huge profits during that volatile time. Expect to hear much more in the coming months from the SEC.
Across the pond, the EU is considering listing "specific examples of strategies using algorithmic trading and high-frequency trading" that should be banned outright and punished by regulators as market manipulation.
Layering, stuffing and spoofing
The Brussels-based commission is targeting "layering," in which traders place large orders they have no intention of putting through, and "quote stuffing," in which investors seek an advantage by delaying data feeds. "Spoofing," in which market participants try to trick other computers into making decisions that can be exploited for profit, would also be banned.
Steps are already being taken to stem abuses. Regulators in the United States and the EU have recently fined traders for using computers to gain advantage over slower investors/traders by illegally manipulating prices. They're also weighing new rules for HFT, with an international regulatory body to make recommendations to global leaders over the next few weeks. Even the HFT industry itself is cooperating, believing that although the majority of HFT is legitimate and lowers costs, it's in favor of policing the market to quell manipulation and support market stability.
The hoped-for benefit of this increased scrutiny and action is confidence among traditional investors in markets and the belief that we can all again play on a relatively level playing field.
Important Disclosures
Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.
Some specialized exchange-traded funds can be subject to additional market risks. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.
Leveraged ETFs seek to provide a multiple of the investment returns of a given index or benchmark on a daily basis. Inverse ETFs seek to provide the opposite of the investment returns, also daily, of a given index or benchmark, either in whole or by multiples. Due to the effects of compounding, aggressive techniques, and possible correlation errors, leveraged and inverse ETFs may experience greater losses than one would ordinarily expect. Compounding can also cause a widening differential between the performances of an ETF and its underlying index or benchmark, so that returns over periods longer than one day can differ in amount and direction from the target return of the same period. Consequently, these ETFs may experience losses even in situations where the underlying index or benchmark has performed as hoped. Aggressive investment techniques such as futures, forward contracts, swap agreements, derivatives, options, can increase ETF volatility and decrease performance. Investors holding these ETFs should therefore monitor their positions as frequently as daily.
Diversification strategies do not assure a profit and do not protect against losses in declining markets.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
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