Beware High-Speed Trading’s Hidden Cost

Interview2I was interviewed this morning about how to discuss the high-frequency trading controversy (on account of a new book by Michael Lewis and related publicity) with clients. The resulting article from ThinkAdvisor is available here. I hope you will read it. A quick snippit follows.

ThinkAdvisor: So in a sense, ordinary investors are barely harmed by this latest Wall Street scandal?

Seawright: That’s the insidious part of it. It’s not something that you readily see. You hit enter on your order and you get filled in part or filled at two different prices and the assumption always was, “Well, that’s where the market was.’

And the reality is that is where the market was, but the market was there because somebody stepped in between really, really fast.

For retail shops like ours it’s not a [significant] issue because our orders aren’t big enough that’s somebody’s going to step in front of them. If somebody’s buying 100 shares of something, there’s not enough money to be made stepping in front.

But when a client owns a mutual fund, and the mutual fund is trading shares, and somebody steps in front of that, it matters significantly to the portfolio as a whole, and by extension it matters to some extent to investors: 2 cents a share is a rounding error, and I get that.

On the other hand, the high-frequency trading firms are spending hundreds of millions of dollars to get another couple milliseconds of an advantage. Clearly it’s a real advantage to them, and that money’s coming from somewhere. That money is coming out of our clients, mutual fund clients and everybody else that’s involved in the market, and that ought to concern all of us.

Beware High-Speed Trading’s Hidden Cost

What Trade Hurts the Most People?

Leading IndicatorBack in my trading days, we often played What If?, a game that took a real or supposed major event and called on the players to postulate what would happen and, more importantly, what trade should be made in response. In his brilliant and acerbically funny book, Liar’s Poker, Michael Lewis describes playing What If? in light of the Chernobyl disaster and thinking “Buy oil” before being one-upped with “Buy potatoes.” It’s a terrific training exercise, requiring quick and multi-layered thinking. 

An off-shoot of What If? is to ask “What trade hurts the most people,” especially when the market seemed like a one-way street.  The idea is not that what seems highly unlikely is necessarily going to happen.  Rather, the idea is that when seemingly everyone is racing in one direction, the opposite is much more likely than appreciated and, if and when it does occur, it can do major damage for those who are 180 degrees wrong. 

When I was in New York recently, Josh Brown and I were asking that off-shoot question and agreed on the answer.  The trade that hurts the most people is the market continuing to grind higher. Continue reading

Paradigm Shifting

I grew up in the investment business in the early 1990s on the ginormous fixed income trading floor at the then Merrill Lynch in the World Financial Center in New York City.  It was a culture of trading and instant gratification. “What have you done for me lately?” covered no more than that day, often less. I frequently argued that we should consider the interests of our customers – among of the biggest investment managers, pension funds and insurance companies in the world – in our dealings so as to build long-term relationships and enhance longer-term profitability even if it meant making a little less in the near-term.

I got nowhere.

Liar's PokerWe called our accounts “clients” to their faces, and I thought of them that way, but they were customers at best and marks at worst to virtually everyone on the floor, and especially to our managers.  We didn’t call them “muppets” like the guys (and it was almost all guys then) came to at Goldman Sachs, but we may as well have. Our mission was clear.  We were to make as much money for the firm as we could as quickly as we could. Lunch was a long-range plan.  In his first and funniest book, Liar’s Poker, about our counterparts at Salomon Brothers, Michael Lewis got the tone, the approach and the atmosphere precisely right. Continue reading

Just Put the Ball in Play

On account of the success of Moneyball (both the book and the movie, nicely satirized here), baseball management is often compared to investment management, and with good reason. Moneyball focused on the 2002 season of the Oakland Athletics, a team with one of the smallest budgets in baseball.  At the time, the A’s had lost three of their star players to free agency because they could not afford to keep them.  A’s General Manager Billy Beane, armed with reams of performance and other statistical data, his interpretation of which was rejected by “traditional baseball men” (and also armed with three terrific young starting pitchers), assembled a team of seemingly undesirable players on the cheap that proceeded to win 103 games and the division title. 

Unfortunately, much of the analysis of Moneyball from an investment perspective is focused upon the idea of looking for cheap assets and outwitting the opposition in trading for those assets.  Instead, the crucial lesson of Moneyball relates to finding value via underappreciated assets (some assets are cheap for good reason) by way of a disciplined, data-driven process.  Instead of looking for players based upon subjective factors (a “five-tool guy,” for example) and who perform well according to traditional statistical measures (like RBIs and batting average, as opposed to on-base percentage and OPS, for example), Beane sought out players that he could obtain cheaply because their actual (statistically verifiable) value was greater than their generally perceived value. 

In some cases, the value difference is relatively small.  But compounded over a longer-term time horizon, small enhancements make a huge difference.  In a financial context, over 25 years, $100,000 at 5%, compounded daily, returns $349,004.42 while it returns nearly $100,000 more ($448,113.66) at 6%.

We live in a world that doesn’t appreciate value.  In the investment community, indexers are convinced that value doesn’t exist or can’t be reliably measured and most other would-be investors don’t have a good process for analyzing the data and are too focused on trading to recognize value when they see it.  While proper diversification across investments can mitigate risk and smooth returns within a portfolio, too much portfolio diversification (“protection against ignorance,” in Warren Buffett’s words) requires that value cannot be extracted. 

Similarly, behavioral finance shows how difficult it is for us to be able to ascertain value.  Our various foibles and biases make us susceptible to craving the next shiny object that comes into view and our emotions make it hard for us to trade successfully and extremely difficult to invest successfully over the longer-term.  Recency bias and confirmation bias – to name just two – conspire to inhibit our analysis and subdue investment performance.  Investing successfully is really hard.

To expand the idea (perhaps to the point of breaking), we must always resist the urge to trade – even a good trade – when investing makes more sense.  While I don’t mean to suggest that a one-off trip to Vegas for a week-end of fun can never be a good idea, too many trips like that can come between you and your goals and can thus be antithetical to a rewarding future.  My ongoing analysis of human nature suggests that we are not just subject to the whims of our emotions.  We are also meaning-makers, for whom long-term value (when achieved) can be fulfilling and empowering.  It simply (it is simple, but not easy) requires the process and the discipline to get there.  What we really need is not always what we expect or want at the time.

This point was driven home to me anew recently by the terrific movie, 50/50, written by Will Reiser about his ordeal with cancer.  As Sean Burns noted in Philadelphia Weekly, Reiser’s best friend was the kind of slovenly loudmouth that you’d usually find played in the movies by Seth Rogen, except that his best friend really was Seth Rogen.  Rogen’s fundamental, unexpected decency and supportive love grows more quietly moving as the film progresses.  Rogen was undervalued generally and his love and support provided great value to Reiser. 

As the cliché goes, nobody lies on his deathbed wishing he’d spent more time at the office.  We appreciate meaning and value more in the sometimes harsh reality of the rear-view mirror rather than in our mystical (and usually erroneous) projections into an unknown future.

All of which brings me back to baseball.  In today’s Grantland, Rany Jazayerli makes a persuasive case in his article, The MLB Prospect Bubble, that while teams once got great value by trading for minor league prospects, the landscape has changed such that prospects now tend to be over-valued. Note in particular his analysis of a recent trade involving Jarrod Parker (the prospect) and Trevor Cahill (the solid major leaguer), suggesting that in this instance Billy Beane got too cute by at least half:

Parker will probably rank somewhere around no. 30 when the Top Prospect lists are unveiled next spring. It will mark the fifth straight season that Parker ranked in the top 50 on Baseball America‘s list, which is itself a dubious distinction. But here’s the thing — in 2009, Cahill ranked no. 11. Cahill was judged to be a better prospect in his time than Parker is now, and Cahill has spent the last three seasons living up to expectations. How is it, then, that the A’s were willing to trade six years of Trevor Cahill for six years of Jarrod Parker?

It’s true that Parker’s ceiling is higher than Cahill’s, but if Parker were guaranteed to reach his ceiling, he wouldn’t be a prospect — he’d be a major league pitcher, probably an All-Star. Increasingly, teams have decided that they’d rather bet on that ceiling than take the guaranteed return.

Read that last line again: “Increasingly, teams have decided that they’d rather bet on that ceiling than take the guaranteed return.”

That’s a (a-hem) trade the I see all the time in the money management world because, after all, chicks dig the long-ball (oh the delightful irony): 


And it’s too bad.  Most investors would be well-served most of the time by resisting the urge to (over)swing for the fences in order simply to put the ball in play.  Reasonable returns together with loss mitigation is a powerful combination.  We should look for them, indeed value them, far more often.