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Rekenthaler Report

About That Rigging ClaimBy John Rekenthaler | 04-01-14 | 08:00 PM | Email Article

High DudgeonMichael Lewis has taken the high moral ground. In publicizing his new book on

high-frequency traders, Flash Boys: A Wall Street Revolt, Lewis has dominated thisweek's investment news, first with Sunday's 60 Minutes interview and then with along excerpt in The New York Times . In both the interview and the Times article,Lewis claims that the U.S. stock market is "rigged."

Uh-huh.

To judge from the Times excerpt (I have not yet read the book), Flash Boys isLewis at his mesmerizing best, detailing how high-frequency traders, or HFTs,burrowed into the marketplace, operating so quietly and surreptitiously that eveninvestment giants like T. Rowe Price and hedge fund giant David Einhorn did not

realize what was occurring. They knew that their trades were not getting processedas they expected and that something odd was happening, but they did notunderstand why.

We learn that HFTs profit through an information advantage. Even if simultaneously placed on every stock exchange, trade requests do not arrive ateach exchange at precisely the same moment. The length of the data transmissionwiring between the broker who places the order and the exchange varies, whichgives the HFT its feeding opportunity. In the very short amount of time that ittakes light to travel the extra distances between the exchanges, HFTs pounce.

As an example, consider a large buy order for Microsoft (MSFT) at $41.50 thatarrives at the first exchange. An HFT will read that order, will anticipate that thisbuy request will temporarily boost Microsoft's stock price, and will place its ownbuy order for Microsoft at $41.50 at the remaining exchanges. A micro-fraction of a second later, the initial buy order arrives--but can no longer be filled. There is noremaining Microsoft stock selling at $41.50. It now costs $41.51 or $41.52.

Is that rigged?

It is in a trivial sense, in that HFTs extract profits from the system in a way thatyou and I cannot. In that aspect, however, HFTs are neither new nor unique. Stockmarket makers, who profit by supplying liquidity, in a fashion that you and I

cannot match, existed long before HFTs were invented. So, too, did retail stockbrokers, who were protected from stock commissions until 1975, and who even fordecades after that served as unavoidable toll collectors. Want to buy a stock? Paythe toll.

Thinking SmallHowever, there is a difference between HFTs and previous profit extractors: TheHFT effect is smaller.

Indeed, for the retail investor who holds stocks directly, it's not clear that there areany effects at all. HFTs don't care if you place an order for 100 shares of Microsoft

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or even 1,000 shares. They care about larger orders, of the size that typicallycome from institutions. So, if you purchase a stock directly, at the usual individual-investor levels, you're probably not triggering an HFT response.

Even at the institutional level, the bill is very modest. Lewis cites the test case of atrade of 10 million Citigroup (C) shares. The savings from eliminating HFTs fromthe trading process was $29,000--less than a penny per share. Not all that longago stock prices were quoted in 8ths, or 12.5 cent increments. In every trade,

market insiders extracted that spread. Now stock prices for large, liquid companiesare quoted by the penny, with perhaps another penny or so captured by HFTs. If that is a bad thing, by all means let's have more bad things.

In fact, many fund managers tell Morningstar researchers that HFTs are a good thing. As with traditional market makers, HFTs provide liquidity in exchange for afee. However, the liquidity that HFTs provide is very high, which has helped toenable the shrinkage of stock spreads, and their fees are relatively low.

Thus, setting aside the trivial case, HFTs might well be an improvement ontradition--a de-rigging of the stock market, so to speak.

The Little PeopleThere is one party, though, that appears to have been significantly hurt by HFTs:hedge funds. Hedge fund performance has plummeted since the mid-2000s, whenHFTs came to prominence. There are several reasons why, including the possibilitythat before HFTs were hatched, hedge funds were the de facto micro-traders, usingtheir superior resources and technology to beat retail day traders.

In the 60 Minutes story, Lewis cites a hedge fund manager who claims to havesuffered a 3.3% annual loss at the hands of HFTs--$300 million in leaked profits ona $9 billion fund. Now that is a real loss; given such an example, it's easy to seewhy hedge funds would be unhappy.

That said, it's a bit rich, to say the least, to see hedge funds leading the charge inthe cry for stock market equality and against the system being set up to rewardinsiders. All right, it's more than a bit rich, it is corpulently so. It's also rich thatLewis' lead sources for Flash Boys are the principals at a new brokerage firm (IEX)that was created to outflank HFTs. That company benefits if investors believe: a)HFTs are bad; b) HFT effects are big; and c) those who are opposed to HFTs are onthe right side of truth, justice, and the American Way.

Those are the parties speaking for the everyday investor in alleging that the stockmarket is rigged--hedge funds, a new brokerage firm, and an author who relays

their story. On the opposing side, former Vanguard chief investment officer GusSauter wrote in 2012, "Net-net we're better off with HFT than without. Individualinvestors have benefited more than institutional money managers." I mean, really.Deciding whom to believe is not a difficult call.

Don't let that deter you from reading the book. It is sure to be entertaining as wellas instructive about the abstruse world of stock trading. And IEX may indeed be auseful invention that further squeezes stock trading costs. But rigging? Toparaphrase Peter Lynch, 10 minutes per year thinking about that is five minutestoo many.

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Final note--Felix Salmon of Reuters shares many of my views on this topic. Theideas are independently derived, as I read his column after completing this one,but there certainly is overlap--and as Salmon published first, the overlap should benoted.

John Rekenthaler has been researching the fund indust ry since 1988. He is now a columnist for

Morningstar.com and a member of Morningstar's investment research department. John is quick

to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his

views are his own .

John Rekenthaler is Vice President of Research for Morningstar.

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