How High-Frequency Trading Benefits Most Investors

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
April 8, 2014

1. March Unemployment Report – The Good, Bad & Ugly

2. High-frequency Trading Actually Helps Most Investors

3. Our “ALPHA ADVANTAGE” Webinar Wednesday, April 16

Overview

A controversial new book came out in late March that lambastes so-called “high-frequency trading” on the major stock exchanges and claims that such computerized trading robs retail investors of good executions and profits on their stock orders. The book, “Flash Boys: A Wall Street Revolt,” was written by former bond salesman turned author, Michael Lewis, who appeared on CBS’ 60 Minutes on March 30. Since then, his book has stirred up quite the controversy among stock market investors.

Mr. Lewis has joined other critics who say that the booming high-frequency trading field, in which computers buy and sell stocks at lightning speed to take advantage of minute changes in prices, has essentially rigged the market against small investors. Lewis and other critics charge that high-frequency traders are essentially “front-running” investors’ orders – a practice that is otherwise illegal.

Today, I will make the counter-argument that high-frequency trading is actually good for retail investors in that it greatly increases trading volume, narrows “bid-ask” spreads and enhances trade execution for most of us. I’ll cite a recent example wherein the Toronto Stock Exchange restricted high-frequency trading and overall market volume plunged by 30%, thus resulting in worse trade executions for most individual investors.

As a result of the latest high-frequency trading controversy, these groups are being investigated by the FBI, the SEC, the New York Attorney General and of late, the Justice Department, and I’m all for that. There probably are some abuses that need to be eliminated. Yet I hope the regulators will not make the assumption that all high-frequency trading is bad for retail investors, as Mr. Lewis concludes.

Before we get into our lead discussion on high-frequency trading, let’s take a look at last Friday’s unemployment report for March. The report was initially declared quite positive, but the more we drill down into the details, the worse it looks. I’ll break it down for you just below.

Finally, I am pleased to announce that our next webinar – “HWM Alpha Advantage” will be on Wednesday, April 16th at 2:00 PM Eastern.  This webinar will outline our new program that combines multiple trading strategies with low correlation into a single investment account.  This informative presentation will explain how the strategies used in Alpha Advantage work exceptionally well together, and how combining them in a portfolio can potentially increase returns significantly and reduce the overall risk of the portfolio.  

March Unemployment Report – The Good, Bad & Ugly

Last Friday’s jobs report for March was initially hailed as good news because the Bureau of Labor Statistics reported that 192,000 new non-farm jobs were added last month. That was better than expected by many forecasters and was well above the 175,000 jobs created in February. But companies almost always hire more workers in March when the weather warms up. The official unemployment rate held steady at 6.7% in March.

The other encouraging news, if we can call it that, is the fact that “total private” employment finally inched above the previous peak in early 2008 when the Great Recession was starting to unfold. As you can see below, total non-farm, private sector jobs climbed to 116.1 million in March. That’s good news in that it was better than in recent months, but it has taken us six years to get back to essentially breakeven with 2008.

Employment is Recovering

Here’s another way to look at it. The chart above represents only the number of non-farm private sector jobs. If we add to that number the roughly 21.9 million government jobs we have today, the country has a total of 137.9 million jobs overall. Yet that number is well below the total number of jobs we had back in 2008 of 138.5 million. That’s a deficit of apprx. 600,000 jobs.

So six years after the start of the downturn, our economy is still roughly 600,000 jobs shy of where it had been, mainly because government at all levels has been forced to cut back workers in austerity moves.

Now let’s look at the labor force participation rate. This number represents the percentage of the total population that is either working or actively looking for work. The number actually ticked higher in March to 63.2%, but take a look at the longer-term trend:

But Participation is Down

Labor force participation rates increased from the mid-1960s through the 1990s, driven largely by more women entering the workforce, Baby Boomers entering prime working years in the 1970s and 1980s and increasing pay for skilled laborers. But over the past decade, these trends have leveled off, and the participation rate has fallen sharply, particularly in the aftermath of the last recession.

The question is, will the participation rate recover to the levels seen in the 1990s? Probably not in the next 20 years or longer. A late 2012 study by the Federal Reserve Bank of Chicago found that about one-quarter of the decline in labor-force participation since the start of the Great Recession can be traced to retirements.

Yet Baby Boomers retiring can’t be the whole story, though, since the participation rate has declined for younger workers too. This part of the drop is a function of various factors, including simple discouragement, poor work incentives created by public policies, inadequate schooling and training and a greater propensity to seek disability insurance. Globalization and technological change have also reduced employment and wage growth for low-skilled workers. These trends are not likely to change anytime soon.

The fierce debate now going on in Washington about extending unemployment insurance and raising the minimum wage largely ignores these issues. Such policies may affect the incomes of some Americans, but they won’t do much to expand opportunity and bring more people back into the labor force. But I’ll leave that discussion for others to debate.

High-Frequency Trading Actually Benefits Most Investors

A controversial new book debuted last week entitled “FLASH BOYS: A Wall Street Revolt” written by former bond trader turned author, Michael Lewis. Mr. Lewis was recently interviewed on CBS’ 60-Minutes program. The book, which focuses on “high-frequency trading” (HFT) has gotten a great deal of attention since then.

High-frequency traders use sophisticated technical tools and computer algorithms to rapidly trade securities. These traders use proprietary trading strategies carried out by computers to move in and out of positions in fractions of a second.

High frequency tradingHigh-frequency traders move in and out of short-term positions aiming to capture sometimes just a fraction of a cent in profit per share on every trade. It is estimated that high-frequency trading now accounts for almost 50% of the volume on major US stock exchanges.

Mr. Lewis’ new book has turned a harsh spotlight on the world of high-frequency trading. He has joined other critics who say that this booming field, in which computers buy and sell stocks at lightning speed to take advantage of minute changes in prices, has essentially rigged the market against small investors. Lewis and other critics charge that high-frequency traders are essentially “front-running” investors’ orders – a practice that is otherwise illegal.

This makes for a gripping narrative, and a strong populist message. But the issue is not nearly so clear-cut, as I will explain below. High-frequency trading may be annoying to large institutional investors like pension funds and mutual funds, but it is actually a real benefit for most retail investors.

These advantages were demonstrated in a recent experiment initiated by Canada’s stock market regulators. In 2012, Canadian regulators limited the activity of high-frequency traders by increasing the fees on trading orders sent by all broker-dealers, such as trades, order submissions and cancellations. This affected high-frequency traders the most, since they issue many more trade orders than other market participants.

The effect, as measured by a group of Canadian academics, was swift and startling. High-frequency traders immediately started to reduce their number of trade orders. The number of trade orders sent to the Toronto Stock Exchange swiftly dropped by 30%, and the “bid-ask” spreads rose by 9%, an indicator of lower liquidity and higher transaction costs.

The conclusion of what happened when Canada effectively curtailed HFT is obvious: the reduced high-frequency trading resulted in lower trade volume and worse execution prices for retail investors on both “buys” and “sells.”

However, if you are an institutional investor trying to buy and sell large blocks of securities without moving the price as you trade, then high-frequency traders are a pest. They swarm all over your trade, messing with the price and driving up your cost as you build up or reduce your position, often on multiple exchanges. Ultimately this affects the return on your trades.

But if you’re an individual investor, trading for yourself, high-frequency trading can help get you better executions, lower transaction costs and create a more efficient, dynamic market. Efficiency and dynamism are good things, especially if you’re a retail investor making a single trade at a time.

In a paper published last year, Terry Hendershott of Berkeley, Jonathan Brogaard of the University of Washington and Ryan Riordan of the University of Ontario Institute of Technology concluded that, “Overall, HFTs facilitate price efficiency by trading in the direction of permanent price changes and in the opposite direction of transitory price errors, both on average and on the highest volatility days.”

Critics also claim that HFT increases market volatility, pointing to the 2010 “Flash Crash” in which the Dow fell 9% before rebounding within minutes. But subsequent analysis by regulators and academics suggests that HFT played only a small role. This analysis found that high-speed traders were no more significant than any of the other market players who stampede for the exits when the unexpected happens. They just run faster than others.

In fact, they found that one reason the market rebounded so quickly that day was that high-frequency trading tends to correct pricing errors quickly. High-frequency traders can of course be overwhelmed in extreme situations, but so can buyers and sellers of every other kind.

Mr. Lewis’s charge that the complexity enabled by technology is leading to more market volatility can hardly be confined to high-frequency trading. These days there is scarcely a corner of the market not affected by the “algorithmic trading” of one kind or another, whether from HFT, hedge funds, mutual funds, ETFs or investment banks.

The bottom line: High-frequency trading should be investigated thoroughly by the various regulators; however, it should not be automatically assumed that reducing or eliminating HFT – and the huge daily trade volume they provide – will resolve the problems. Before outlawing high-frequency trading, it might well be worth investing more in fail-safe systems, trading curbs and/or circuit breakers to stop unwanted trading.

High-frequency trading creates a great deal of “noise” – millions of short-term trades – that are welcomed by some and despised by others. It makes sense to monitor it and perhaps regulate it more closely, as one should for any new innovation. But it would be a shame to silence it just because it challenges the best informed in the market – institutional investors – who might have to work a little harder at getting their large block trades executed at the prices they want.

But whether or not high-speed trading is sinister, revenues for these firms have been declining for several years. In 2013, they were about $1 billion, after peaking at around $5 billion in 2009, according to estimates by Rosenblatt Securities. If, as Lewis says, these traders are doing nothing more than ripping off the rest of the market, it’s a shrinking problem.

In any event, the latest controversy over high-frequency trading has sparked investigations that have recently been announced by the FBI, the SEC, the New York Attorney General and just last week, the Justice Department. And there is no question that high-frequency traders should be investigated thoroughly.

It will be very interesting to see how these investigations play out over the next several months. I’ll keep you posted. Finally, there is a very good article in the links below that offers a comprehensive explanation on whether or not high-frequency trading is illegal.

Our “ALPHA ADVANTAGE” Webinar Wednesday, April 16

Halbert Wealth Management (HWM) is pleased to announce that our next webinar – “An Impressive Strategy Combination for Your Portfolio” featuring HWM Alpha Advantage will be on Wednesday, April 16th at 2PM Eastern. The webinar will outline this new professionally managed program that combines multiple trading strategies with low correlation into a single investment account. 

This informative presentation will explain how the strategies used in Alpha Advantage work exceptionally well together and how combining them in a portfolio can potentially increase returns significantly and at the same time reduce the overall risk of the portfolio.  

Attendees to the webinar will see the impressive net annualized hypothetical return from August 2005 to February 2014 which would have been 23.4%, versus only 7.1% for the S&P 500 Index during the same period. Just as impressive, the worst drawdown (measured as of month-end) would have been only -13.8%, compared to -50.9% for the S&P 500.

(As always, past performance is no guarantee of future results. Be sure to read Important Disclosures below, including limitations on using hypothetical numbers and limitations on comparisons to Indexes before making a decision to invest.)

We are excited to present this webinar and share this combination of strategies that quite simply blew our doors off! Attendees will learn about this combination of strategies that together would have significantly outperformed stock market returns with considerably less downside risk as measured by drawdowns.

Register TODAY for this informative webinar. Space is limited.

Cliff Montgomery, President of Scotia Partners, LLC, will be our featured speaker for the webinar on April 16. His company is the Trading Manager for HWM Alpha Advantage. Cliff has been in the active money management business for many years.

Alpha Advantage is the hottest strategy combination I have seen in years. Following the presentation will be a Q&A period when you can submit any questions you may have. So I hope you will make plans to join us on Wednesday, April 16 at 2:00 PM Eastern. This is one webinar you don’t want to miss.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES

High-frequency trading’s revolutionary effect on the markets

Is high-frequency trading illegal? (very good)

IMPORTANT NOTES:  Halbert Wealth Management, Inc. (HWM) and Scotia Partners, Ltd. (SPL) are Investment Advisors registered with the SEC and/or their respective states.  Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors.  HWM receives compensation from SPL in exchange for introducing client accounts.  For more information on HWM or SPL, please consult Form ADV Part 2, available at no charge upon request. Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As a benchmark for comparison, the Standard & Poor's 500 Stock Index (which includes dividends) was used.  It represents an unmanaged, passive buy-and-hold approach, and is designed to represent a specific market.  The volatility and investment characteristics of this Index may differ materially (more or less) from that of this trading program since it is an unmanaged Index which cannot be invested in directly.  The performance of the S & P 500 Stock Index is not meant to imply that investors should consider an investment in this trading program, which is actively managed, as comparable to an investment in the “blue chip” stocks that comprise the S & P 500 Stock Index.   

The performance from inception through January 31, 2014 is hypothetical performance provided by SPL that was constructed using the actual performance numbers of multiple strategies used in this program, assuming approximately equal initial allocations to each strategy.  The amounts allocated to each strategy were rebalanced as the individual strategies move back into the cash position.  The hypothetical performance was reduced by the maximum annual fee of 2.5% on the first calendar day of each quarter.  From February 1, 2014 forward, the performance is from an actual account traded using the same strategy used in the hypothetical track record.  The maximum fee (2.5%) was deducted from the account, though not necessarily on the first calendar day of the quarter.     

This combined performance illustration through January 31, 2013 is hypothetical and not model results, and has many inherent limitations.  The limitations include: 1) there are often large differences between hypothetical performance results and the actual trading results achieved by a particular program; 2) hypothetical performance results are prepared with the benefit of hindsight; 3) hypothetical results may not reflect the impact that market or economic factors might have had on the investment methods if actual money was invested; 4) hypothetical returns do not reflect the actual performance of an account and may not be indicative of the Advisors’ ability to manage money; 5) other clients may have had materially different investment results; and 6) these numbers should not be used to predict future performance.

The performance numbers provided by SPL have not been verified by HWM, and therefore HWM is not responsible for their accuracy. Statistics for “Worst Drawdown” are calculated as of month-end.  Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.  Mutual funds carry their own expenses which are outlined in the fund’s prospectus.  An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results.  The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Alpha Advantage program.

In addition, you should be aware that (i) the Alpha Advantage program is speculative and involves a high degree of risk; (ii) the Alpha Advantage program’s performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Scotia Partners, Ltd. will have trading authority over an investor’s account and the use of a single program could mean lack of diversification and consequently higher risk; and (v) the Alpha Advantage  program’s fees and expenses (if any) will reduce an investor’s trading profits, or increase any trading losses.

Returns illustrated are net of underlying mutual fund management fees, and other fund expenses such as 12b-1 fees.  Management fees are deducted quarterly, and are not accrued on a month-by-month basis.  They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. The program trades frequently and most gains or losses will be short-term in nature. No adjustment has been made for income tax liability. Consult your tax advisor.  “Annualized” returns take into account compounding of earnings over the course of an investment’s actual track record. Dividends and capital gains have been reinvested.  Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss.  The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.


Read Gary’s blog and join the conversation at garydhalbert.com.


Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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