Sensible Perspectives


Posted by on July 10, 2014

I’ve had the great good fortune to read a number of Michael Lewis’ books, including some on financial topics, like Liar’s Poker and The Big Short, some on sports (The Blind Side and Coach) and one on the financial side of sports (Moneyball). I think he is an outstanding storyteller, and his books often make a deeper and more important point than the underlying story would seem to allow. His books show more than they tell.

Flashboys: A Wall Street Revolt is his most recent book, and it has received a good deal of press.

The New York Times Magazine published excerpts, and there has been a lot of discussion elsewhere, including the Financial Times and Morningstar online. Lewis made the talk show rounds, too, and rated a segment on 60 Minutes. Finally, Brad Katsuyama (the hero of Flashboys) and the president of BATS (one of the villains) debated on CNBC.

I won’t attempt to summarize the book here – Lewis writes much better than I do, and I wouldn’t be able to do the story justice. I will say that you can learn a lot about High Frequency Trading (HFT) from Flashboys – who the traders are, how HFT works, and something about why it might matter. Just as importantly, you will probably have fun doing it. Like every other Michael Lewis book I’ve read, it’s a great read. There are interesting characters and several well-integrated storylines. Finally, the book flows well. I found it hard to put down, and I read it in one sitting.

When you finish the book, however, you will likely have a number of unanswered questions, and all of them really boil down to one: is HFT a threat to me as a saver and investor? The short answer to that question is no, at least not in the way that Lewis suggests.

There are two reasons.

First, in contrast to Lewis’s contention that the market is “rigged,” HFT appears simply to be unnecessary intermediation. That is, as Chris Rice (head of State Street Global Advisors’ $10-billion-dollar-a-day global trading operation) observes “some HFT firms appear to … be using their speed advantage to … insert themselves between buyers and sellers who would have found each other anyway.”

For example, suppose a buyer is willing to pay $95.01 per share for Apple stock (ticker AAPL), and a seller is willing to accept $94.99. Before they find each other and execute the trade (say at $95.00), a high frequency trader jumps in to “help,” buying from the seller at $94.99 and selling to the buyer at $95.01, pocketing the $.02 per share that the buyer and seller might have divided otherwise. The high frequency trader isn’t necessary to the process, and adds no value for the money he or she extracts. However, there is no distortion in the sense that “rigging” suggests: the trade would have occurred anyway, and the right thing happens: the seller sells the shares, and the buyer buys them.

Therefore, the impact of HFT on your ability to trade is nil. If you place a buy order, and there is a seller willing to sell shares for less than you are willing to pay, you will get those shares.

Second, the cost to you is small. Lewis estimates the HFT to all traders in US markets at $160M per day, or $40B (billion with a B) per year. That seems to be a very large number until you realize that the annual stock trading volume on US markets is $56T (trillion with a T). That works out to roughly 7 basis points, or 7 cents per hundred dollars traded.

This applies, however, only to stocks (and ETFs – mutual funds that trade like stocks). Bonds don’t trade in the national market system, and neither do traditional mutual funds. I’ve estimated that the cost for the average Sensible Financial® portfolio last year was roughly 4 basis points, or 4 cents per hundred dollars of assets in the portfolio. On a hundred thousand dollar portfolio, that is roughly $40, on a million dollar portfolio, about $400. If you have more bonds in your portfolio, it was a bit less (not zero, because some of your bonds are probably held through ETFs); if you have more stocks, a bit more. Annoying, but unlikely to affect your ability to accomplish your goals.

By the way, as a number of commentators have pointed out, the costs of trading today, even after the extra HFT costs, are much lower than they were in the not-too-distant past. Investing may not be costless, but even with HFT, it’s pretty darn close.