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Home>Research & Insights>Fund Times>What David Swensen Didn’t Write About Stock Trading Spreads

What David Swensen Didn’t Write About Stock Trading Spreads

His New York Times editorial was correct—as far as it went.

John Rekenthaler, 08/01/2017

Bad Eggs
My initial take on Michael Lewis’s 2014 best-seller, "Flash Boys," was respectful but skeptical.

Lewis, of course, is the leading chronicler of financial shenanigans, possessing deep subject knowledge along with his ability to spin a yarn. Clearly, Lewis had done his homework; he understood that book’s arcane topic, high-frequency traders. Using data that other investors do not receive, and technology that they do not possess, HFTs flit like mosquitoes, alighting to sip from other parties’ trades, then darting away before being seen.

(Star Trek fans may picture a different simile: the invaders of “Wink of an Eye". Worry not for Deela—she will evade that phaser blast.)

Lewis told that story well, and I believed him. My doubts came when he assessed the damage. That HFTs are parasitic is without question. Also unquestioned is the culpability of the stock exchanges, which, by accepting payments from HFTs in exchange for exclusive data feeds, sell out the interests of their other customers. The picture is not pretty.

Less-Bad Outcomes
However, aside from principles, it didn’t appear that HFTs harmed retail investors. HFTs extract much less than a penny per share when making their trades, meaning that they depend on very high volume to generate their profits. This makes them a danger to other giant traders, but not to the rest of us. An investor with $1,000,000 held directly in stocks and portfolio turnover of 50% will shed about $10 per year to HFTs. As scandals go, that’s not much.

(The math: $500,000 of stock sold per year, another $500,000 purchased, for a total of $1 million. Assuming a share price of $50—as good as any assumption—that means 20,000 shares traded. With Deutsche Bank estimating that HFT profits have dropped in recent years to one-twentieth of a cent per share, those 20,000 shares would yield $10 for the HFT.)

Indeed, the individual investor may well have ended up ahead on the deal. Although it’s not possible to measure HFTs’ effect on stock-market spreads directly, we do know that since HFTs began to surface, the average trading spread for the U.S. stock market has dropped significantly. Many if not most institutional investors agree with Vanguard CEO Bill McNabb’s perspective from a few years back, which is that HFTs have probably played their part in that success.

Thus, while I shared Lewis’s qualms, I couldn’t muster any real dislike for HFTs. Yes, they are are unprincipled. In that, they can join a very large crowd. If I became outraged each time people acted in self-interest, without regard to others, I would have a very long enemies’ list. The key point for me was that Lewis failed to make the case as to how investors were harmed, and therefore I shrugged off his book as being entertaining and informative, but ultimately not terribly important.

is vice president of research for Morningstar.

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