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By Samuel Lee | 04-03-2014 04:00 PM

Be Thankful for High-Frequency Trading

Despite the criticisms, high-frequency traders make the market more efficient, allowing for the viability of vehicles such as ETFs, says Morningstar's Sam Lee.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. High-frequency trading has been a hot topic of conversation recently, but should investors really care that much about it? I'm here today with Sam Lee, editor of Morningstar ETFInvestor, to see what the impact is.

Sam thanks for joining me today.

Sam Lee: Glad to be here.

Glaser: Let's start with just exactly what high-frequency trading is. It's not a new phenomenon but one that’s been talked about a lot recently. Could you describe kind of how the strategies work briefly.

Lee: High-frequency trading is what it sounds like. It's basically trading strategies that occur very, very quickly, and it's been around for decades. There's no one high-frequency trading strategy; there are multiple strategies that can involve market-making, arbitrage, and even some signal-based rules. You can't talk about high-frequency trading as one thing. It's a collection of many different strategies. Some are good, and some are bad. So the discussion has to move beyond this monolith.

Glaser: Let's look at the intersection of high-frequency trading and exchange-traded funds. Does it have a big impact in the ETF market, as it does in the stock market.

Lee: Definitely. The modern ETF can't exist without high-frequency traders. ETFs have a market price, and they also have an underlying net asset value--the prices of all the securities that the ETF holds. And the high-frequency traders are the people who are involved in making the market price of an ETF in line with its net asset value. So when you're investing in say the SPDR SPY, you are pretty much assured that it's going to be very, very close to the underlying value of the S&P 500 constituents because of these market makers making sure that the price is close to fair value.

Glaser: It sounds like for ETFs, most of these strategies are not a big problem then.

Lee: They actually reduce costs and make things a lot easier for most investors.

Glaser: Then what are some of these concerns that are being voiced? What are some of the strategies that are potentially hurting investors.

Lee: There are strategies that can hurt investors. Front running, that is anticipating when orders are going to come in and somehow getting an unfair advantage. But it's not clear how much front running is going on. So there's a lot of discussion that all high-frequency trading must be somehow front running. But Michael Lewis's book even admits that most of the money is not made in front running; it's made in what's called slow-market arbitrage. If a stock is listed on one price on one exchange and another price on another exchange, what the high-frequency traders do is they will sell the one that is higher priced and buy the one that's lower priced and bring those prices back in line. So that sounds like traditional arbitrage. That's a good thing.

The bad thing is: Is society served by having a bunch of math geniuses and computer science geniuses sitting around thinking about ways to shave off milliseconds from this arbitrage process? And hundreds of millions of dollars go into making this process slightly faster, and there is an arms race about it. There are no real benefits to having prices move a millisecond faster.

I would say that's probably the bigger, less considered cost, that society is diverting very smart people who could be out doing serious work in science and making them optimize code to make this arbitrage occur a little bit faster. And that seems kind of pointless to me.

The discussion I think is more sensibly centered around what is the optimum amount of resources that we want to devote to arbitrage within the high-frequency area, and what are ways to perhaps reduce the brain drain that's going on into these high-frequency strategies.

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