Skip to Content
US Videos

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.

Be Thankful for High-Frequency Trading

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.

<TRANSCRIPT>

Glaser: How about the argument that this is creating a lot of instability in the market? We look at the flash crash where a lot of securities almost went to zero, and there was some computer trading what was blamed for this. Do you think we could see more instability because of the rise of high-frequency trading?

Lee: Definitely. Whenever you have computers operating very quickly, more quickly than humans can react, then there are going to be these instances of flash crashes, flash melt-ups, and that's just a part of technology. I think that with flash crashes, they say that it reduces investor confidence in the market, but that seems like a very vague, amorphous criticism of high-frequency trading. If you are an investor, you actually want flash crashes because you can actually buy things more cheaply. So I think flash crashes and whatnot are not problems that most investors have to worry about.

One way to avoid taking it on the chin during a flash crash is just to use limit orders and not ever use a market order. So these are very manageable problems that I think are very small in relation to the benefits that high-frequency traders bring to the table.

Glaser: If you are an individual investor, should you care at all about high-frequency trading? Should you be writing your congressman and trying to get the SEC more involved, or should you just kind of chalk it up to potentially another transaction cost that you can't really control?

Lee: Actually, you should be thankful for high-frequency trading, especially if you're an active participant in the markets because high-frequency traders have made bid-ask spreads extremely narrow. And so if you are buying shares of Microsoft, for example, you're going to get a very, very good execution. The people high-frequency traders really hurt are smart, informed hedge funds, hedge funds that have private information about how a stock is going to move. So if you're, say, David Einhorn or Bill Ackman, you can no longer put a $10 million trade in without some high-frequency traders figuring out that, "Hey, this is a smart investor who's trying to buy up a lot of shares. Let me move prices up a little bit." That's efficient market at work.

High-frequency traders actually make the market more efficient. They're really hurting traditional hedge fund managers, smart money, who before could actually move big chunks of money without necessarily moving prices, but that came at the cost of the other people on the other side of the trade, who didn't have that information. Overall it's actually a good thing; you should be thankful as an individual investor. If you are a big hedge fund, it's not a nice thing.

That's why you see these people, these hedge fund managers coming out against high-frequency traders, and Michael Lewis has actually done a weird thing where he's made this into an issue where it affects the little man. So that is these hedge funds and these hedge fund managers manage money for pensions, 401(k)s, and whatnot, and if they are being hurt, by extension, the individual investor is being hurt invested in that. That doesn't seem very plausible to me.

Glaser: Sam, thanks for your thoughts on high-frequency trading today.

Lee: Thanks for having me here.

Glaser: For Morningstar, I'm Jeremy Glaser. 

ETFInvestor Newsletter
ETFInvestor Want to hear more from Sam Lee? Subscribe to Morningstar ETFInvestor for fresh ideas for income and total return plus a bird's-eye view of valuations around the globe, portfolio construction advice, and data on the biggest and most popular ETFs. One-Year Digital Subscription

12 Issues | $189
Premium Members: $179

Easy Checkout

Disclosure: Morningstar, Inc.’s Investment Management division licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

Sponsor Center