Follow-Ups

Big Hat, Small Cattle
I wrote my initial column on Michael Lewis' book Flash Boys before reading the reviews. That was somewhat reckless because I knew little about high-frequency trading. Then again, who does? At least my errors would be original, rather than stale imports.

(Preferring fresh mistakes is not always the policy of book reviewers. Amy Chua, author of Battle Hymn of the Tiger Mother, says that the book's most infamous scene, when she locked her daughter in the basement on her birthday, never happened. Chua joked in the book about wishing to lock her child in the basement, an early reviewer misread, and future reviewers were, ahem, "inspired" by the first writer.)

That initial column seems to be standing up pretty well, though. The key argument remains intact: Although Lewis portrays high-frequency traders as defrauding small investors, HFTs bring benefits as well as costs, and the effect on the typical individual investor is very small.

That case is succinctly laid out in "Tempest in a Teapot: Michael Lewis' Flash Boys Solves a Problem that is Barely There," by Laurence Siegel. Unlike your author, Siegel has real credentials, currently serving as director of research for the CFA Institute and previously serving as research director for the Ford Foundation.

Writes Siegel, "Flash Boys is a terrific read, with dashing heroes and dastardly villains. But life isn't like that, and high-frequency trading is neither good nor evil. It's a new way of profiting from the trading activity of buyers and sellers of equities. It either raises or lowers total transaction costs by a small amount, but we have no way of knowing which."

In some ways, Siegel believes, high-frequency trading can be compared to cars.com. The latter also seems to incur additional costs. With cars.com, auto buyers must not only pay traditional dealers but also must indirectly pay a fee to cars.com (which receives a referral fee from dealers). That would be two charges where only one existed before, no? Well, no. Armed with better information, today's car buyers have become tougher negotiators and are paying lower overall commissions. Everybody wins except the traditional car dealer.

Similarly, states Siegel, there are times with high-frequency trading where "everyone wins except for the original market maker, who is knocked out of the game by this new, low-cost provider of what traders call liquidity."

High-frequency trading is not an unambiguous good. As Siegel points out, many HFTs are front-runners, which cannot be defended. That the overall economic effects are modest does not excuse the sin. Also, as I wrote in a second column, HFTs can be destabilizing. The stock markets have already suffered a few "flash crashes" sparked by HFTs; perhaps worse ones will follow.

I'll leave the final words to Siegel: "Lewis sounds as though he's discovered a cache of suitcase nukes stolen from the Russians by a gang of terrorists."

On (and Off) Target
MarketWatch's Chuck Jaffe shares my view that the SEC should adopt an easy solution for the long-standing issue of improving target-date fund disclosure. It's time to close that particular book and move forward. 

Writes Jaffe, "There's a remarkably simple solution available: make 'target-date' and 'life-cycle' meaningful terms. A target-date is 'to' the target date, ending with a portfolio appropriate for someone who's about 65 years old at that point.  A 'life-cycle fund' should take investors through to the end of their lives."

That beats my suggestion that target-date funds should depict their glide paths (an idea that Jaffe derides as "hypnotic but ineffectual"). The first type of fund does indeed have a target date, and the second type does indeed intend to carry investors through their entire life cycle. Well done, Mr. Jaffe. Let's formalize those two labels and make it so.

Jaffe also had the Morningstar research staff chuckling. When discussing consumer confusion, he writes "... with ratings firms like Morningstar having more than 50 categories for target-date issues ...” Curious, that. One might think that Morningstar is a "firm like Morningstar." However, Morningstar is in actual fact a firm unlike Morningstar, as Morningstar has 11 target-date categories. 

Spock: "Morningstar is like Morningstar. Morningstar is not like Morningstar. Please resolve."

Computer [voice rising]: "Like Morningstar. Not like Morningstar. Like Morningstar. Not like Morningstar. Like Morningstar. Not like Morningstar."

Spock: "Resolve."

Computer [now shrieking, with gray smoke billowing from its sides]: "Like Morningstar! Not like Morningstar! Like Morningstar! Not like Morningstar! Like Morning ..." [Bang! The computer explodes, belching dark black smoke and a flash of fire.]

[Brief silence]

Kirk: "Well done, Mr. Spock."

Yes, I know, I'll be receiving a lump of coal this December.

Righting the Ship?
For the first time in months, there's a whiff of good news--or at least acceptable news--at beleaguered PIMCO. Although flagship  PIMCO Total Return (PTTRX) is still trailing the competition and the Barclays U.S. Aggregate Bond Index for the year to date, it has rallied over the past month to place slightly ahead of each. That's not much by the fund's historic standards, but it certainly is a creditable showing under the very difficult circumstances.

Business prospects, too, have been less than feared. The Wall Street Journal's February expose started an avalanche of PIMCO coverage, including a story that Bill Gross had written about his cat in a shareholder letter, but it doesn't appear to have greatly increased investor redemptions. From the preliminary figures, outflows from the funds (I can't speak for the institutional, separately managed accounts) are similar to pre-story levels.

All in all, guarded optimism.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.