Is High Frequency Trading Evil?

The recent publication by Michael Lewis of a book, Flash Boys, that is critical of High Frequency Trading (HFT) is wrong. The cost of other problems such as excessive fees or bad trading decisions or bad spreads or tax traps, or risk that zero percent Federal Reserve controlled rates rob retirees of their ability to retire is far, far greater.

Of course two wrongs don’t make a right. However, the HFT adds liquidity thus lowering investors’ costs. When critics of HFT complain that the price offered wasn’t really available they are talking in terms of the exact price, surely at a slightly worse price the non-HFT investors would be able to make a trade. During the days of stock market specialists and market markers the spreads were much higher. The possibility exists that if a stock is quoted as $100.00 bid and $100.02 ask and then when your order arrives in the market the HFT moves the price up a few pennies so you have to pay $100.08. The HFT may be making a profit off of your transaction but basically they are providing liquidity and doing so at a far lower cost than traditional 1% bond spreads or the 2.25% spread between bank savings rates versus bank lending rates.

Which is worse, to pay 6 cents to the HFT per $100 for a trade or to deposit $100 in a bank earning 0.5% when a more fair and just yield on a bank account rate might be roughly 2% and thus suffer a 1.5% opportunity cost as a bank depositor? How about an annuity with a 10% commission which reduces your income correspondingly? Or what about paying taxes so that farmers can get a subsidy and then consumers pay artificially high prices for milk because of price controls on milk? What about real estate where the commission is 5% and the transfer tax maybe 1%.

What if an investor cavalierly buys a stock during a bubble and overpays by 70%? Currently proponents of the PE10 theory and Tobin’s Q maintain stocks are overpriced by roughly 70%. That is a far greater cost than paying for HFT.

Securities markets originally were very illiquid and thus had huge spreads between buyer and seller. Over a century enormous progress has been made to make publicly traded securities tradable with minimal frictional costs such as the spread between bid and ask.

Investors should do the following to reduce costs:

  1. Use no load open end institutional class mutual funds with low to moderate fees. These funds have no bid/ask spread and have one price for everyone at the end of the day.
  2. Try to hold on to an asset at least a year to minimize trading cost and income tax.
  3. Don’t buy individual bonds because spreads are huge.
  4. Avoid owning overpriced bubbly assets. By not owning these at the top of the market you may be able to reduce the risk of a crash and in the case of mutual funds that may reduce the risk of getting distributions, which usually occur at or just after a top.
  5. Be careful not to overpay for tax advantaged investments such as Cash Value Life Insurance or Annuities. These can be a worthy tool if evaluated carefully but if the tax savings are eaten up by insurance company fees then you haven’t made any progress. Also annuities can make capital gains in an annuity become taxed more expensively as ordinary income should one make a taxable withdrawal. Some annuities have a 10% commission which is a huge drag on your return.
  6. Be wary of buying individual stocks, especially small cap or Emerging Market stocks.
  7. Avoid investing directly into foreign currency deposits as the spread to exchange money can be exorbitant.
  8. Avoid or use lightly the exotic funds with high management fees that use hedge-like strategies, especially ETN’s and managed futures.

    Investors should seek independent financial advice about the risks of HFT and other hidden costs. I wrote an article “Stock prices inflated by offshore accounting”. Corporate management can manipulate earnings causing investors to massively overpay for stocks which is far worse than giving a few pennies to an HFT.

About the author

Don Martin, CFP®

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