February 1, 2019
Speed of Information – Not ETFs, Algos or HFT
Why when the markets go down or become volatile do people blame ETFs, algorithms and HFT (high-frequency trading) when the real, and perhaps less obvious, culprit is speed of information?
Maybe it is human nature to build up success stories – ETFs – only to tear them down or to attack new technologies like algos and HFT that many people are familiar with but don’t actually understand or have access to.
The recent market volatility is nothing new. We have seen volatility spike in a variety of different markets over the years for various reasons. The market sell-off that started in October is not unusual given that the bull market has been long in the tooth but with relatively stable economic indicators and thoughts of a Fed Chairman being fired. Uncertainty is and will always be the Achilles heel of the markets.
The current market rally started in March of 2009 and has risen close to 300%, but even a healthy market needs to take a breath. It’s been a great, historic run. Maybe so much concern exists because so many of the people involved in the markets today have never witnessed a bear market. They lack a baseline for guidance and thus have a fear of the unknown.
There are real reasons for the markets moving the way they do, and they have always moved that way even before the proliferation of ETFs. While some of the largest ETFs track markets, they are merely access vehicles that provide investors with exposure to the markets and various asset classes. ETFs are not their own asset class. ETFs are not down, the markets are down. They merely reflect that move; they are not the cause.
ETFs help calm market volatility since they can be bought and sold throughout the trading day. This levels volatility as ETF investors can more readily access the market. However, this is very different for mutual funds. Mutual funds are priced only once a day at the 4:00 p.m. NAV price so when you sell your ETF at 10:00 a.m., you receive the 10:00 a.m. price. When you sell your mutual fund at 10:00 a.m., you must wait until the end of the trading day and will receive the 4:00 p.m. price. Markets can move dramatically between 10:00 a.m. and 4:00 p.m., and mutual fund investors shoulder that risk on every trade.
The fact that mutual funds are priced only once a day at 4:00 p.m. is one of the primary reasons markets tend to move so much during the last 30-45 minutes of the trading day. Mutual fund managers who trade the underlying securities owned by the fund send their trade orders in an order type called Market on Close (MOC) orders. A MOC order is a trade that is not executed at the time the trade is made but rather at the closing price on the day of the trade (typically 4:00 p.m.). If the mutual funds are selling their portfolio securities for any number of reasons, including pressure from large redemptions by their shareholders, then the traders need to accommodate those trades and sell enough shares before the close. Thus, there can be big market moves in the last minutes of the trading day. Again, the same is true for when they are buyers, but no one seems to complain about those situations.
Keep in mind that there is close to $18 trillion of mutual fund AUM as compared to nearly $3.5 trillion of ETF AUM. Hard to accept that ETFs impact the markets, especially in comparison to mutual funds given the difference in assets invested and the contrast of pricing mechanisms.
Another advantage of having ETFs trade on exchanges is that the trading in ETFs is mostly in shares of the ETFs and not in the shares of the underlying securities. As a result, ETF trading in most circumstances does not impact the price of a market index like the S&P 500 because market participants are only trading shares of the ETF back and forth, not the shares of the underlying securities. In other words, millions of shares in SPY (the ETF tracking the S&P 500 Index) can trade without buying or selling any shares of any company in the S&P 500 Index. While this might not always be the case for ETFs that track less liquid securities, trading in less liquid securities has always been a market structure issue that is difficult for the regulators to solve. It is not an ETF issue but a markets issue.
HFT, like ETFs, is often targeted for disrupting the markets. However, it isn’t the problem either and like ETFs, it is highly beneficial to markets. Back when there was a floor-based exchange and brokers were the market’s intermediary, they could take anywhere from six cents to 50 cents out of every trade. High frequency traders, one of today’s key intermediaries, trade for fractions of one penny. HFT’s impact on the cost of a trade is negligible versus the liquidity HFT provides. Yes, there are bad actors, but the regulators have caught up to most of them by outlawing many of the order types and practices that were harmful. In fact, the regulators are catching up to technology changes quicker than they ever have.
If not ETFs and high-frequency trading, it must be algorithms that are to blame when markets behave erratically. Not so fast. A lengthy argument can be made that algorithms are just doing what humans have asked them to do. They do not cause the market to move, they just speed up the process. Back in the days before algorithms, the information that traders and investors needed to make decisions was very fractured. The institutional and professional investors had access long before the retail investors ever did. Brokerage houses that had the information called their institutional clients first, mostly with information they received from their hedge fund clients. When markets sold-off or ran higher, retail was last in the pecking order of the information flow. For example, if there was a 20% sell-off in the market, retail investors would not be able to react to it until after the market was down and in some cases, more than 15% down. It might have been an orderly sell-off that took a week or two to filter out, but the retail investor was at a major disadvantage.
Fortunately, regulatory and technology changes came along to level that playing field so information now flows quickly and to all market participants at the same time.
Today, thanks to technology, that “sell signal” is disseminated to everyone at the same time. Thus, everyone is a seller and markets move faster. Some people call it the “herd mentality.” Everyone is now reacting to the markets in the same way because we all have the same information at the same time if we look for it.
The markets aren’t perfect, market structure isn’t perfect. But, we reap the benefits of the most liquid, most regulated and fairest markets in the world despite what the conspiracy theorists say.
A news item, a presidential statement delivered through a Tweet or a geopolitical incident can project uncertainty in the markets and trigger market signals, which will move the markets. ETFs are not to blame and neither are algos or HFT; it’s just the natural order of the markets in today’s digital age. But if you still feel the need to play the blame game, then blame the speed of information.