How To Beat High-Frequency Traders

Includes: IWV, VOO
by: AAII


Given the technological arms race, the only way you can beat high-frequency traders is to circumvent them.

The less you trade, the less chance high-frequency traders have to jump in front of your orders.

High-frequency traders focus on the stocks most favored by institutional investors, so invest where institutional investors can't.

Author Michael Lewis ignited a debate within the financial community with his appearance on "60 Minutes" last Sunday. Lewis, the author of "Flash Boys: A Wall Street Revolt" (W. W. Norton & Co., 2014), called the stock market "rigged." His reasoning? High-frequency traders are seeing what trades are being placed, jumping in line ahead of those investors who placed the trades and profiting at the expense of everyone else.

Brad Katsuyama, the man whose story Lewis tells in his book, used an analogy of buying tickets. Katsuyama described to "60 Minutes" a situation of placing an order to buy concert tickets for four adjacent seats on ticket exchange StubHub at $20 a ticket. A confirmation comes back saying only two tickets have been purchased. At the same time, the price of the other two adjacent seats has risen to $25.

The jump in prices described by Katsuyama, 20%, is a big exaggeration, but it clearly explains the allegation he trying to make: High-frequency traders are getting ahead of investors and are profiting as a result. High-frequency traders and their proponents counter that trading costs are being driven down and liquidity is being improved in the process.

Where's the truth? The five-year 21.7% annualized return for the iShares Russell 3000 fund (NYSEARCA:IWV) as of March 31, 2014, shows good returns could have easily been realized by an individual investor who merely tracked the broad market's performance. (A big reward for participating in the so-called "rigged" market.) Self-described long-term institutional investors Clifford Asness and Michael Mendelson of AQR Capital Management claimed in a Wall Street Journal op-ed that high-frequency trading is reducing their costs. On the other hand, if high-frequency trading firms weren't making money, they certainly would change their approach.

It's hard to discuss this subject without igniting emotions. It's even more difficult to separate the facts from the hyperbole. What's lost in the conversation is a focus on the market's complexity. The digital structure underlying the market has become so complex, there isn't a clear answer as what actual impact high-frequency traders are having on all other investors. Even Asness and Mendelson admitted not being "100% sure" as to whether high-frequency trading is actually reducing their costs. What we do know is that complexity not only can lead to problems such as the flash crash, but it can create anomalies and opportunities for malfeasance (legal, ethical or perceived).

As an individual investor you can fret about this or you can exploit your advantages. Those advantages are:

  1. Opting not to play their game. Day trading was a loser's game for the majority of those who tried it before the advent of high-frequency trading. Now the odds are even more stacked against individual investors who attempt to day trade. The arms race favors ultra-high-speed connections and servers as close to the exchanges as possible. The only way you can beat high-frequency traders is to circumvent them.
  2. Limiting the number of transactions. The less you trade, the less chance high-frequency traders have to jump in front of your orders.
  3. Buying funds with less portfolio turnover. The average large-cap mutual fund covered by our mutual fund guide had a portfolio turnover ratio of 64% last year. In comparison, the Vanguard 500 Index fund (NYSEARCA:VOO) had a turnover ratio of 3%. Even if high-frequency trading does drive up costs, buying funds with low turnover ratios will limit the impact on your wealth.
  4. Investing where the professionals aren't looking. Many pension funds, mutual funds and other institutional investors have restrictions on what they can and cannot invest in. It only makes sense for high-frequency traders to focus on the stocks most likely to be bought and sold by institutional investors. You, as an individual investor, are not encumbered by the restrictions placed on institutional investors. So do what we do at AAII, which is to go into the shadows of the market and seek out small, profitable companies with attractive valuations. By investing where others aren't, our Model Shadow Stock Portfolio has realized a five-year annualized return of 44.5% (through February 28, 2013)-a performance number that includes all transaction costs.

Disclosure: I am long VOO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. The author of this article owns the mutual fund equivalent of VOO.