It’s been a terrible decade for hedge funds. According to James Bianco, 76% of active managers have underperformed the benchmark indices. It makes a good case for passive investing. (CFA Institute – Hedge Funds and the Active Management Crisis)
A headline I saw in the Wall Street Journal this morning reads “Exclusive Club: No High Frequency Trading Allowed at Luminex.” That headline led me to reflect about how trading has changed in the last 25 years and the process that orders go through to be executed.
In the last 25 years, changes that began out of reforms put into place after the 1987 stock market crash have enabled anyone with an internet connection to access the market. Those changes have empowered the individual investor to make instantaneous trades without human involvement and led to the market being dominated by trades made by computer programs.
High frequency trading according to the SEC, now accounts for 50% of the trading volume in US listed equities. So why would a group of the biggest institutional money managers want to form an exclusive club where they would not have access to 50% of the market participants? The answer is that while they represent 50% of the volume they provide very little liquidity and continually extract money from each transaction. (Equity Market Structure Literature Review Part II: High Frequency Trading, March 18, 2014 sec.gov)
When an individual enters an order to execute a stock trade through an online broker, that order is routed to a market maker. The market makers are some of the biggest high frequency trading firms in the world, such as Citadel and Virtu Financial, which pay the online brokers for their order flow. Effectively, the trading firms pay the the brokerage firms to be able to take the other side of the broker’s trades. The positive effects of using this arrangement are that the investor gets an instantaneous execution and a low commission charge, but the hidden costs are significant.
Because the individual investor enters their buy and sell orders in increments of pennies, the computers can front run the orders by offering a better price in increments of sub pennies. (In other words, the computers can place their orders in increments of .001 while the individual can only enter orders priced in increments of .01.) This allows the computer programs to race from exchange to exchange or dark pool to dark pool (A dark pool is a private trading venue) looking for another order that is waiting to be executed at a better price than the individual’s order. Therefore, since the computer program has offered a better price through the extra .001 cent, they get the trade execution rather than the individual who entered the order.
The reason this represents a problem for investors is that these transactions add cost and suck liquidity from the transaction. Add these costs up over a typical trading year and you can see why the high frequency trading firms are so profitable and why the institutional investors want to avoid this transaction tax by forming their own club.
For the individual investor with the long term approach and very few transactions the high frequency trading firms have lowered the costs of investing, but for active portfolio managers they have enacted a huge tax in the form of extra costs and extracted liquidity from the market by taking over the market making function.
According to McKinsey & Co., Wall Street trading will be dominated even more by firms that embrace cutting edge technologies to streamline operations and trim costs. More efficient trading technology will lower the costs for the investor, but at what cost?
Based on my observances over the last 25 years, I would say the cost to investors will be the continued erosion of liquidity, and more “Flash Crash” events.
Financial market unicorns are the magical market elves that grind out eye-popping compound annual returns for multiple years and with limited […]
There are only two ways to grow earnings in a business, one is to sell more and the other is to spend less. Valeant Pharmaceuticals is an example of taking those two axioms to the extreme and what the consequences can be when the investors have decided that the strategy is no longer executable.
Valeant Pharmaceuticals has been one of the best performing growth stocks of the last five years taking revenues from $2.4 billion in 2011 to $9.2 billion in 2014, and generating an 854% return for shareholders. So what’s the problem right?
The problem is that investing in “Rollups,” or stocks that grow through serial acquisitions, usually reaches a tipping point where the investors and sponsors of the strategy lose faith in management’s ability to continue to execute and decide to exit. When the stock begins to fall, management loses its currency to make further acquisitions and the story usually ends badly for investors.
So let’s look at what we can learn from the get rich quick through acquisitions strategy:
- Growth is the key to the strategy – Valeant did 50 acquisitions – Making acquisitions to grow the top line revenues and cutting redundant expenses is great for results in the short-term, but integrating 50 acquisitions into one company can be a daunting task. Given that the CEO of Valeant has been described as a hard-charging deal maker whose McKinsey & Co. background has trained him how to make a P&L look good in the short-term, there has been little spent on R&D and a big emphasis on hitting the quarterly EPS numbers.
- Rollups are not growth stories – The growth comes from adding revenues through acquisitions, not producing innovative new products or finding some new untapped market. Basically it boils down to financially engineered growth.
- The party eventually ends – Like a game of musical chairs, the stock will continue to perform as long as investors have confidence that management can execute, but as the acquisitions required to grow the top line become bigger and bigger, the management needs a strong stock price to continue to execute and when the stock begins to sell off it becomes a broken strategy and ultimately a broken stock.
Rollup strategies are just get rich quick schemes for the insiders. Invest in companies where the management is intent on creating shareholder value through building better products or providing a better service. One with a competitive advantage in the marketplace and a large moat that protects that advantage.
Barry Ritholtz’s new Washington Post column nails one of my favorite lessons from Economics, “There’s No Such Thing as a Free Lunch” (The Washington Post)