Beware computer traded funds

Business Times - 01 Aug 2009

Individual investors should have tight stop-loss orders to limit risk as the 'big boys' hold sway with high frequency trading

By NEIL BEHRMANN
LONDON CORRESPONDENT

THERE is a good reason why the expression 'Bull markets must climb a Wall of Worry' is a trader cliche.

The latest scare is High Frequency Trading (HFT) when quant hedge funds, investment bank proprietary traders and Exchange Traded Fund (ETF) managers buy and sell baskets of stocks, using sophisticated computer hardware and software.

Their trades are carried out electronically, milliseconds ahead of the institutional and individual investors.

What should ordinary investors do? Should they flee the markets and leave it to the high-frequency machines, which make gains or incur losses on fractional price changes?

Alternatively, should they ignore the invariably illogical daily moves and seek opportunities taking a medium- or long- term view?

Before answering that question, individual punters should understand the nature of the High Frequency Trading beast. By buying or selling ahead of institutions and the individual punter, the HFT programs push prices up or down.

Joseph Saluzzi, head of institutional trading at US broker Themis, fears that these trades are currently generating more than 60 per cent of Wall Street's market volumes.

They push the markets up, invariably in the final hour before Wall Street closes, or turn tail and push it down. The results of their actions have an impact on Asian and other markets around the globe as they slavishly follow US markets. HFT programs are also raising trading costs for others as they get the best prices first.

Mr Saluzzi frets that in the current upward market trend, the computer programs have been pushing equities higher and higher without fundamental economic reasons.

They follow a variety of technical signals such as moving averages and momentum. This explains why the market has gone up day by day since early July. The computer signals say that since markets bottomed out in March, a bull trend is in force, so they automatically gauge trading ranges and buy en masse.

Mr Saluzzi worries that some unexpected international or market event could change HFT signals and cause them to dump stocks. Their selling could swamp the markets. Wall Street would slump, leading to a crash in Asia and Europe.

This is precisely what happened in October 2007, when after a boom there was a sudden sickening stockmarket slump. Investment banks were offering 'portfolio insurance' to institutions by selling stock index derivatives to institutions via program trades.

During the summer of 1987, the market sailed along merrily, but by September began to flatten out. Then suddenly, mid- October, prices crashed 30 per cent on Wall Street and London as programs went into sell mode. This caused chaos in other markets around the globe.

Then, similar to recent events, some pessimists compared the October 1987 crash with October 1929 and predicted a 1930s-style depression. They were hopelessly wrong. Instead, stock markets revived swiftly and 1988 proved to be an outstanding year to buy stocks for a bull market that lasted until the beginning of the new millennium.

The focus on High Frequency Trading also brings us back to the awful events of October and November last year and, after a brief rally, another horrid downturn in February and March. To be sure, the automated program traders played no small part during the severe slide in the 2008 to 2009 bear market.

Not surprisingly, Mr Saluzzi believes that regulators and stock exchanges should introduce trading limits similar to actions post-1987. This would give markets breathing space. Since the authorities are examining a variety of ways to counter another systematic financial crash, such moves are likely.

With the knowledge of High Frequency Trading and general market and macro- economic and geopolitical risks, where does that leave the average individual investor? For a start, the odds have worsened against day traders who are in and out of shares and play the derivatives markets and make spread bets.

These people are playing a dangerous game and, at most, individual investors should invest a tiny percentage of their portfolio and have tight stop-loss orders to limit risk.

The medium- and long-term investor has to take a view and could use wide stop losses - say, around 10-15 per cent - for protection. Many are tagging along and are purchasing Mutual Funds and much cheaper Exchange Traded Funds (ETFs) that spread risks. Indeed, such is their popularity that there are now some 1,700 ETFs with total assets of around US$800 billion.

Some wealthy investors are entrusting their money to hedge funds. Others are finding the gaps between the giant electronic machines, hedge funds and institutional crowd. They are seeking and finding value gems that have been pushed down for no logical reason and are selling overvalued stocks.

These investors, provided they are not greedy, have proved to be the most successful over the long term. That precept is unlikely to change now.