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ETFs invest in ten stocks instead of the three best in the sector. That’s inefficient. With passive investing, money doesn’t go where it is efficiently allocated.

At the US ATF in the summer, when one broker asked what kind of algos they could provide to suit the buy side’s needs, one asset manager responded: ‘Stop giving us algos!’ It’s a race to zero for rates, and I think we’re pretty close to that already.

The US stock market is in deep trouble, hurt by a declining small-cap market and the global shift towards passive investing. A look under the hood of the market reveals some deeply worrying structural flaws, according to Patrick Connors, head of outsourced trading at Weeden Prime Services, based in Greenwich, Connecticut, USA. 
Fifteen years ago, Connors co-founded Greenwich Prime Trading with Eric Savitz. At the time, they were pioneers of outsourced trading. The idea was that smaller asset management companies could outsource their trading, thus replacing a fixed cost with a more scalable one. In September 2016, both Connors and Savitz joined Weeden Prime Services to run an outsource trading desk (which the firm previously didn’t have). Weeden Prime itself mainly serves hedge funds and family offices in the US. 

“Small-cap stocks are being killed off by the separation of commission payments for research and execution,” said Connors. “Brokers are reluctant to make markets in small stocks because it’s no longer economically viable. Small caps are being cut out from the market.”


This matters. While small-cap stocks typically account for a smaller share of the buy-side’s trading activity than larger cap stocks, small-caps are crucially important to the wider economy, since they are potentially the large companies of the future. Small companies need to raise capital to grow and succeed; if they are unable to do so by raising money in the capital markets, their alternative would either be to curtail their plans, or to find alternative sources of funding.  “The question is, can you do an IPO, or go to the secondary market under these conditions?” added Connors.


The situation favours large buy-side firms over small ones, too. While some asset managers are bringing research analysts in-house to provide their own research, only the larger companies can afford to do so. Smaller firms will find it difficult to keep up; the resulting unbalanced market structure could arguably be criticised for being anti-competitive. Combined with the lack of coverage from brokerages, the outlook for small-cap stocks is worrying.
“Some people say you don’t need brokers. I believe we do,” said Connors. “The value is in the small and mid caps. If you trade a small cap, it may only trade a few times a day. You need a broker to find the natural liquidity in that stock.”


The problem with small caps translates into a problem for the whole economy, with a number of undesirable consequences. A series of so-called “unicorn” crashes in the last couple of years can be linked back to the poor state of the capital markets. According to Connors, companies are over-valued and investors don’t know what they are investing in. This creates bubbles, some of which then inevitably burst with damaging effects for all concerned.

Turning passive?
The structural problems in the US market go beyond mid- and small-caps. As these markets are eroded, a global shift towards passive investing and ETFs is causing a return to the mean in performance. Some voices in the market are already warning that the result is inefficient allocation of capital – and damage to the real economy. 
In August, analysts at broker Sanford C. Bernstein released a paper called The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism. In the paper, they argued that the best model is a capitalist economy with functioning capital markets, which creates economic growth; the second best model is a Marxist economy, where “at least somebody is at least someone is doing the planning of capital allocation”. The argument is that even if this were somewhat inefficient, it would at least be preferable to the passive investing model, in which no party even makes an attempt to allocate capital effectively.

“It’s a misallocation of capital,” said Connors. “ETFs invest in ten stocks instead of the three best in the sector. That’s inefficient. With passive investing, money doesn’t go where it is efficiently allocated.”


The US election may also have contributed to the problem in recent months. As asset managers reduce exposures, this causes them to under-perform. Asset allocators then pull resources from the hedge funds that under-performed, and in many cases it goes to ETFs and passive trading strategies instead. This increases the number of participants essentially chasing the same strategy. The uncertainty driven by the forthcoming election in November perpetuates the cycle.
As with many issues in the capital markets, problems in one area are linked to other changes elsewhere. Connors believes that the rise of automated trading and the proliferation of high-frequency trading has not been to the advantage of long-term investors, nor has the fragmentation of exchanges and trading venues over the last decade.

“There are too many algos,” he said. “At the US ATF in the summer, when one broker asked what kind of algos they could provide to suit the buy side’s needs, one asset manager responded: ‘Stop giving us algos!’ It’s a race to zero for rates, and I think we’re pretty close to that already.”
Above all, the rise of sophisticated trading strategies and the potential for the abuse of the market are concerns for Connors, as they are for many buy-side traders worldwide. While suspicion of HFT is not new and has existed for years, the rise of passive investing could be making the market more vulnerable to aggressive and predatory trading strategies.
“If an algo can front-run an active trader from an asset management company, what’s stopping them from front-running an ETF? It would be possible in theory to work out what their fund is doing, work out which stocks they are active in, figure out the money flows behind it and take advantage,” said Connors.

Taking a stand
While the industry has debated the benefits and costs of high-frequency trading to the market for many years, the main arguments can be summarised as follows: 


1. HFT adds liquidity to the market, helping to bring narrow spreads and therefore lower the cost of trading for all participants


2. HFT firms are not a substitute for traditional market makers; when market conditions become tough, the HFTs disappear from the market, a practice that many of the buy side have complained about


3. The buy side often accuses HFTs of picking off long-only asset managers, getting in front of their trades and ripping them off


4. The liquidity provided by HFTs is often not real, since many HFTs cancel a very high proportion of their orders; most of these orders are essentially just a way of pinging the market to see what flows are there

The debate over HFT spills over into almost every aspect of trading. For example, exchanges have been criticised in the past for spending large sums of money on upgrading their trading platforms in a bid to attract more volume from HFTs. The resulting “race for pace” led to increased costs for market participants, who had to then expend resources connecting and upgrading to these new venues. Meanwhile trading functionality was stripped away as exchanges sought to reduce latency as far as possible, while the long-only investor often found that as soon as they attempted to act on a price, the market moved against them. Essentially, HFTs were getting in front of their orders, using sophisticated co-location technologies and HFT strategies, to make a profit at the expense of other participants.
“Best price should be the best bid or offer. Instead of having someone come in at a tiny fraction of a penny higher or lower, in such a way that they get in first,” said Connors. “That’s not adding value. It is an exploitation of the market structure.”


To make matters worse, the trading venues themselves suffered from instability and crashes, caused in part by the move to new technologies that did not receive proper testing. Crashes affected the London Stock Exchage, Bats Europe and many other trading venues over the last several years, going back at least as far as the Flash Crash of May 2010, when $1 trillion was briefly wiped off the value of the US stock market in an incident that was blamed partly on rogue algorithms feeding off each other in an automated spiral to the bottom. 
According to Connors, there are some positive moves. In the US, the SEC is currently trying out the tick size pilot, which is a data-driven test to determine whether or not widening the tick size from $0.01 to $0.05 for securities of smaller capitalization companies will impact trading, liquidity, and market quality of those securities.

“The tick size pilot is a good step,” he said. “I am trading a stock that trades at a volume of 150,000 shares today. Yet it’s priced at the same increment as Microsoft. Stocks should be priced in fixed increments based on volume. Of course, it’s interesting that the HFTs are the ones who are against it.”


In an attempt to reduce some of the perceived negative effects of HFT on long-term investors, Borsa Italiana has already started charging firms that cancel a high proportion of their orders; other markets in Europe (notably Germany) have unilaterally introduced laws in an attempt to clamp down on such practices. “We should start doing that in the United States,” said Connors.
“HFT is front running. They don’t add liquidity to the market. If I steal one dollar from your bank account a month, that’s twelve dollars a year. You probably won’t notice or care. But if you do that to a million people, have you committed a crime? That’s what HFT does.”
In response to growing dissatisfaction on the buy side, a number of trading venues have attempted to come up with new products and services aimed at long-only investors. Among these, the US-based exchange IEX has been one of the most well-publicised, having featured in the best-selling book Flash Boys by Michael Lewis. IEX uses a system of “speed bumps”, random delays in the latency of execution, to prevent HFTs from gaining an advantage on its platform. Connors is a supporter of IEX, but believes more will have to change before the buy side can consider the issue solved to satisfaction.
“Venues like IEX are a start, but they have a long way to go yet,” he said. “The regulators are trying to chase a Ferrari with a Ford Mondeo. It’s likely there will be another Flash Crash of much larger porportions. US exchanges are in denial that there is any problem with the market structure, because they’re a 'profit organization'. They won’t change until there’s another crash and they are forced to do so.”
 

America at the crossroads

Patrick Connors, head of outsourced trading, Weeden Prime Services

Elliott Holley
Head of Global Buy-side Research
eholley@kandkgc.com
+44(0)7759 476779

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