While you ponder, a confession: We’re guilty of a bait and switch. If I’d written “implementation shortfall,” which is what I mean, rather than “missing the mark” above, which is what I said, I might be responsible for a chain-reaction narcoleptic catastrophe, people randomly falling asleep mid-word and banging heads on laptops, iPads, desks, afternoon pub beverages.

“Implementation Shortfall” is some software engineer’s term for not meeting your target in a trading scheme. By analogy, say you want to sell your house for $500,000 and you get $480,000. That’s implementation shortfall. In trading, it’s the difference between what the client wants and what you deliver. Say you’re tasked with selling 200,000 shares within a price range of $0.25, and with set trading costs. The degree to which you don’t meet that target is implementation shortfall.

In the IR chair, you don’t need to know all that stuff. But you should understand how implementation shortfall can impact how your stock trades. Maybe you can’t target the institutions you thought you could because at the trading desk, the implementation shortfall risk keeps trades from occurring. Plus, it’ll show up in your stock price. I’ve got a story to tell to illustrate it.

But before that, a word on trading since options expirations 8/18-20. The Dow Jones Industrial Average is off 440 points since. Data for clients show the chief cause not to be a rout from equities by informed money, but a shifting of the balance of resources. An institution at expirations decides to swap $500 million of tech stocks for a basket of bonds and Treasuries. The transaction does not hit the open market, but because the investor had been trading around his position before expirations and now has ceased, the effect is a gradual decline in the whole sector, because each algorithmic trade causes a ripple into the behaviors of other algorithms, many of which are there to match up trades now occurring at a lower level. The sector slides 10%.

It relates to algorithmic (mathematically managed) execution. If the placing of trades is less than random, machines identify an absence of randomness and game the order flow. What we have at the moment instead is a widespread effort to randomize so others cannot front-run orders and cause implementation shortfall. The result is chaos, combined with small shifts that produce big changes in price.

In markets where investment behavior, or rational thought, is principal price setter, value money would be at work, seeking value. We don’t have that. Instead, money seeks alpha or reacts to change. That’s why you see randomness everyday in trading.

Which brings us to our story. A particular basic materials small cap stock showed miniscule nudges in algorithmic trading on but two of ten program desks. Yet this smallest lack of randomness between overall buying and overall selling caused slippage of nearly 20% in the price. No value money tried to buy shares until the whole implementation shortfall had run its course by August 26. Perhaps because it too had been randomized. Unless you see these features in your own trading, you can’t truly say if your stock trades well or not (it varies, by the way, which is why IR must learn to be tactically nimble).

One answer to this problem is for IR professionals to color a broader palette of institutional relationships, not just buy-and-hold sorts, who have largely gone random. I was speaking with Jim MacGregor at IR/PR consultancy MacGregor Abernathy, and I agree with Jim that market structure almost demands that IROs court a coterie of aggressive hedge funds.

In a sense, hedge funds are the last institutional investors standing whose actions haven’t been randomized and ionized into a form of managed, program-driven behavior incapable of responding to value opportunities. I’m talking of course about active hedge fund portfolios, and not, say, DE Shaw’s Oculus portfolio. DE Shaw runs active money too. Their ability to act can alter the randomness in your market structure with one small hedgy step.

And now if you’ll excuse me, my schedule is experiencing an implementation shortfall.

Before we answer, we enjoyed New Orleans last week, despite humidity that had us struggling to distinguish the surrounding atmosphere from Lake Pontchartrain.

The NIRI Southwest Regional Conference concluded with brisk canvassing of key issues, wrapping on “would you choose an IR career again?” (Unanimous yes from panelists)

Bourbon Street hopped as usual, tourists with beer in cups labeled “giant donkey,” in so many words. We heard from the bartender at Pierre Maspero’s that the Lower 9th Ward and Chalmette still aren’t the same, folks picking up and moving across the lake to Covington. Many for-sale signs in the Quarter. We strolled by Brad and Angelina’s, who’ve done their part and taken one sign down. They didn’t look to be home.

So here’s your New Orleans Analogy about market structure. When the levees broke, water spread out, and equalized. The law of diffusion spreads molecules to fill available space. Physics. There are spreads, and there are spreads. Imagine how handy it would have been if at the spots where levees ruptured, the water just stayed in place, a sort of Moses effect. Alas.

The Game column in today’s Wall Street Journal by Dennis Berman notes how Senator Ted Kaufman thinks the SEC should revisit whether narrow spreads help investors. Good article, we recommend it. It brings us to our opening question. Often, a percentage of our client base moves in intraday aggregate by more than 5%. Size doesn’t matter. I can think of a client who reported a couple weeks ago and missed expectations widely that’s up 18% from after the call. Another client in the same timeframe beat, and is down 19%.

How? Did the minds of investors radically shift in days, such that intrinsic value, without one update to a metric, has shrunk or inflated by factors? What accounts for monumental value gaps from minute market spreads?

At the thought of what answer may come, you may grope for your monolithic moke of a brew (labeled otherwise in the Quarter) to gulp some down. Relax. No complicated constructs here. The answer is simple: by controlling both prices and volatility at the point of entry through the national best bid or offer and penny pricing increments, we create giant pricing wrinkles that move not according to fundamentals – fundamentals don’t set entry and exit points – but according to the levees.

Put another way, if the levees direct the flood away from equities to, say, US Treasuries, then all the business acumen on the planet will not keep your price frozen there at your rational price, Moses at the Red Sea, while the waters rush on.

You will be re-priced by everything else in the market. Is that fair? According to current rules, it is. We’re improving competition, so say those crafting them. If you like that, then be prepared to suffer market slings and arrows in spite of fine fortune.

Something to consider diffusing into that letter we suggested last week you pen for your C-suite on market structure: why not a test market that does the opposite of what we’re doing? No intermediaries. If you buy it, you own it. No price controls. You may bid or offer what you wish, and if someone agrees, more power to the both of you. No circuit breakers – let caveat emptor do its cleansing thing when or if it must. Voluntary membership by public companies, who get to offer a set number of shares there.

Why not? The levees didn’t work in New Orleans and constricting prices and behavior isn’t working in the markets. Sure, it might take the spirit of Andrew Jackson from 1812 in the Big Easy. But that worked out pretty well.

Recently Kate Welling at Weeden & Co. interviewed Prudential’s vice-chairman, Mark Grier about being public in 2010. I read it and asked if we could highlight it here. It’s critical knowledge for IROs and public-company execs now.

Prudential (NYSE:PRU) has market capitalization of $26 billion, 38,000 employees, some $700 billion of assets under management. Before the May 6 Flash Crash, Vice-Chairman Grier had lamented to the SEC about the lack of fundamental content in stock prices.

In the interview, Grier said: “What happens when the market’s fundamentals are algorithms and signals and pings and all the stuff that goes on between the machines? What happens when the machine doesn’t know whether it’s buying Prudential or McDonald’s or Continental Airlines? What happens when that is really the way in which stock prices are being determined?”

Grier said, “I believe that this disconnect between company fundamentals and stock prices is a much more serious source of systemic risks than anybody is giving it credit for. The systemic risk – if the markets are materially wrong, if they are broken down, if they are not reflecting fundamentals, and if, as a result, real investors are hunkering down and not participating – could be devastating.”

“Stock prices,” Grier said, “are reflected in corporate accounting statements, in the financials, in earnings, in capital, in mark-to-market valuations, in regulatory capital. Then we have the rating agencies that use them. We have all the headline risks that go along with the market volatility as they affect employees and as they affect clients.”

And what if the whole underpinning construct isn’t fundamentally priced? Grier said, “There’s a basic conflict between using the stock price as our report card and the way in which that price gets set.”

Grier talks about the financial crisis of the past two years. “Instead of reflecting fundamentals,” Grier says, “the market itself became the fundamental. And that’s not the way it’s supposed to work…everybody is scratching their heads trying to figure out what’s going on, and that gets translated into expectations and plans and spending and pretty soon into real behavior. So pretty soon the economy was going through a cycle that was driven by the market itself.”

These are but a few nuggets from Kate Welling’s treasure-trove interview. Read it. Pass it on to your CFOs and CEOs.

We can’t solve the problem until we first understand it. The problem is that the market only marginally reflects what we do every day. Changing it starts with IR professionals getting a grasp on how markets work.

Second, companies need to be involved in setting rules for stock markets. Public companies are the life blood. Yet rules are made by traders, for traders, and companies are silent. Imagine if supply and demand were irrelevant in the grocery store and price-setting power belonged to a cartel selling groceries. And then suppose that economists considered prices to have been set by supply and demand. Could you trust their predictions?

Here’s a challenge, IR professionals: Educate yourself about markets. This interview is a great starting point. Write a letter for your CEO to submit to the SEC, a position statement on our capital markets.

The first step toward change is forming an opinion and expressing it. These are our capital markets, after all.

It’s about time for a Sazerac.

It’s a decent name for a rock band, yes. But it means “what stuff can you do with this?”

Traders want actionable data – something to drive opportunity for profit. Investor-relations professionals want actionable tools – something that’ll improve stock ownership, share price, results of IR effort.

Knowing who owns your stock is good. But what actions can you take? Talk to sellers? That’s uncomfortable. Plus, unless you’re screwing up, selling is a compliment, an investment objective. The sellers should well buy again, when the time’s right.

How do you know the time’s right? Ownership and targeting data are fine but limited if you don’t know who or what is controlling your liquidity. Without knowing your trading behavior, it’s difficult to accurately measure actions, plot outreach, and target investors.

Money won’t simply take a flyer because you run a good business and your IR team is suave and debonair. Today, institutions cannot afford to buy stocks in a vacuum, without respect to how the first 1,000 shares alter baskets, ETFs, derivative trading tactics and all the rest swirling around your liquidity. Institutions mind risk-management obsessively now, which is about market structure.

We track data for a living. For clients, we graph volume from prop traders like RGM Advisors, against, say, executed order flow for Credit Suisse. We observe how the behaviors of the two are eerily similar in some issues (and not in others). RGM is a scientific, machine-learning trader.

Say you’re using Credit Suisse for support on a non-deal road show, but most of their volume is trend-driven. That knowledge should inform what investors you ask Credit Suisse to bring from its client ranks. You’ll want high-turnover GARP or growth money, because that’s the kind likely to wade into a mathematical market. It can be a win-win – Credit Suisse likes those customers, too.

Market structure can shape who you choose for support. Some firms have high-turnover clients because their trading products facilitate high-speed trading. If you’re after a different investor-class than what a sellside firm tends to serve, you might use a different firm with a lesser trading operation – and thus more dependence on its research. Great story isn’t enough. If your market structure doesn’t suit the money you’re targeting, you’ll waste a road trip.

IR professionals should become more tactical. Use the big picture to do it – beyond story, to structure. The final frontier for IR effectiveness rests on the actionable quality of market-structure data. Do you know how much of your daily volume is speculation? What kind of investor should you target tactically, in context of your IR strategy, if more than 50% of your volume is arbitrage? These are important things to know now.

Here’s a product announcement from Direct Edge yesterday:

ACK – SPX Accelerated Return Notes due September 30, 2011

CDK – SPX Capped Leveraged Index Return Note due July 27, 2010

ELD – WisdomTree Emerging Markets Local Debt Fund

MHM – SPX Market Index Target Term Securities due July 31, 2015

As products like these roll out each day, there’s something else for that money you’re meeting in Chicago to choose besides you. Kick it up a notch. Target more tactically. Sometimes you’re right for high-turnover hedge funds. That alone is a new notion. Then, be ready, using market structure as guide, to get on the radar of conventional fund investors before hedge funds rotate.

It’s not an exact science. But these are tools with abundant actions. If you’re expert in your own market structure, your results are going to be different from those of other IROs, because you’ll think differently about what actions you need to take.

You’ll be the IRO for the 21st century.

The DXY, the spot market for the US dollar, declined 7% in July. Stocks were up 7%. May was a good month for the DXY, which rose from 81 to 87, roughly. May crucified equities and gave us the Flash Crash on the heels of a surge in the value of the dollar.

Is it six of one, half a dozen of the other? The dollar in your pocket loses 7% of its purchasing power versus other currencies in July. Stocks appreciate 7%. Call me simple, but it seems that when a thing you buy is worth more because the thing you buy it with is worth less, that these sort of cancel each other out.

Which brings us to making and taking liquidity, the main method by which traded shares move today. In this “maker-taker” model, market centers pay participants to provide shares that attract customers, and charge customers to consume these offered shares. The spread is profit. At BATS Exchange the cost gap between consuming and providing shares is one penny per hundred shares. On the Nasdaq and the NYSE it’s about five or six cents, but narrows if you offer tens of millions of shares daily.

This is crucial to understand. If you conclude that your volume is buying and selling meeting up, that’s true only sometimes. Most of the time, buyers are consuming shares offered by other market participants whose principal job is to keep the liquidity flowing, for pay. This is why high-frequency trading exists, really. Technology and human ingenuity adapted to market structure built around incentives. So now, there are systems doing both the providing and consuming, and if the spread between the two prices is a penny, and your stock moves two pennies, why that’s riskless profit. Mind, that’s harder to do than it seems!

Where do shares come from that liquidity providers offer for sale? Somebody always has inventory. Sometimes it’s coming from major broker-dealers whose millions of retail and institutional account holders don’t realize that their positions are used to generate profits for market-making operations. This is the main reason why Citadel invested in E*Trade. In many other cases, shares simply move from place to place at high speed.

To do that, traders can arbitrage different structures. Most market centers now, like BATS, Nasdaq, Direct Edge, and so on, are “time-priority” models, where the first to show up at the best bid or offer gets to complete the trade. On the NYSE floor, it’s a “parity” model that gets apportioned to all parties priced at market. So if you’re fast enough, you can move shares from parity to time priority and back and forth. This constant replenishment generates revenues for the firms doing it and looks like massive volume. It’s often the same liquidity appearing again in different places.

What’s good about this? It keeps price spreads tight, and it ensures that vast numbers of securities, regardless of appeal, offer anyone wanting to transact in them an easy, ready market. If you’re asset allocation managers, these are great conditions. Think of it like swiping your credit card through a reader rather than needing the exact cash price each time you buy.

What’s bad about it? Number one, market centers are motivated to entice volume that isn’t real. They make money through transactions. More transactions, more data to monetize too. This is not the fault of exchanges. They are businesses producing returns for shareholders. But if parties matching your product with buyers and sellers are financially incented to attract middle men, in time your market is most appealing to intermediaries and least appealing to real buyers and sellers.

That’s what maker-taker models encourage. Transient intermediation. It’s the most reliable way to make money. If 80% of volume is moving from place to place, and you’re in the 20% buying and holding, what form of activity is more likely to produce a return on investment? Clearly, making and taking liquidity, not owning things.

But the biggest problem is the same one afflicting the US dollar. In stock markets now, the maker-taker model has removed the focus of market participants from the value of businesses to the supply or demand of shares. The study, manipulation, and maximization of liquidity movement have come dangerously near to disconnecting underlying business fundamentals from stock markets. Intermediaries trade stuff for spreads. They don’t own investments for their intrinsic value.

This is true of the dollar too. Its value bears no connection to underlying national productivity or assets. That’s the essence of “fiat” currencies, and we’re near now to having “fiat stocks” too. Movement of the dollar from place to place alters the value of all the goods and services denominated by it. In time, no one knows the value of either the goods and services or the currency in which these things are valued. Then, the data derived from transactions in it are incorrect or distorted, too.

Think about this: does the same thing happen in the global economy that we described with the DXY and stocks? What if it’s just yin and yang of currencies and goods and services, with no real change in economic output? That path would lead almost ineluctably to large national debts.

Oh. Hm.

We’d warned that markets showed excessive arbitrage. Arbs capture net spreads between opposing trades and care little about price appreciation. When it’s high in the broad markets (and in specific issues, too), it often points to impending switches in the direction of money, say from one mix of assets to another. Why? Traders apparently detect algorithmic activity and move to profit from it.

We’d seen the same thing in June and thought it might occur again. It didn’t, and the market removed all doubt that we were the fools we appeared to be.

Or so it seems. Are investors responsible for this nice recent run back to positive turf on the major market measures? We can only share general observations from data. The data are what they are. We observed two developments on 7/22. First, Nomura traded more than half our client base that day, a rarity. Nomura had become a primary dealer to the Spanish Treasury a few days earlier, and it’s also a primary dealer for the US Treasury. It owns the trading platform Instinet and Lehman’s Asian and European operations.

How do those facts bear on equity trading when treasuries are a credit market? We can only speculate. But we believe banks can effect carry trades – borrowing and paying interest to earn higher interest on something else.

At the same time Nomura rippled through equity markets, we saw a surge in conventional program trading. Our measures differ from what the exchanges use. Different kinds mean different things. In this case, it was the biggest firms helping global institutions manage transitions from one asset class to another. While market volumes have been relatively light, this increase in market share by big program traders attracted a surge in mathematical trading, which identifies disparities in market structure and capitalizes on them.

Together these could represent a bait-and-switch, not fundamental investment. Banks with trading technologies and commitments to governments to help them fund operations could get money from overnight treasury or central-bank facilities at low cost and use it to trade in equity markets and attract demand. Profits from these operations provide funds for use in required bidding at government primary-dealer auctions. It also gives the bond market a head feint by pulling demand to equities to improve bond-market rates and prices.

We’re not saying this happened. But trading data show that confusion reigns in equity trading markets. That’s not a mark of rational investment. Money may respond sporadically to earnings, and we do certainly see that. But the broad behavior is a mix of discordant sentiments and reactions. We see that, too. Somebody buys in a dark pool, and programs react to it, and algorithms follow, and speculative traders and all the auto-quote systems (translation: “high frequency trading”) tag along, and none of it knows the worth or driver.

Following rules of deductive reasoning, we conclude that if it’s not rational, it’s something else. What else would it be? Well, what dominates the global financial agenda now? Government debt.

So be ye not lulled into a false sense of security, IR pros. Trouble lurks below the rapids. But for now, we’re rafting on big programs, which seem, right or wrong, to know more than you and me.

A word on trading: We expected money to move after options expirations, but changes to program-trading plans came early, on July 14, we observed in the data. So with expirations July 15-16, markets were shellacked when money shifted to other assets. The past two days have given us massive arbitrage around this shift and ahead of tomorrow’s volatility expirations. Thus, the week could end on a rough note, we fear.

Switching gears, you’ve heard of Direct Edge? It came out of Knight Capital Group and has for many years operated Electronic Communications Networks, or ECNs, called EDGA and EDGX. One was for active algorithms, the other for passive black-box trading systems, in essence.

In 2008, Direct Edge traded Eurex, the operator of the International Securities Exchange, a 31.5% stake for the ISE Exchange. Started ten years ago, it was the first all-electronic options exchange, and it’s one of the globe’s biggest such, offering electronic trading in options for more than 2,000 equities, ETFs, indices and foreign-exchange products. Eurex is itself owned by the German and Swiss exchanges, the Deutsche Borse and the SIX. Direct Edge is partly owned also by Citadel Derivatives, Goldman Sachs and Knight.

With the advent of two new Direct Edge full exchanges tomorrow, EDGA and EDGX, the ISE Exchange will be blended in and discontinued.

Why does this matter to IR? You need to know what’s happening out there. Direct Edge routinely handles nearly a billion traded shares daily. Its platform best serves highly automated volumes in multiple asset classes. It commands about 12% of total equity volume. Its growth mirrors the explosion of global high-frequency trading in equities and other asset classes.

Like other trading innovators, Direct Edge sees growth opportunity in the evolving nature of trading. Both NYSE Euronext and the Nasdaq operate two options exchange each, and midcontinent rival Bats Exchange got approval in February this year for an options exchanges. Direct Edge hopes to offer simultaneous trading in many things – currencies, commodities, stock loans, futures, options, equities.

Why operate exchanges rather than alternative trading systems? It lowers clearing costs, expands data revenues from the consolidated trading tapes (exchanges get a better share than ATS’s), and opens doors to more products for traders.

For IROs, it’s a window into what’s behind price and volume. These are things you have to know now. Markets are fragmented and trading is spread across asset classes. It’s akin to the digital book market. Amazon is now selling more hardback books via the Kindle than in print. That’s how customers are consuming books.

How are customers consuming your shares? One big key to longevity in the IR chair is becoming the source of data and information about trading. We can’t control how traders use liquidity – but we sure can become expert at understanding how it works.

And from that knowledge comes the power to change markets. Or least understand them — and that’s both cool and valuable these days.

The question was: Can smart order-routing algorithms quoting in increments of less than a penny front run the national best bid or offer?

In English this phrase translates to: “My Name is Inigo Montoya. You killed—”

Wait, wrong decoder. It means: If every trade in your stock must be made at the best available national price, according to rules established by Regulation National Market System, could someone or something trade at a different price?

The logical answer is “of course not.” The correct answer is “of course.”

Under Rule 612 of Reg NMS, quotes of less than a penny – that is, instead of $20.10, the price might be $20.1001 – are forbidden. Except for broker-dealers offering clients “price improvement.” If a broker dealer working an order for a client steps in front of the best bid or offer in that fashion, it’s allowed by existing rules. It’s no big deal on the surface because an order for 1,000 shares, for instance, would cost just ten cents more.

But suppose an investor has a limit order to sell 10,000 shares, and the price next drops to $20.09 and never again is at $20.10. What’s the cost then? While in theory only broker-dealers may do these things, the fact is that aside from a finite set of liquidity providers, the great bulk of program-driven volume today derives from broker-dealers and agency traders – who could in theory use the exception.

These things may seem unimportant to an investor-relations officer in the throes of editorial rounds on the script, the release, and the Q&A plan for the quarterly report next week or the week after. And we’ve oversimplified a complex event in the markets today that involves more than sub-pennies.

Our purpose today isn’t to vet the issue, but to put it on your radar. If someone stops you on the street and says, “What’s sub-penny quoting?” we want you to be able to do something more than make a toilet-flushing noise.

To us, it’s a structural issue. If intermediaries have any advantage at all, then why wouldn’t everyone prefer to intermediate trades rather than own things? This blurs prices. In one sense, there’s an advantage to straight auctions. Someone hosts the auction and gets a cut of the action, and then the parties at the auction place value on the goods. But if auctioneers are determining outcomes by getting pricing advantages over the participants…well, that doesn’t seem consistent with either common sense or sound principles of finance.

Now if you’ll excuse me, I’m going to look for some boot-legged high-flow toilets. I hear Canada has got them.

Passing through last weekend, we had to concede that Iowa was in fact a place of surpassing and bucolic beauty, with its rolling corn-planted hills and manicured farms. The heartland at Independence Day reminded us that this land of ours and yours is jeweled.

Anyway, we’re a day late this week because it’s a long way from Bratenahl on Erie to the banks of the Platte.

Speaking of eerie, your management teams must be wondering what caused stocks to cross chasms today to the upside. Do you think investors suddenly decided stocks were cheap? To paraphrase Saturday Night Live…really?

No, today is why every corporate IR professional should develop a rudimentary grasp of market structure. The way of the world now in trading markets is more like the movement of tides than the patient fashioning of edifices. To do your job with purpose and ease of mind, it’s helpful to know when the tide turns. We said last week that stocks should benefit from a return of capital after the 4th of July. We saw surging proprietary trading by liquidity providers July 1-2, indicating that software systems expected money to arrive this week.

How do software systems find bargains where investors don’t? They look at different data. To explain, let me tell you a story. Yesterday, we traversed the plains in Kansas from Fort Riley to the Colorado border and west to Denver. Once, that area belonged to the southern Cheyenne tribe. For history buffs like me, it’s living history, crossing that grassy canvas. The Sand Creek massacre site is southward. Battles were fought with the legends of the Cheyenne people at Beecher’s Island and Summit Springs just north of I-70.

The plains people had a narrow, rational worldview. Life revolved by seasons on a finite patch of earth. It worked in predictable fashion. It wasn’t possible for most of them to study different data and reach new conclusions. Now suppose you could sweep up and away in Google Earth fashion from the trace remains of Fort Sedgwick, west of Julesburg township (which the Cheyenne twice looted and burned), and observe continents and hemispheres. What’s happening on the Smoky Hill River isn’t quite so important now.

Trading software sees continents and hemispheres. If it’s summer in Patagonia, it’s time to ski Aspen. By the same token, the movement of money and trading liquidity isn’t limited by individual financial performance, but by where the sun shines and where the skiing’s good – so to speak.

How long will it last? No one knows these days, but the tides move fast. We suspect we could hang ten till July 21. The cool, contemporary IRO won’t try to control the seasons or tides. But it’s good to know about them so you can prepare, enjoy the autumn colors, and abide with a sense of purpose and ease. It beats the agitated uncertainty that can linger when you don’t know what’s over the next knoll. And it certainly beats becoming an archaeological curiosity.

All analogies break down. So let’s finish with a more mechanical explanation. Trading systems can incorporate multi-dimensional data, including the supply and demand of currency, derivatives and stocks. That data is often quicker to imbalances than are rational bottom-up investors looking for intrinsic disconnects between market valuations and financial metrics.

We are not in Iowa, or Kansas, or Fort Sedgwick, anymore.

Buttressed on either side with those brackets about illusion and means, let’s look today at what’s afflicting our market and why some institutions like transient trading when others don’t.

Vanguard, an institutional investor focused on passively managed funds, supports high-frequency trading. George Sauter, CIO for the Vanguard Group, wrote in the firm’s comment letter to the SEC on market structure that high-frequency volumes reduce trading costs through competition and tighter spreads. He quantifies the benefit to investors at roughly 10% over a decade. A passive fund providing 9% returns per annum would deliver only 8% returns without HFT.

By contrast, Mason Hawkins, founder of Southeastern Asset Management, which runs active investments for subsidiary Longleaf Partners, commented to the SEC on April 28 that intermediation by short-term traders costs long-term investors $20 billion per year, distorts true prices, crowds growth and value capital out, and delivers no social purpose or benefit, like investment capital.

How can two marquee institutions arrive at such dissonant conclusions? Different purposes and time horizons – a crucial element of understanding market structure. These are our views now, not Vanguard’s or Southeastern’s. Vanguard rebalances assets constantly as redemptions and inflows wax and wane, benchmark indices reconstitute – as occurred both June 18 and June 25 – and assets are allocated. Regardless of purpose, these monies follow risk-management tenets, and algorithms work like a blender, combining many different ingredients into a smooth batter.

The maker-taker model of markets today, where the consumption and production of liquidity describes market function and architecture, is ideally suited to Vanguard. It works well for general, standard-deviation, risk-management. We could go on at great length here. You’ll be glad to know that we won’t.

Southeastern Management, on the other hand, is seeking intrinsic investment value. This time horizon and purpose faces execution disadvantages now because the aim of the money is fairly singular. Constant high-speed re-pricing of securities doesn’t meet its needs.

We’re talking strictly about market function, not what theses prosper. But think about it from an IR perspective. Which investor is going to entertain your management team? So which sort of execution should concern you?

Which leads to our concluding point, for which we owe thanks to alert reader Leen Simonet at Coherent, Inc. On June 18, S&P indices rebalanced for the quarter. On June 25, Russell indexes reset for the year. Leen noted that these events lent themselves to strange market-structure conditions. We saw it in the data – massive leverage. We could only conclude that money made bets on divergences between components and on the supply and demand of shares that might arise as a result. We think swaps – market positions in off- market contracts, not open-market transactions – were huge. We saw tremendous cash trading at options desks.

These are speculative tactics, not investment purposes. They resulted in significant losses of market capitalization for issuers. On the whole, markets – we had warned that this might well occur with expirations – experienced a big shift in dollars from equities to derivatives.

That would suggest that money may return to equities after the 4th of July. It may not happen. But it’s logical. Traders will bail from options plays before time-decay costs them much. Money will buy equities. Reporters will think money anticipates good Q3 earnings when really it’s a trading tactic. An illusion. The money behind it isn’t concerned with prudence, such as living within one’s means. It’s all about the gaps.

That’s how things work now. For some it’s good. For others, it’s not. What do you think about that? We invite your input.