February 15, 2012

Algo Rhythm

At Winter Park Sunday scooting off the Panoramic high-speed chair at 12,060 feet and cooking downslope on skis, the trip was anything but algorithmic.

No, skimming from summit to the lift slow zone was uniquely and individually exhilarating. But in equity markets, unique exhilaration more often comes from derivative bets that randomly pop stocks 7-8%. Otherwise, your shares blend with millions of other securities across asset classes mixed and matched in proprietary recipes aimed at unique outcomes from ordinariness.

Last week, we likened the movie Moneyball, about baseball statistics, to how stocks trade today. Let’s go one step further. Your story is unique. You differentiate your performance from your peers. We as individuals want to be valued on our own merits. So we hope our company’s shares are examined discretely.

Institutional and retail investors want the same thing, right? Distinct success stories, diamonds in the rough. Listening to advertisements from big mutual funds, you get the sense that analysts are rooting in the rice paddies of southeast Asia to learn why fiber optics from the Philippines are the next big opportunity for a German manufacturer of diodes. Or whatever.

That’s terrific. But everybody from advertisers to IR professionals forgets about the process between the rice paddy and the ticker tape. It’s in this abacus that the great majority of trading, no matter its noble incipient intention, morphs into arbitrage.

Here’s how. Institution A sets out to buy 200,000 shares of XYZ stock up to a certain price. The execution mechanism is an algorithm. It includes features to monitor market and portfolio risk and add “alpha,” or returns related to how trades execute. The algorithm must meet rules that conform its behavior to market norms.

As it jostles with other algorithms buying and selling the same things the same way for different purposes and time horizons, something happens. The dynamics of the marketplace change. What began as an effort to acquire shares shifts to managing market risk in response to these other behaviors, so now the algorithm is selling the shares it was just buying. Investment and risk-management are now competing. Then alpha-generation kicks in and trade-executions begin plucking tidbits of profit on securities spreads.

The original purpose disappeared. Multiply that across the market. The flaw is neither the rigorous study of rice paddies nor the energetic telling of corporate story. It’s the way markets work. Yet NIRI is silent. Public companies ignore it. We take the Dave Barry approach to car troubles. Something in the engine starting to knock? Turn up the radio until you can’t hear it.

My ski buddy Kevin told me a story Sunday. In his community, a group of homeowners fond of horses commandeered the board, raised association dues 200%, and allocated new resources to equine improvements. This set poorly among those without equines. They could have ignored it. They could have groused. They could have turned up the radio until the bad stuff disappeared in the sound waves.

Instead they voted to dissolve the board and disband the association, choosing to work as friends and neighbors on needs rather than be railroaded by behaviors not in everybody’s best interest.

Public companies might take a page from Kevin’s neighborhood. Dues have been misallocated. Markets have been commandeered. It’s time public companies turned down the radio and tuned in.

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