December 14, 2010

Why Franklin Templeton Likes HFT

Last week in Miami, I took part in a panel discussion about modern trading realities. The weather Thursday was like it is in Denver now, about 60 degrees. Those of you south or north who need to warm up, come visit. I clocked some hours on the bike Saturday and Sunday. It wasn’t sunburn weather, but on bikes in December at 5,000 feet? Life’s good.

Getting back to trading, how come some investors rail at churn trading, while others love machine intermediation? Somebody must be wrong, right?

Take Templeton Global Advisors, which runs about $100 billion. The president there, Cindy Sweeting, was a fellow panelist. They favor the low-touch, low-cost structure in markets today. With fast machines taking the other side of institutional trades, funds like Templeton can re-allocate portfolios fluidly across asset classes for 60% of the commissions they used to pay, and with abundant liquidity.

What’s more, machines create value opportunities, the Templeton folks believe. The propensity of money to run in algorithmic packs today, what’s called Macro Focus investing because it’s built around big trends and large scale risk-management, means sometimes this group or that sector are left behind. Templeton can swiftly allocate resources, feed out orders through card-shuffling automated trading systems, and blend a fresh investment hand in a new suite into the deck.

Sounds great. How come everybody doesn’t agree? Mason Hawkins at Southeastern Management somewhat famously opined to the SEC that “current market structure is flawed because unfair structural advantages permit short-term professional traders to insert themselves between long-term buyers and sellers. This intermediation conservatively results in $20 billion per year in execution costs and untold billions in opportunity costs for investors.”

One says costs are lower. One says costs are higher. Our point, and we do have one, is to give IR professionals answers. So, when somebody dashes breathlessly up on the street and bleats, “High Frequency Trading is bad!” And you reply, “that’s correct,” and then you turn, and Cindy Sweeting, a very smart and informed investor and a really nice person to boot says “we love it,” well, how to avoid appearing the fool?

The answer lies in the difference between liquidity and capital formation. We have reached an odd place in the capital markets where the interests of growing businesses and the objectives of institutional investors are at odds. Intel went public in 1971 at $23.50, and raised $6.8 million. Its market cap is $120 billion today. That’s capital formation. But in 2005, its market cap was $150 billion.

This is part of the “untold billions” Mason Hawkins meant. We have traded capital formation for the efficient movement of liquidity, and the two are not equal. For many modern global institutions, finding gaps and divergences that span months and weeks, combined with cheap trades and bountiful liquidity, is sufficient.

It can and will produce returns for nimble investors. If it didn’t, we would not have seen fundamental investment fall from 50% of daily volume a half-decade ago to below 10% now, while speculation, program trading have exploded. In some mega caps now, forms of fast-moving liquidity ranging from Templeton’s comings and goings to mathematical arbitrage account 95% of volume.

But it’s not truly investment, but more like the nexus of dislocation and intermediation. Market caps for many fine companies are stuck in neutral (there are always outliers). Money hasn’t forsaken equities; it’s morphed from buying low and selling high on fundamentals, to buying low and selling high on divergence.

And that’s the difference. High-frequency trading is not bad. It’s superbly efficient for moving securities from point to divergent point. But intermediation replaces capital formation. How many IPOs have you seen raising $7 million now? It’s not done, and so companies don’t grow anymore from tiny to giant, which is not only the heart of job-creation, but the root of investment, and wealth.

So when you’re asked why some like it fast and some don’t, you might just say, “The card shuffler revolutionized card shuffling, just like fast trading did for liquidity. So how come they don’t use automatic card shufflers in the World Series of Poker?”

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