Editorial Note: This Market Structure Map first ran June 29, 2010. It’s reprinting because Tim Quast is following the lead of congresspersons by taking a “fact-finding junket” aboard a sailing vessel off the coast of Belize. It’s in the public interest.
Oscar Wilde said that illusion is the first of all pleasures. Of course he also wrote that anyone who lives within his means suffers from a lack of imagination.
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, 2010, 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.
The money behind it isn’t concerned with prudence, such as living within one’s means. It’s all about the gaps. Maybe Oscar Wilde would approve. But he would probably say it lacks imagination.