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Aon Retirement and Investment Blog

High Frequency Trading and Your Portfolio

What is High Frequency Trading (HFT)?

In existence since 1999, HFT utilizes technology to make quick trading decisions, often within milliseconds. Estimated at 50% of all equity transaction volumes in the US, some believe that this trading strategy provides a great deal of benefit to overall market structure in terms of increased liquidity and tighter bid/ask spreads.

Why is it controversial?

HFT has evolved with market structures, and as speed of information and proximity to trading exchanges have increasingly rewarded High Frequency traders driven by those factors, the discussion of this trading approach, and the assumptions underlying the most popular exchanges on which it functions, has gained momentum. Definitions and perspectives are varied. For example, some claim that HFT increases liquidity in the marketplace because the actions of High Frequency firms reduce the overall bid/ask spread, while others claim that the interference affects the quality of the bid/ask spread – forcing sellers to sell at a lower price than they would otherwise – and manipulates the liquidity within the market.  These differing perspectives make HFT a rich topic for discussing trading practices and market structures.

Is it legal?

HFT is legal. How information is obtained to run the HFT strategy presents the potential for illegal activities.

Am I paying more or less to trade securities because of HFT?

In a general sense, HFT decreases the bid/ask spread, and that lowers overall trading costs. However, if High Frequency Traders are generating revenues, then they must be generating them from somewhere, and the worry of most investors is whether those earnings are unknowingly coming from their pockets. This is a difficult concern to address, as one can simultaneously lose money to HFT on a case basis but, say, benefit from tighter bid/ask spreads overall.

Does HFT increase systemic risk?

Potentially, yes. Consider the flash crashes that were a product of demands for a great deal of liquidity in short order. The big question that has come out of discussions of HFT considers whether it should or should not be more regulated given its potential for market influence.

What Should I Do?

Most institutional investors (via their investment managers) are holding securities for extended periods of time. The lower the turnover of the portfolio, the less likely an investor will be susceptible to “predatory” HFT activities. Of course, not all investment strategies are long-only, and if this is the case, it is important to question the trading practices of your investment managers. Are they accessing liquidity and seeking best execution from a variety of sources (Electronic Communication Networks, dark pools, as well as traditional “lit” exchanges)? How and to what extent are they evaluating and monitoring the trading venues available to them? Given that HFT has existed for some time, the most experienced and sophisticated investment managers have approaches and structures to deal with HFT. Investors should ask about these as part of their due diligence when hiring managers.

Will HFT Go Away?

HFT has developed over time, and it is not only a complex participant but also a reflection of the challenges that have developed out of current market structures. Individuals profiting from this activity have adapted (and continue to adapt) to changes in market regulations as well as adapting to advances in technology.  HFT isn’t a concept that will simply disappear, but it is a concept that provides reasons for assessing the current market structures.

 

Shane Schurter is a Senior Consultant at Hewitt EnnisKnupp.

 


The information contained above should be regarded as general information only. That is, your personal objectives, needs or financial situation were not taken into account when preparing this information. Accordingly, you should consider the appropriateness of acting on this information, particularly in the context of your own objectives, financial situation and needs.Nothing in this document should be treated as an authoritative statement of the law on any particular issue or specific case, nor should it be treated as investment advice. Use of, or reliance upon any information in this post is at your sole discretion. It should not be construed as legal or investment advice. Please consult with your independent professional for any such advice. The blog content is intended for professional investors only.


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