Make the "Rigged" Markets Work for You

The recent appearance by Michael Lewis on 60 Minutes and the publication of his book Flash Boys has generated a furor over the perceived inequities of high-frequency trading.

The idea that those engaged in high-frequency trading are permitted to "see" your trades, purchase stock ahead of your order and resell it to you at a higher price is clearly repugnant. There are claims that high-frequency trading permits insider trading and illegal front-running by disrupting the normal sequence of orders placed or "spoofing" fake trades to create an illusion of market activity. These allegations are deeply troubling and worthy of investigation and responsible regulation.

It will not be easy or quick to sort all this out. In the interim, new trading platforms like IEX level the playing field by depriving high-frequency traders of their information advantage. Its goal of "institutionalizing fairness in the markets" is a worthy one.

Here's what you may not know: You have the power to game this system and make it work for you.

A comprehensive study of high-frequency trading reached some surprising conclusions about its effects on trading. It found that high-frequency trading has had the effect of minimizing trading costs, reducing short-term volatility and increasing market liquidity and market efficiency. Another study concurred with these findings, noting that high-frequency trading "improves market efficiency by reducing bid/ask spreads and market volatility while making markets more liquid."

These conclusions were validated in an op-ed piece written by Clifford Asness and Michael Mendelson of AQR Capital Management in The Wall Street Journal. AQR is an institutional investor managing long-term investments. It does not engage in high-frequency trading.

AQR believes high-frequency trading helps reduce the firm's trading costs and helps increase its returns, thereby increasing the value of its business. It notes that retail investors who trade for themselves have been the "one unambiguous winner" of high-frequency trading because of lower trading costs.

So how do you position yourself to benefit from the positive effects of high-frequency trading, while avoiding its perils?

First, recognize that you may already be a beneficiary of lower trading costs and greater market efficiency.

Second, understand that those who are most affected by high-frequency trading are hedge funds and mutual funds under pressure to move large blocks of stock. Even if you are an investor in these funds, the pass-down impact will be minimal.

Third, you can avoid even this minimal impact by investing in passively managed funds that have a patient and flexible approach to trading. These funds have the discipline to defer executing orders in order to minimize market impact and trading costs.

Fourth, stay focused on issues you can control like your asset allocation, keeping costs low and tax efficiencies. Avoid stock picking, market timing and looking for the next "hot" mutual fund. These factors can have a far more meaningful impact on your expected returns. All the fuss about the harm to Main Street investors from high-frequency trading has obscured the far more meaningful cost of buying expensive, actively managed funds, the majority of which have historically underperformed comparable, lower-cost index funds.

Fifth, if you are really worried about the ability of high-frequency traders to get a "sneak peek" at your trades, pressure your broker to use platforms like IEX.

With a modest knowledge of how high-frequency trading really works, you can adjust your investment philosophy to be a beneficiary rather than a victim of it.

2014-04-01-Hiresfrontbookcover.jpgDan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, The Smartest Sales Book You'll Ever Read, has just been published.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.