Walking the high-frequency tightrope

Controversy over high-frequency trading, fomented by Michael Lewis' new book, highlights the conflict many chief investment officers experience over the practice.

On the one hand, both pension fund executives and their external money managers are grateful that the development of electronic trading and the competitive exchanges established to serve the growing high-frequency trading segment has dramatically lowered trading costs.

On the other hand, it's maddening for many CIOs to suspect their portfolios' returns might be harmed from front-running by high-frequency trading algorithms.

A Pensions & Investments' online reader poll conducted last week showed 51.5% of respondents believe high-frequency trading is bad for institutional portfolios, while 17.1% said it's good. The remainder said it was neither good nor bad.

So far, most CIOs interviewed for this story report heightened water-cooler chatter about high-frequency trading, a result of the headlines surrounding the publication of Mr. Lewis' “Flash Boys.” They say they've yet to get any formal requests from trustees for an investigation into the practice and its impact on returns.

The $23 billion Texas County & District Retirement System, Austin, invests passively in the U.S. equity market, so high-frequency trading “hasn't been a topic of discussion in many of my conversations, but that was before Michael Lewis' book came out,” Paul J. Williams, investment officer, said in an e-mailed response to questions. Mr. Williams said he's curious to see if system trustees bring up the issue during their next board meeting.

But high-frequency trading has long been a serious conundrum for institutional investment teams.

“We see some (anecdotal) articles that seem to suggest that HFT helped lower trading costs, which have indeed come (down). (If) this (is) true, how does one prove it?” Jon M. Braeutigam, CIO of Michigan's Bureau of Investments, Lansing said in an e-mailed response to a request for reaction.

“On the flip side, computer programs that trade in front of investors and which raise prices somewhat don't seem ethical, do they?” Mr. Braeutigam asked.

The bureau manages the $53.5 billion State of Michigan Retirement Systems, Lansing. A total of about $19.6 billion was managed internally as of Sept. 30, $12.9 billion of which was invested in domestic and international equities.

Craig Husting, CIO of the $34.5 billion Missouri Education Pension Trust, Jefferson City, is less neutral about the impact of high-frequency trading strategies. He said he's worried.

In response to P&I's question — high-frequency trading and your portfolio: good, bad, neutral? — Mr. Husting said that “from a system's perspective, we do not consider it good.”

“I have been concerned and (am) becoming more concerned (because) change is coming,” he wrote in an e-mail. “HFT does not provide liquidity and there is plenty of evidence on this issue. HFT has not lowered spreads, and one must distinguish electronic trading from HFT. One of those lowers cost and the other lowers ethics.”

Officials at the $180.8 billion California State Teachers' Retirement System, West Sacramento, answered P&I's question this way: “With so many flavors of high-frequency trading and the lack of conclusive data on its effects, the answer is neutral,” said an e-mailed statement from spokesman Ricardo Duran.

CalSTRS managed $60.5 billion, or about a third of the fund, internally as of Sept. 30, of which $34.2 billion was in domestic and international equities.

The fund's in-house traders take defensive action when needed through selective use of different markets and exchanges.

“Part of our duty as investment managers is to ensure that ... these assets (are) appropriately invested in markets that we believe to be fair and stable,” the statement said. “The equity traders at CalSTRS are well aware of the market structure and trade their orders accordingly. This includes the use of dark pools when the trade type necessitates.”

Like CalSTRS, consultants are realistic: Many said high-frequency trading is here to stay and one of many market risks with which investors must contend.

“High-frequency trading has existed for more than 20 years and has driven down costs for investors by making markets deeper and spreads tighter,” said Eric Winig, managing director at institutional investment consultant Cambridge Associates LLC, Boston, in an e-mailed response to questions.

In addition, Mr. Winig said “the use of technology to rapidly trade securities is within the letter of the law. This is not to say HFT is riskless, as the prospect of computers crashing markets is one which must be taken seriously. But this risk is no greater than others that exist in the marketplace, e.g., human error in trade execution.”

Other consultants said most of their institutional clients are relying on their external money managers, which hold fiduciary responsibility for the investment, to deal with the impact of HFT.

“I think plan sponsors are focused on what they can control in the investment process — asset allocation and manager selection,” Susan N.McDermott, Chicago-based partner and CIO-institutional advisory, at investment consultant Pavilion Advisory Group Inc., said in an interview.

But institutions also are relying on their consultants to scrutinize money managers' trade execution practices, which has led to “more discussion between consultants and managers about this issue. Trade execution is not the primary factor in manager selection and retention, but it has definitely moved up the rank of priority issues in recent years,” Ms. McDermott said.

Manager-of-managers Commonfund, Wilton, Conn., does little direct trading, but is monitoring its underlying managers very carefully when it comes to best trade execution practices, said David Belmont, chief risk officer, in an interview.

But Mr. Belmont acknowledged that outsmarting high-frequency trading with strategies such as statistical arbitrage, order flow prediction and latency arbitrage is extremely difficult for most money managers and pension funds that manage a lot of equities internally. Some pension funds have joined money managers in trading through dark pool exchanges, which don't release trading information or give outsiders access to the live trade flow.

The true impact on the returns of institutional investment pools resulting from front-running by high-frequency traders is hard to gauge.

“What the whole HFT industry needs is more empirical evidence and transparency based upon actual facts, from unbiased sources such as academics. The industry is not there yet,” Michigan's Mr. Braeutigam said.

What is clear is that in aggregate, high-frequency trading strategies are the biggest consumers of global equity market volume, increasing the likelihood that other participants will become prey as HFT algorithms take advantage of millisecond price variations in a stock.

High-frequency trading firms accounted for 32% of global stock market volume in the first quarter of 2014, compared with 29% in all of 2013, according to data from trade research firm Kissell Research Group LLC, Great Neck, N.Y. In 2003, such strategies amounted to just 1% of market volume, KRG data showed.

HFT threats notwithstanding, Michigan's Mr. Braeutigam and his investment team remain committed to equity investment.

“While we are concerned about HFT, we are long-term-investment focused and we value stocks based upon projected future cash flows. Therefore, we will still be buying stocks, with or without HFT,” he said.