We need a new market theorem.
Perception about equity-trading is disconnected from observable data. Conventional stock-picking isn’t often pricing the market – yet investors and the executives and boards at public companies act, think and speak as though it is.
After modeling celestial data, 15th-century mathematician Nicolaus Copernicus concluded the earth was not the center as convention declaimed. Jettisoning geocentrism for heliocentric reality didn’t alter life on the planet but it rocked the tectonic plates of perception (and a guy who can convince others to pay him to go to Italy and study stars is obviously bright).
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Today investors and issuers consider market structure a curiosity rather than a central behavioral tenet. Take the growth of index-investing. Across our client base reflecting $1.3 trillion of market capitalization there isn’t a single member not held by both Blackrock and Vanguard. In most cases both are big holders.
Below these are a sea of fellow asset-allocators from the Powershares Exchange Traded Funds (ETFs) offered by Invesco to so-called robo-advisors like Betterment and Charles Schwab’s ETF-powered Intelligent Portfolios. In the past decade trillions of dollars have shifted to passive vehicles. They don’t listen to earnings calls or build financial models.
This community claims to be “perpetual owners” – they just hold things. But if an investment portfolio has inflows, it buys. Redemptions, it sells. If it tracks a market benchmark like the S&P 500, it relentlessly buys and sells to track movements in the benchmark.
With a lot of volume. Bloomberg in a July article put ETF trading dollar-volume over $18 trillion annualized, a chunk in the most active ETF, SPY, a Standard & Poor’s Depositary Receipt (SPDR) from State Street. Turnover in SPY alone is $6 trillion annually and billions daily. Three of the four most active stocks by dollar-volume are ETFs.
Second is Intermediation. The public has come to recognize thanks to Michael Lewis’s riveting nonfiction thriller Flash Boys that traders distort outcomes. It’s worse. Intermediaries are half the volume. Three billion shares daily are chaff, no ownership changing hands.
What’s a reasonable commission for service? Real estate agents split 4-6%. Hedge funds seek 2% plus 20% of profits. Your waiter would like 20% on a restaurant dinner. The government wants about 30%.
Virtu (Nasdaq:VIRT), a high-frequency trader deploying its own capital, had revenues of $148 million last quarter and net income of $77 million, a 52% net margin. No customers, no commissions. But sitting between others, they keep half and own little. And they are setting prices.
Regulators tout low-cost trading. If intermediaries are responsible for half the sales, cheap trades are meaningless and missing the point. Grocery stores as middlemen for producers and consumers have single-digit margins, often about 2%. You don’t need an algorithm to hide your attempt to buy spinach.
What’s more, intermediaries are a regulatory cartel. Fifteen years ago after accusing big brokers of colluding, regulators decimalized prices to diminish intermediary incentives. Today Finra oversees 4,000 brokers yet trade-execution data for our clients show 30 control 90% of volume – just half of those having customers.
The reason?
Rules require brokers with customers to meet trading standards comprised of averages in the marketplace. The biggest brokers are handling order flow for the most active sources of trades: Indexes and ETFs. So the biggest brokers define the standards. Since Finra fines brokers for failing to match averages, smaller brokers route orders to big brokers, who roll them up in algorithms powered by the central tendencies defining the bulk of their trade-executions – indexes and ETFs. It’s self-perpetuating.
This is key to why 80% of stock-pickers can’t beat the market. Their trades are not setting prices.
A third factor blunting rational-pricing is Risk Management. There’s little true “long only money” in markets because everybody hedges macro uncertainty. Sifma, the financial industry’s lobbying group, puts interest-rate swaps notional-value at $500 trillion. The Bank for International Settlements adds currency, equity and credit-default instruments to reach $630 trillion. Macro factors price markets through risk-transfer. Any currency ripple can become a splash in the S&P 500 (and thus in SPY).
Copernicus reshaped our place in the solar system with data. Facts about our stock market should do the same. If it’s demonstrably dominated by asset-allocation, risk-management and intermediation, the new market theorem will measure these behaviors and our understanding of market-moves will trace to behavioral-change, not just price or volume, moving averages or ticks. The risk if we don’t adopt new metrics is an expectation of rational behavior from a market largely lacking it.
Tim Quast is the founder and president of Modern Networks IR LLC.
The views represented in this commentary are those of its author and do not reflect the opinion of Traders or its staff. Traders welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com.
