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Here's Why Investors Are Pulling Money Out of the Market

Sal Arnuk and Joseph Saluzzi |Themis Trading LLC, and Co-authors of "Broken Markets"
Thursday, 7 Jun 2012 | 12:50 PM ET
Broken Markets
Source: Amazon.com
Broken Markets

Trust and confidence in the stock market has been shattered in the past few years.

Events like theMay 2010 Flash Crash, the failed BATS IPO and the Facebook IPO fiasco have frustrated investors, leaving them wondering “what the heck is going on?”

In response, they have pulled their money out of domestic equity mutual funds week after week.

Since the Flash Crash, nearly $300 billion has been withdrawn from domestic equity mutual funds, according to the latest report from ICI.

Institutional and retail investors tell us they believe they have no way of competing against the machines that now dominate the market and make money in every kind of tape. Markets have changed dramatically over the past 15 years mainly due to technological advances. No longer are institutional and retail investors – once called “owners” of the market -- the primary source of supply and demand. Their volumes are being drowned out by short term computerized “renters” of the market that can take high-speed advantage of order flow.

As institutional agency traders, we began studying these changes early on, most notably after the implementation of several SEC rules, including Reg ATS in 1998, Decimalization in 2000 and Reg NMS in 2007. We kept our clients abreast as we pieced together the story. The problems, however, have become so complex and threatening to the economy that we found it necessary to consolidate what we learned into a book that would help retail and institutional investors understand what was happening.

In our book, "Broken Markets," we explain how these problems have become embedded in our market structure and are harming traditional retail and institutional investors.

  • Stock exchanges, or "arms merchants," as we like to call them, are now for-profit companies, offering services, such as colocation and private data feeds, that benefit only a small number of their clients. However, these clients, which include high frequency trading firms (HFTs), represent a major portion of the exchanges’ revenue. Thus, the exchanges need to cater to and service HFTs at the expense of traditional investors in order to maintain revenue growth.
  • What in the past was an imperfect, yet elegant, oligopoly of a few stock exchanges has become a broken, fragmented vase held together loosely by high frequency trading. Today in the U.S., there are 13 exchanges and more than 40 dark pools where shares are traded. This fragmentation has created microsecond arbitrage opportunities for HFTs to insert themselves, as well as other unwanted intermediaries, between true buyers and sellers, not only enabling them to shave pennies off the price of virtually every share they buy and sell but also displacing traditional investors.
  • What has been lost along the way in the so-called “evolution” of our markets is the original purpose of a stock market. That is, to help companies go public, raise capital, grow, expand productivity and employment, and give investors the chance to invest. Despite recent publicity, the IPO market collapsed some time ago. The current market structure has taken away all the economic incentives for brokerage firms to finance and support new companies.

Serious reforms need to be implemented if we ever expect institutional and retail investors to return. In our book, we suggest potential fixes, including new alternative markets. However, before our great nation can even consider these solutions, traditional retail and institutional investors need to let regulators and lawmakers know that they are unhappy with the current market structure and want it fixed.

It’s time for our Capital Superhighway to once again be run sensibly, where capital formation and traditional retail and institutional investor needs reemerge as the focus of our markets. Then, and only then, will investor confidence return.

TUNE IN:

Tomorrow, June 8, 2012 the authors are scheduled to appear on CNBC's "Squawk Box" to further discuss this topic and their book. Their appearance is scheduled (pending breaking news) for 7:30am/et.

Sal Arnuk and Joseph Saluzzi own and manage Themis Trading LLC, an institutional brokerage firm and are co-authors of the just released book Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio." They are experts in electronic trading and market structure, frequent contributors to CNBC and Bloomberg TV, and their views have been published in The Wall Street Journal, New York Times, USA Today, Los Angeles Times, and The Financial Times, as well as trade publications and quoted by market reporting writers. Before founding Themis, for nearly a decade they were associated with electronic trading pioneer Instinet and with Morgan Stanley.

Email me at bullishonbooks@cnbc.comAnd follow me on Twitter @BullishonBooks

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