How to beat this week's 'front running' machines

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The steep falls in U.S. equity markets at the start of this week were accentuated by "front running" from high-frequency traders, according to Jim McCaughan, CEO of Principal Global Investors – although he said there could still be opportunities amid the turmoil.

"I think the fundamental explanations of the last week's action in markets are fundamentally flawed," he told CNBC Thursday.

Traders work on the floor of the New York Stock Exchange.
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The Dow Jones industrial average fell as much as 1,089 points at the open Monday and experienced its biggest intraday swing in history. Since then it's been on a roller-coaster ride but has managed to recover to trade 1.18 percent for the week by the end of Thursday's close.

Chinese growth concerns, fears over an interest rate hike by the U.S. Federal Reserve and a plunge in the oil price were widely believed to be the major drivers of the hefty selling at the start of the week.

However, McCaughan argued that many other factors were at play, which turned a 2-3 percent fall into something much worse.

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"You get other trading effects -- the exchange-traded funds being on market stop-loss orders, you have the high-frequency traders. I'll use a pejorative word, and if the cap fits they can accept it, front-running some of the other selling," he said.

Front running is a loose term that can refer to the unethical practice of traders using lightning-quick computer programs—high-frequency trading—to detect orders from rival traders, then jump in front of that trade

"There are mechanisms that turn a 2 or 3 percent fall in the market into a 10 percent fall. I think that's what happened and I believe that longer-term more fundamental investors should be taking advantage of that," McCaughan added.

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He stressed that investors should look to rebalance their portfolio in an effort to benefit from this market "phenomenon." He encouraged investors to move away from trading on sentiment – which can result in buying high and selling low – and back to a "defined allocation," which he said tends to lead to buying low and selling high.

One way to trade recent events, in U.S. equities at least, would be to "buy on setbacks" and steer clear of emerging markets, McCaughan added.

The New York Stock Exchange invoked the little-used Rule 48 to pre-empt panic trading this week. This aims to ensure orderly trading amid financial market turbulence and speeds up a market opening by suspending the requirement that stock prices be announced at the open.

But McCaughan is unconvinced by the rule, which he said "sets aside" a process of balancing buys and sells at the opening, which is intended for investor protection.

"I would like to know what the implications of that were," he said. "I have a suspicion that it allows inordinate profit making by some of the market makers. If that's true then investor interest demands that it is thought about (by regulators)."

On Tuesday, celebrity investor Mark Cuban also stressed that high-frequency traders were dominating the stock market this week. On the messaging app Cyber Dust, he wrote that this computer-based rapid trading poses risks for investors who wouldn't be able to react as quickly as the machines.

Traders work on the floor of the New York Stock Exchange.
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There has been some defense of the practice this week, however. Virtu Financial is a high-frequency trading and market making firm and its CEO stressed that the technique had not played an exorbitant role in the market selloff.

"We don't cause volatility, as a market maker we're absorbing volatility and we think we soften it," he told CNBC's "Squawk on the Street" in an interview Tuesday. "We're really just in the role of transferring risk from natural buyers to natural sellers."