Man Vs. Machine: Commentary—Shouldn’t the SEC Focus on High Frequency Products?

When financial assets move in highly correlated ways, that should be the worry for regulators

ETFs and the derivatives built around them have become the proverbial tail that wags the market

The SEC’s focus on high frequency traders should be instead on the proliferation of high frequency products. The traders are the good guys in the Man versus Machine debate. My worries are about the 30-some sponsors of Exchange Traded Funds (ETFs) who are said to be creating all sorts of new ready-to-exploit pricing inefficiencies in small capitalization stocks, sectors, industry ETFs, ETF futures, ETF options, and ETF fund-of-funds.

While the SEC openly worriesabout the speed of trading, staff there facilitates the rapid birth of high frequency products in increasingly exotic ETF packages. I am convinced that the May flash crash of stock values owes the day to ETFs and the high frequency traders who enable the product to exist.

The wisdom of the New York Stock Exchange, which has long used a time out to clear order imbalances, and has been widely emulated in the German stock market, broke down the physical hedging needed to take the other side of the cascade of institutional ETF trades.

Ironically, the regulator’s initial fix was to ignore ETF order imbalances. That’s where supply and demand equilibrium should be managed—they are after all derivative securities.

Has anyone stopped to consider what happens when the fourth largest physical holder of gold bullion needs to begin destroying ETF creation units? Will the buyers of physical gold be there to unwind these ETFs as fast as they have been created over the past three or four years of unprecedented pessimism toward paper currencies?

We can’t seem to list more U.S. companies, so instead we create enormously complex packages that wrap the same finite universe of securities and call it innovation. It reminds me of the whole financial engineering mess in mortgages.

The opportunities provided hedge funds to exploit fleeting arbitrage opportunities between securities held in these packages generates knock-on effects that have been little discussed. Richard Bookstaber in his seminal 2007 book A Demon of Our Own Design talks about tightly-coupled systems which, if left unattended, will regularly produce events like the flash crash (where 65 percent of cancelled orders were for ETFs). The front flap of his far-sighted book describes the increasing complexity of our financial markets “that is ever edging toward disaster.”

The speed with which we trade securities has little to do with these effects. The introduction of an amazing array of derivative securities against a static number of underlying physical equity securities suggests that a stock’s relative value in a package may be more important than its intrinsic value.

The hedge funds and high frequency trading communityworry only about temporary price discrepancies of a stock, or option, or future held in a variety of synthetic packages and overseen by two separate regulators.

I’m told that many hedge firms have established sophisticated techniques that set up trades with little market risk, thus allowing them to stomp on the gas or the brakes of small company stocks held in a glistening array of ETF packages—all the way from broad indexes to lithium or palladium packages.

The July 2010 report by Empirical Research Partners illustrates that the cap-weighted correlation among large cap stocks has been 60 percent for a good part of this year—a level exceeded only twice in 84 years (1929 and 2009). The data illustrates that correlations have been rising most of the decade in both the broad market and within sectors like financials, capital goods and transportation.

When financial assets move in highly correlated ways that should be the worry for regulators. This is a sign that markets may be misallocating capital and failing to discriminate among investments by not properly disciplining risk and rewarding success.

ETFs are contributing to this phenomenon. I understand that executives of companies considering a public offering want assurances that their company will not be included in an index. Other market participants tell me they worry that the trading of relative values derived from ETFs and options and futures may be hollowing out the price discovery function important for very small companies to attract capital to facilitate both growth and job creation.

I speak often to hedge funds who earned strong profits shorting large cap securities and buying illiquid small cap securities up until 2008 when they found that “market impact” kept them from getting out of small cap stocks when investors asked for their money.

Sharply falling small company stock values made them call “No Mas,” in a saying made famous by the middleweight boxer Roberto “Hands of Stone” Duran as he was slapped about by Sugar Ray Leonard. Instead, they avoid individual illiquid stocks by achieving equivalent portfolio “exposures” by relying on ETF sector portfolios, which they characterize as liquid.

Wall Street seduces us several times a decade with products promising unlimited liquidity—trading ease—for inherently costly, difficult to trade securities. Because illiquid small cap companies are repackaged, they do not suddenly become liquid. This is the fatal assumption in tightly coupled systems. Ask anyone who holds a leveraged ETF in their portfolio for more than a few days and wonders where their money has gone.

Despite concerns about the speed of trading, the SEChas rapidly increased creation of new trading vehicles whose very existence depends on high frequency traders and instant arbitrage to underlying securities. At the beginning of this decade, there were 80 ETFs. At the end of 2005, there were about 200. Today, 30 sponsors manufacture more than 900 ETFs and there are more than 500 in the regulatory pipeline.

The first ETFs were set up to escape the confiscatory tax policy applied to individual investors in mutual funds who must pay taxes on stock specific gains in a portfolio that might be down significantly in value. To this degree, broad based ETFs contributed directly to improving the tax outcomes for some smaller investors.

But over time, these mostly cap-weighted stock index portfolios, with the $782 billion in ETF assets trading an astounding $18.2 trillion last year, have grown too fast and are now morphing in new unexpected ways. Simply put, ETFs and the derivatives built around them have become the proverbial tail that wags the market.

Harold Bradley is Chief Investment Officer of the Ewing Marion Kauffman Foundation.