This matters . While small-cap stocks typically account for a smaller share of the buy-side ’ s trading activity than larger cap stocks , small-caps are crucially important to the wider economy , since
they are potentially the large companies of the future . Small companies need to raise capital to grow and succeed ; if they are unable to do so by raising money in the capital markets , their alternative would either be to curtail their plans , or to find alternative sources of funding . “ The question is , can you do an IPO , or go to the secondary market under these conditions ?” added Connors . The situation favours large buy-side firms over small ones , too . While some asset managers are bringing research analysts in-house to provide their own research , only the larger companies can afford to do so . Smaller firms will find it difficult to keep up ; the resulting unbalanced market structure could arguably be criticised for being anti-competitive . Combined with the lack of coverage from brokerages , the outlook for small-cap stocks is worrying . “ Some people say you don ’ t need brokers . I believe we do ,” said Connors . “ The value is in the small and mid caps . If you trade a small cap , it may only trade a few times a day . You need a broker to find the natural liquidity in that stock .” The problem with small caps translates into a problem for the whole economy , with a number of undesirable consequences . A series of so-called “ unicorn ” crashes in the last couple of years can be linked back to the poor state of the capital markets . According to Connors , companies are over-valued and investors don ’ t know what they are investing in . This creates bubbles , some of which then inevitably burst with damaging effects for all concerned .
Turning passive ? The structural problems in the US market go beyond mid- and small-caps . As these markets are eroded , a global shift towards passive investing and ETFs is causing a return to the mean in performance . Some voices in the market are already warning that the result is inefficient allocation of capital – and damage to the real economy . In August , analysts at broker Sanford C .
“ If an algo can front-run an active trader from an asset management company , what ’ s stopping them from front-running an ETF ?"
Bernstein released a paper called The Silent Road to Serfdom : Why Passive Investing is Worse Than Marxism . In the paper , they argued that the best model is a capitalist economy with functioning capital markets , which creates economic growth ; the second best model is a Marxist economy , where “ at least somebody is at least someone is doing the planning of capital allocation ”. The argument is that even if this were somewhat inefficient , it would at least be preferable to the passive investing model , in which no party even makes an attempt to allocate capital effectively . “ It ’ s a misallocation of capital ,” said Connors . “ ETF invest in ten stocks instead of the three best in the sector . That ’ s inefficient . With passive investing , money doesn ’ t go where it is efficiently allocated .” The US election may also have contributed to the problem in recent months . As asset managers reduce exposures , this causes them to underperform . Asset allocators then pull resources from the hedge funds that under-performed , and in many cases it goes to ETFs and passive trading strategies instead . This increases the number of participants essentially chasing the same strategy . The uncertainty driven by the forthcoming election in November perpetuates the cycle . As with many issues in the capital markets , problems in one area are linked to other changes elsewhere . Connors believes that the rise of automated trading and the proliferation of highfrequency trading has not been to the advantage of long-term investors , nor has the fragmentation of exchanges and trading venues over the last decade . “ There are too many algos ,” he said . “ At the US ATF in the summer , when one broker asked what kind of algos they could provide to suit the buy side ’ s needs , one asset manager responded : ‘ Stop giving us algos !’ It ’ s a race to zero for rates , and I think we ’ re pretty close to that already .” Above all , the rise of sophisticated trading strategies and the potential for the abuse of the market are concerns for Connors , as they are for many buy-side traders worldwide . While suspicion of HFT is not new and has existed for years , the rise of passive investing could be making the market more vulnerable to aggressive and predatory trading strategies . “ If an algo can front-run an active trader from an asset management company , what ’ s stopping them from front-running an ETF ? It would be possible in theory to work out what their fund is doing , work out which stocks they are active in , figure out the money flows behind it and take advantage ,” said Connors .
Taking a stand While the industry has debated the benefits and costs of high-frequency trading to the market for many years , the main arguments can be summarised as follows : 1 . HFT adds liquidity to the market , helping to bring narrow spreads and therefore lower the cost of trading for all participants 2 . HFT firms are not a substitute for traditional market makers ; when market conditions become tough , the HFTs disappear from the market , a practice that many of the buy side have complained about 3 . The buy side often accuses HFTs of picking off long-only asset managers , getting in front of their trades and ripping them off 4 . The liquidity provided by HFTs is often not real , since many HFTs cancel a very high proportion of their orders ; most of these orders are essentially just a way of pinging the market to see what flows are there
The debate over HFT spills over into almost every aspect of trading . For example , exchanges have been criticised in the past for spending large sums of money on upgrading their trading platforms in a bid to attract more volume from HFTs . The resulting “ race for
October 2016 www . buysideintel . com
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