Thursday, April 3, 2014

Making Sense of the “Markets are Rigged” Nonsense

Michael Lewis has a new book that is gaining a lot of attention this week, especially since 60 Minutes ran a promotion of it, and when asked on that program what the punch line is from the book, Lewis responded with, “Markets are rigged”.  The subject of this book and Lewis’ ire are high frequency traders, who use market buy and sell information to make lightning fast trades to make pennies on transactions.  But I think some perspective is in order. 

First, Lewis claims that these firms have made “tens of billions of dollars”.  Let’s accept that claim (even though it is likely he is excluding the firms who have also lost significant sums with these types of trades).  The U.S. stock market has increased approximately $12 trillion in value since the lows of the economic crisis.  If we add back in the amount that Lewis claims high frequency traders have made at other investors’ expense, the value increase would have been $12.05 trillion (taking the midpoint of $50 billion for Lewis’ approximation) without high frequency traders.  $12.05 trillion vs. $12.00 trillion.  I am not exactly outraged.  And if you take his comments to mean you should get out of the market, consider how much wealth creation investors would have missed if they concluded markets were too rigged against them.

Also, Lewis talks about the “front running” that these traders do, although front running is illegal, and the high frequency traders are not accused of doing anything illegal.  But the basic argument is that they know you are going to buy a stock, and so they buy it in front of you and sell it back to you for a higher price.  An analogy on the program is given using buying tickets for a show, whereby you want to buy 4 tickets to a show all at $20, but after you buy 2 tickets, the price of the other 2 goes up to $25 before you can complete the purchase (since someone saw your demand for the first 2 tickets).  The problem with this example is that the difference in prices for stocks is a penny or two, not $5.  Lewis says as much in the 60 Minutes advertisement.  So, if you bought a stock 7 years ago at $50 and sell it today for $100, your profit could have been maybe $50.03 instead of $50 without high frequency traders.  You are not exactly getting ripped off.  Funny enough the investors who get hurt the most are hedge funds who might trade more frequently or other slower high frequency traders.  Are Lewis and 60 Minutes really trying to make people feel bad for hedge funds?

And finally, all of this ignores any potential value that these traders provide in terms of added liquidity to markets.  While the amount of that value may be debatable, assuming it is zero is clearly misleading.

So does this mean it is not a problem at all?  Maybe, maybe not.  Obviously if something is being done illegally, that should be stopped.  But this is not a significant concern given the size of financial markets, even if you want to argue they add no value.  If you really want to get outraged, consider perhaps the 1% or more in fees an actively managed fund charges EVERY YEAR for providing returns that are no better than if you bought an index fund.  This is a far bigger drain on the average investor.  But if you are a buy and hold investor in stock index funds, you have nothing to worry about.


  1. For what it's worth, I completely agree with all of your arguments ...

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