High-frequency trading is symptomatic of a broader problem on Wall Street

By DAVID MOON, Moon Capital Management, LLC
April 27, 2014

Michael Lewis’ new book, “Flash Boys,” claims that Wall Street is rigged. Lewis writes that investment firms operating both as traders and brokers have advance knowledge about their customers’ orders and can use that information to automatically place trades a split second before everyone else, capturing perhaps a penny a share profit across thousands or millions of transactions.

Lewis is right.

But there are so many other, low-profile ways in which Wall Street is rigged that high frequency trading (HFT) is of little practical importance to most individual investors. It would be an improvement for most people if they were only screwed a penny a share.

Many of the conflicts in the investment industry, including HFT, arise because the majority of large investment firms are, or can be, on both sides of most transactions.

For example, when an investment company sells bonds to its clients, those bonds might come from the firm’s own inventory. If so, the firm might be selling you a bond for 102 that it just purchased from another client at 97.

Wall Street specializes in creating complicated structured products, with difficult to understand fees, designed to capitalize on the emotions promulgated by whatever happened last year. In 2009, firms began creating and promoting risk-averse, capital preservation products after the stock market declined 40 percent, not before.

People who bought these things mostly missed a 100 percent increase in the S&P 500.

Which brings us to this week’s Really Stupid Investment, the ETRACS Monthly Reset 2x Leveraged S&P 500 Total Return Exchange Traded Note (ETN.)

If the name of an investment doesn’t fit on a single line of print, it deserves extra scrutiny.

This product is, according to its marketing materials, linked to the monthly compounded 2x leveraged performance of the S&P 500 total return, reduced by investor fees.

Never forget the fees.

The simple sales pitch is that this ETN will provide an investor twice the total return of the S&P 500.

Unlike an exchange traded fund, an exchange traded note is an unsecured debt of the issuer, subject to the same bankruptcy risks and liquidation preferences as any other unsecured lender. There is no third-party guarantee or assets pledged as security.

The bigger problem, however, is the difficulty recovering from leveraged negative returns.

If the market declines 20 percent, then increases 30 percent, an investment in a vanilla S&P index fund would return four percent. (Do the math. It’s not ten percent.)

You might expect this ETN to increase 8 percent (twice the four percent index return,) but it would actually lose four percent, because of the compounding of the initial leveraged negative return.

And when the market does poorly, this product will react very poorly. If you had owned this thing from the market peak in October 2007 to the March 2009 trough, you would have lost 78.3 percent.

Excluding fees, of course.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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