How to Beat High-Frequency Traders
Thursday, April 3, 2014
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 35.4%, up 4.2 points
  Neutral: 37.9%, down 2.4 points
  Bearish: 26.8%, down 1.8 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »


Author Michael Lewis ignited a debate within the financial community with his appearance on “60 Minutes” last Sunday. Lewis, the author of “Flash Boys: A Wall Street Revolt” (W. W. Norton & Co., 2014), called the stock market “rigged.” His reasoning? High-frequency traders are seeing what trades are being placed, jumping in line ahead of those investors who placed the trades and profiting at the expense of everyone else.

Brad Katsuyama, the man whose story Lewis tells in his book, used an analogy of buying tickets. Katsuyama described to “60 Minutes” a situation of placing an order to buy concert tickets for four adjacent seats on ticket exchange StubHub at $20 a ticket. A confirmation comes back saying only two tickets have been purchased. At the same time, the price of the other two adjacent seats has risen to $25.

The jump in prices described by Katsuyama, 20%, is a big exaggeration, but it clearly explains the allegation he trying to make: High-frequency traders are getting ahead of investors and are profiting as a result. High-frequency traders and their proponents counter that trading costs are being driven down and liquidity is being improved in the process.

Where’s the truth? The five-year 21.7% annualized return for the iShares Russell 3000 fund (IWV) as of March 31, 2014, shows good returns could have easily been realized by an individual investor who merely tracked the broad market’s performance. (A big reward for participating in the so-called “rigged” market.) Self-described long-term institutional investors Clifford Asness and Michael Mendelson of AQR Capital Management claimed in a Wall Street Journal op-ed that high-frequency trading is reducing their costs. On the other hand, if high-frequency trading firms weren’t making money, they certainly would change their approach.

It’s hard to discuss this subject without igniting emotions. It’s even more difficult to separate the facts from the hyperbole. What’s lost in the conversation is a focus on the market’s complexity. The digital structure underlying the market has become so complex, there isn’t a clear answer as what actual impact high-frequency traders are having on all other investors. Even Asness and Mendelson admitted not being “100% sure” as to whether high-frequency trading is actually reducing their costs. What we do know is that complexity not only can lead to problems such as the flash crash, but it can create anomalies and opportunities for malfeasance (legal, ethical or perceived).

As an individual investor you can fret about this or you can exploit your advantages. Those advantage are:

  1. Opting not to play their game. Day trading was a loser’s game for the majority of those who tried it before the advent of high-frequency trading. Now the odds are even more stacked against individual investors who attempt to day trade. The arms race favors ultra-high-speed connections and servers as close to the exchanges as possible. The only way you can beat high-frequency traders is to circumvent them.
  2. Limiting the number of transactions. The less you trade, the less chance high-frequency traders have to jump in front of your orders.
  3. Buying funds with less portfolio turnover. The average large-cap mutual fund covered by our mutual fund guide had a portfolio turnover ratio of 64% last year. In comparison, the Vanguard 500 Index fund (VFINX) had a turnover ratio of 3%. Even if high-frequency trading does drive up costs, buying funds with low turnover ratios will limit the impact on your wealth.
  4. Investing where the professionals aren’t looking. Many pension funds, mutual funds and other institutional investors have restrictions on what they can and cannot invest in. It only makes sense for high-frequency traders to focus on the stocks most likely to be bought and sold by institutional investors. You, as an individual investor, are not encumbered by the restrictions placed on institutional investors. So do what we do at AAII, which is to go into the shadows of the market and seek out small, profitable companies with attractive valuations. By investing where others aren’t, our Model Shadow Stock Portfolio has realized a five-year annualized return of 44.5% (through February 28, 2013)—a performance number that includes all transaction costs.

  5. More on AAII.com

    The Week Ahead

    Alcoa (AA) will “officially” kick off first-quarter earnings season when it reports on Tuesday. Dow component JPMorgan Chase (JPM) will report on Friday. Joining them will be fellow S&P 500 members Bed, Bath & Beyond (BBBY), Constellation Brands (STZ) and Progressive (PGR) on Wednesday; Family Dollar Stores (FDO) on Thursday; and Fastenal (FAST) and Wells Fargo (WFC) on Friday.

    The minutes from the March Federal Reserve Open Market Committee meeting will be released on Wednesday. March import and export prices will be released on Thursday. Friday will feature the March Producer Price Index (PPI) and the preliminary University of Michigan consumer sentiment survey.

    Several Federal Reserve officials will make public appearances. St Louis president James Bullard will speak on Monday. Minneapolis Federal Reserve president Narayana Kocherlakota and Philadelphia president Charles Plosser will speak on Tuesday. Governor Daniel Tarullo will speak on Wednesday. Chicago president Charles Evans will speak on Wednesday and Thursday.

    The Federal Reserve will auction $30 billion of three-year notes on Tuesday and $21 billion of 10-year notes on Wednesday.


    AAII Sentiment Survey

    The proportion of individual investors expecting stock prices to be essentially unchanged over the next six months continues to be above the historical average, according to the latest AAII Sentiment Survey. Optimism increased, while pessimism declined.

    Bullish sentiment, expectations that stock prices will rise over the next six months, rebounded by 4.2 percentage points to 35.4%. Even with the increase, optimism remains below its historical average of 39.0% for the third consecutive week.

    Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined 2.4 percentage points to 37.9%. Neutral sentiment is now above its historical average of 30.5% for the 13th consecutive week.

    Bearish sentiment, expectations that stock prices will fall over the next six months, declined 1.8 percentage points to 26.8%. This is the fourth time in five weeks that pessimism has stayed within a 0.7 percentage-point range. It is also the eighth consecutive week and the 26th time in 30 weeks with a bearish sentiment reading below the historical average of 30.5%.

    The current streak of consecutive weeks with above-average neutral sentiment is the longest since 1999. Neutral sentiment stayed above its historical average for 15 consecutive weeks between July 29, 1999 and November 4, 1999.

    All three indicators are within their typical ranges. Keeping some AAII members encouraged about the short-term outlook for equities is the overall upward momentum of stock prices, earnings growth, economic expansion, the Federal Reserve’s tapering of bond purchases and low interest rates. Other AAII members are fretting about elevated stock valuations, the pace of revenue growth, the slow rate of economic expansion and Washington politics.

    This week’s special question asked AAII members what they considered to be the most important characteristic for judging a stock’s potential upside. Responses varied, though profits were cited by the largest number of respondents (37%). These members not only wanted to see earnings, but expressed a preference for earnings growth and earnings exceeding expectations. Valuation was the second most popular characteristic, named by 10% of respondents. Good management and positive cash flow tied for third with each named by 7% of respondents.

    » Take the AAII Sentiment Survey

    AAII Asset Allocation Survey

    March Asset Allocation Survey results:
    Stocks/Stock Funds:
        67.2%, up 0.3 points
    Bonds/Bond Funds:
        15.7%, down 0.5 points
    Cash:
        17.13%, up 0.2 points

    Asset Allocation Survey details:
    Stocks:
         31.0%, down 4.0 points
    Stock Funds:
         36.1%, up 4.2 points
    Bonds:
         3.2%, down 0. 7 points
    Bond Funds:
         12.5%, up 0.2 percentage points

    Take the AAII Asset Allocation survey »


    Individual investors’ fixed-income allocations fell below their historical average of 16% for just the second time in the past five years. The March AAII Allocation Survey bonds and bond funds reading of 15.7% is the second lowest since May 2009. Stock and cash allocations rose slightly last month.

    Stock and stock fund allocations rose 0.3 percentage points to 67.2%. This is the third largest allocation to equities since June 2007 (68.6%), trailing only September 2007 (68.1%) and December 2013 (68.3%). March 2014 was also the 12th consecutive month and the 14th out of the past 15 with equity allocations above their historical average of 60%.

    Bond and bond fund allocations declined 0.5 percentage points to 15.7%. As noted above, this is just the second time since 2009 that fixed-income allocations are below their historical average of 16%.

    Cash allocations increased by 0.2 percentage points to 17.1%. The increase was not large enough to prevent March from being the 28th consecutive month with cash allocations below their historical average of 24%.

    It is important to consider the magnitude of the shifts in portfolio allocations when looking at these latest survey results. Across all three asset categories, the changes were modest. Though the low level of fixed-income exposure is notable—especially when compared against the levels of the past several years—the March results signal a continuation of a longer-term trend. Since last staying above 20% in January 2013, bond and bond fund allocations have decreased by a cumulative 4.5 percentage points. The decline reflects both the expectation that interest rates have bottomed as well as a reaction to the ongoing bull market in stocks.

    This week’s special question asked AAII members what primarily caused their portfolio allocations to change over the past month. Slightly less than half (44%) of all respondents said buying and selling altered their allocations. A variety of reasons for transacting were given, including rebalancing, taking profits in stocks, raising cash and buying stocks. About 24% said their allocation did not change last month, while 23% attributed the changes in their allocations to market fluctuations. A small group (4%) said they increased their cash positions because of fear or the anticipation of a forthcoming market pullback.

    » Take the AAII Asset Allocation Survey