HFT and ETF’s

By now, we have all heard on how to prevent another flash crash from the HFT proponents. They all seem to read from the same playbook and it goes something like this:

1- Single stock circuit breakers will prevent another flash crash.  The 5 minute “time out” will help cooler heads prevail.

2- “Stub quotes” should be banned to prevent  stocks from trading at $0.01 or $100,000/share

3- “Market makers” should be required to quote in a 10% band of the NBBO.

4- Market orders are very dangerous and should be banned.

The script must have been written by the HFT chief and passed on to the foot soldiers who at every chance spew this to the media.  We expect nothing less from such a well funded, powerful lobby.  We expect guys who operate above hardware stores and trade 100 million shares a day to run with this party line.  But we don’t expect one of the biggest mutual funds in the world to  also read from that  HFT playbook.   Listen to this Morningstar interview with a senior executive at Vanguard:  http://www.morningstar.com/cover/videoCenter.aspx?id=343775

 To be honest, in the past we were surprised by Vanguard’s public support of so many HFT positions, as we expected their thoughts to be in line with nearly all other long term investors, mutual funds, and pension funds.  We were surprised to see Burton Malkiel pen a piece in the FT titled High-frequency trading benefits both large and small investors  (Mr Malkiel is a board member of Vanguard).   I guess we feel pretty dumb now, as the probable reason for their position has been so obvious: Vanguard’s substantial ETF business.  At one point in the referenced interview, the interviewer pointed out that although HFT market makers have been vilified,  they are essential for the ETF product to exist and for all these trades to happen very quickly.  Mr Sauter confirmed that “It’s great to take out the middle man, but unfortunately there aren’t always people ready to transact at same price at same time. So, you need these market makers who are willing to bridge that gap between the two investors.”

The US market for ETF’s is estimated to be $800 billion.  According to Vanguard https://personal.vanguard.com/us/whatweoffer/etfs/etf-costs, the average expense ratio for an ETF is 0.52% (Vanguard expense ratio is only 0.18%).  So, let’s do some quick math, $800 billion x 0.52% = $4.16 billion.  This is a huge market and ETF providers need the HFT market makers  so that they can keep pumping out more ETF’s.  Without HFT “liquidity”, the ETF market would probably not have seen its dramatic increase in size.   But we ask,  at what cost does this liquidity come?  Are unsuspecting ETF investors actually the ones that have been unknowingly funding the HFT industry?  Please also remember that two thirds of the Flash Crash Disaster erroneous trade names were ETF’s; there alone is the HFT smoking gun and footprint. 

Everyone has a stake.