Sun Tzu, Schroders Research Piece, and How Long Term Investors Are Hurt by Modern Market Structure and HFT



Time and time again we hear arguments from defenders and advocates for high frequency trading, and our current market structure, that purport that long term investors should not concern themselves with high frequency trading and the plumbing that underlies our modern markets. Just this past Friday we were interviewed by a media outlet doing a story that attempted to make those arguments yet again, which go something like:

“Long-term investors are little affected by mini flash crashes, system glitches, and early data releases; their investment horizon is long term while HFT investment horizons are short term.”


“Long term investors have never had it better, as they enjoy narrow spreads, cheap commissions, and fast execution fills.”

The advocates of such arguments are guilty of engaging in classic misdirection and misinformation. They don’t want you to know how the sausage is made, because they systematically make money by making the sausage. They don’t want you to remember that most long term investor money is pooled into large orders, as it is institutionally managed, and those large orders are the food for their sausage grinders.

The Chinese military general, Sun Tzu, stated “Know Thy Self; Know Thy Enemy. A Thousand Battles A Thousand Victories.” It sure seems as if General Sun Tzu was talking about high frequency trading, doesn’t it? This morning we would like to draw your attention to an August 2013 research paper authored by Will Psomadelis (Schroeders) and Stuart Baden-Powel (RBC) titled Know Thy Counterparty.

The points that the authors make in this piece, and the academic papers they cite within it, should not be alien to our readers, as we have made those points and highlighted those very academic papers numerous times for you in the past. What their piece does do however, and does extremely well, is tie many of them together in a way that answers the question, “How are long term investors really hurt by high frequency trading and modern market structure.”

While HFT proponents frequently claim that the mismatch between investor and HFT investment horizons (long vs. very short) is of little concern, these authors correctly dispute that claim; buyside trading desks interact with the market typically using algos, and each child order they send is short term.  The destinations that each child order frequents are toxic, or less toxic. Reversion and fills each from these destinations differ, and gamed child orders are feasted upon by HFT bandits – with the result being costs incurred by the investment manager and long term investor.

In addition, the authors note that the delivery of these child orders (by the institutional algos) exhibits predictability and signaling that is:

“Discernible by genetic algorithms using Bayesian probabilities – for example those adopted by HFT. These signals lead to material cost increases for counterparts who revisit the market several times to complete one parent order.”

The breaking up of a 500,000 share order into hundreds of “child orders” does not minimize leakage and slippage;  it enhances it.


The authors also measured dark pool executions by destination:

“Given the diversification of orders, order types, anti-gaming rules and counterparty selection, we expected a normal distribution of returns – however there were persistent losses in certain venues more consistent with arbitrage.”


And the authors also note (actually they quote from an ASIC report on Dark Pools) that the type of liquidity that most dark pools operators claim their dark pools focus on is much different than the type of liquidity they really have:

“Many crossing system operators have described their crossing system (s) to fund managers and to us (ASIC) as providing “natural liquidity” or as having no high frequency trading….however some crossing systems allow, or have previously allowed access to their crossing systems by clients that the industry widely considers to be high- frequency traders while maintaining there is no high frequency trading in their crossing system” (paragraph 226a, pg 59).

“Seven crossing system operators simultaneously display on a lit exchange market at least some element of orders within the crossing system.” (paragraph 174, pg 49).

“It appears that one or more crossing system operators may be offering specific order types to an exclusive subset of their clients and advising these clients how to benefit from these ordertypes” (paragraph 230, pg 60).


The authors even address order cancellations:

“Whilst it is usually the objective of investors to actually buy or sell stock when a bid or offer is placed, the discovery of orders being cancelled as they are about to be fully executed is interesting.”


We also urge you to look at Figure 9 on page 14 when you read this study. It visually demonstrates the temporary market impact and “significant price disturbance” experienced by using predictable execution methods that are easily detected by HFT. Institutional investors are paying more for stocks than they should be, and selling them for less, because of the sausage grinder.

There is a systematic exploitation of large orders, nearly every order in fact, by every fund manager every day. That exploitation results in slippage and “death by a thousand cuts.” The authors’ Figure 9 illustrates this nicely.

Please give this piece a good read. We have both met the authors on a few occasions, and are pleased with their efforts in highlighting pitfalls and less-understood ways in which institutional orders are impacted negatively in modern markets.