The New Challenges Of Price Discovery: What Investors Need To Know
Frank Holmes | Sep 08, 2014 03:47PM ET
Investing in the Age of High-Frequency Trading, Falling Volumes and Widening Bid-Ask Spreads
As investment managers, one of our most important fiduciary responsibilities is buying and selling stocks for the best possible price and execution. We do this by using the statistical strategies I’ve previously covered, from monitoring
Despite the challenge, we try to take advantage of the volatility that other investors might flee from. Decisions to buy or sell a company are first fundamentally driven, and then trading is based on statistical analysis of fund flows, volatility over different time periods and relative performance to the gold indices we strive to beat. For the Gold and Precious Metals Fund (USERX), it’s the FTSE Gold Mines Index; for the World Precious Minerals Fund (UNWPX), the NYSE ARCA Gold MinersIndex.
Our style resembles that of the Navy SEALS, in that we prefer to be nimble, surgical and tactical. During the bear market that ran from mid-2011 until February 2014, we nibbled rather than munched on inexpensive companies that were lagging in relative performance over one day, one month and one quarter. And when these companies showed a surge in price and volume, we often trimmed our holdings rather than sold outright. This incremental “nibbling” strategy is a little like investment reconnaissance, enabling us to test our conviction in a company before taking a weightier position.
Another disruptive factor to price discovery has been the proliferation of exchange-traded funds (ETFs). Accounting for more than 30 percent of trading volume in the markets, some ETFs are influencing the markets they track and impacting their underlying holdings. A study by Goldman Sachs confirmed that ETF trades influence stock prices. The study looked at which individual stocks move more with the dynamics of the ETF than on their own fundamentals and found that those stocks most affected by ETF activity are in the Russell 2000, probably because of their lower levels of liquidity, lower volume and cheap prices.
We’ve witnessed this same phenomenon with some junior gold stocks in the GDXJ. A gold stock can have a significant price move based not on changes to its fundamentals or a corporate event but rather shifts in sentiment toward gold that is compounded by fund flows. The inclusion or exclusion of a stock in the underlying index can result in a flurry of disruptive trading unrelated to changes in the company’s fundamentals.
Just as one man’s trash is another man’s treasure, one man’s fear of volatility is another man’s opportunity. Part of successful active management is not getting discouraged, learning to adapt to a changing climate and coming to terms with the market’s often erratic behavior.
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But the erratic behavior has only ramped up in recent years.
HFT: Trading at the Speed of Greed
As I said earlier, price discovery has become much more difficult in recent years because of growing high-frequency trading (HFT), dark pools and non-exchange trading—all of which have changed, perhaps irreversibly so, the formation of capital in the investment industry.
HFT is a controversial practice whereby automated computers using sophisticated algorithms transact orders at lightning-fast speeds. In a process called latency arbitrage, high-speed traders are able to gain access to crucial order information and other market data milliseconds before “normal” or “slow” traders. They manage to do this through a number of means, including placing their computers as close as possible to stock exchanges and using best-of-the-best fiber optic cables.
After acquiring the information, such traders can get in front of other buyers’ purchases and, almost instantaneously, turn around and scalp the shares within less than a blink of an eye. Often gains are less than a penny per share, but because they trade so frequently and rapidly, it’s easy to make fast money.
This new form of legalized front-running became the talk of Wall Street after the March 2014 publication of financial writer Michael Lewis’s critical book on the matter, Flash Boys: A Wall Street Revolt. In one passage, Lewis deftly recounts the infamous Flash Crash that occurred at 2:34 on May 6, 2010:
[F]or no obvious reason, the market fell six hundred points in a few minutes. A few minutes later, like a drunk trying to pretend he hadn’t just knocked over the fishbowl and killed the pet goldfish, it bounced right back up to where it was before. If you weren’t watching closely you could have missed the entire event… Shares of Procter & Gamble, for instance, traded as low as a penny and as high as $100,000. Twenty thousand different trades happened at stock prices more than 60 percent removed from the prices of those stocks just moments before.
A spread of $99,999.99. If that doesn’t give a trader pause, I’m not sure what will. The chart below shows just how dramatically HFT has heightened intraday volatility in the SPDR S&P 500 (ARCA:SPY) ETF, arguably the most popular of its kind in the U.S. Up until 2007, daily price changes had a relatively steady heartbeat. But in 2007, when HFT as we know it today emerged, the average intraday volatility more than doubled. In August 2011, the peak volatility climbed to one that was 10 times higher than in 2006.
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As active managers we are confident in our use of these analytical tools, enthusiastic in our approach and optimistic about the future. Happy investing!
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Gold, precious metals, and precious minerals funds may be susceptible to adverse economic, political or regulatory developments due to concentrating in a single theme. The prices of gold, precious metals, and precious minerals are subject to substantial price fluctuations over short periods of time and may be affected by unpredicted international monetary and political policies. We suggest investing no more than 5% to 10% of your portfolio in these sectors.
The S&P/TSX Venture Composite Index is a broad market indicator for the Canadian venture capital market. The index is market capitalization weighted and, at its inception, included 531 companies. A quarterly revision process is used to remove companies that comprise less than 0.05% of the weight of the index, and add companies whose weight, when included, will be greater than 0.05% of the index. The Market Vectors Junior Gold Miners Index is a market-capitalization-weighted index. It covers the largest and most liquid companies that derive at least 50 percent from gold or silver mining or have properties to do so. The S&P 500 Stock Index is a widely recognized capitalization-weighted index of 500 common stock prices in U.S. companies. The Nasdaq Composite Index is a capitalization-weighted index of all Nasdaq National Market and SmallCap stocks. The FTSE Gold Mines Index Series encompasses all gold mining companies that have a sustainable and attributable gold production of at least 300,000 ounces a year, and that derive 75% or more of their revenue from mined gold. The NYSE Arca Gold Miners Index is a modified market capitalization weighted index comprised of publicly traded companies involved primarily in the mining for gold and silver. The index benchmark value was 500.0 at the close of trading on December 20, 2002. The Dow Jones Industrial Average is a price-weighted average of 30 blue chip stocks that are generally leaders in their industry. The Russell 2000 Index is a U.S. equity index measuring the performance of the 2,000 smallest companies in the Russell 3000. The Russell 3000 Index consists of the 3,000 largest U.S. companies as determined by total market capitalization.
Fund portfolios are actively managed, and holdings may change daily. Holdings are reported as of the most recent quarter-end. Holdings in the funds mentioned as a percentage of net assets as of 6/30/2014: Market Vectors Junior Gold Miners ETF (0.55% in Gold and Precious Metals Fund, 0.55% in World Precious Minerals Fund); SPDR S&P 500 ETF (0.00%); Proctor & Gamble (0.00%); Goldman Sachs Group, Inc. (0.00%); E*TRADE Financial Corporation (0.00%); Virtu Financial (0.00%).
Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is also known as historical volatility.
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Before deciding to trade in financial instrument or cryptocurrencies you should be fully informed of the risks and costs associated with trading the financial markets, carefully consider your investment objectives, level of experience, and risk appetite, and seek professional advice where needed.
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