Better in their words…

Second article. Some good stuff.
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A few nights ago, CBS’s “60 Minutes” provided a forum for author Michael Lewis to announce that Wall Street is “rigged” and for the sponsors of a new trading venue called IEX to promise to unrig it. The focus of the TV segment was high-frequency trading, or HFT, an innovation now over 20 years old.

The stock market isn’t rigged and IEX hasn’t yet generated a lot of interest. In our profession, what we saw on “60 Minutes” is called “talking your book”—in Mr. Lewis’s case, literally.

The onslaught against high-frequency trading seems to have started about five years ago when a blogger made a wildly exaggerated claim about one firm’s HFT profits. Nowadays after any notable market event, and again last Sunday for no reason other than a book launch, the world gets bombarded with arcane details and hyperbolic assertions about HFT strategies. If you find the discussion overwhelming, we have some good news: The debate can be understood without knowing how equity orders are routed, matched or canceled.

Few professionals completely understand the details of market microstructure. Rather, when someone has a strong opinion about the subject, it’s likely to be what they want you to believe, not what they know.

Our firm, AQR Capital Management, is an institutional investor, primarily managing long-term investment strategies. We do not engage in high-frequency trading strategies. Here is where our interest lies: What is good for us is lower trading costs because it translates into better investment performance and happier clients, which makes our business slightly more valuable.

How do we feel about high-frequency trading? We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars. We can’t be 100% sure. Maybe something other than HFT is responsible for the reduction in costs we’ve seen since HFT has risen to prominence, like maybe even our own efforts to improve. But we devote a lot of effort to understanding our trading costs, and our opinion, derived through quantitative and qualitative analysis, is that on the whole high-frequency traders have lowered costs.

Much of what HFTs do is “make markets”—that is, be willing to buy or sell stock anytime for the cost of a fraction of the bid-offer spread. They make money selling at the offer and buying at the bid more often than they have to do it the other way around. That is, they do it the same way that market makers have done it since they were making markets in Pompeii before Mount Vesuvius halted trading one day. High-frequency traders tend to do it best because their computers are much cheaper than expensive Wall Street traders, and competition forces them to pass most of the savings on to us investors. That also explains why many old-school Wall Street traders hate them.

One of the biggest headline-grabbing worries about HFTs is how fast the trades are conducted. The speed sounds unnecessary, dangerous and possibly nefarious—”These guys care about the speed of light!” For the most part, though, HFTs don’t need that super speed to get ahead of the little guy or even institutional traders, but to get ahead of other HFTs. Some of the loudest complaints about high-frequency trading come from the slower traders who used to win the races.

While we like HFTs on balance for reducing our clients’ trading costs, some may push the envelope at times. Some of them may negotiate advantages that might be bad for markets. Worse, these arrangements tend to be little understood by the broader range of market participants. A little more transparency would be good here, and the market venues that have been offering these deals have been moving in that direction. They should move faster.

But these concerns are occupying too much attention. The biggest concern we have with modern markets is their complexity and the associated operational risks. The market structure that enables the HFTs and provides us with their benefits may also be one that risks technological calamity.

The good news has been that regulators began to focus on this potential problem last year. Unfortunately, the recent fusillade of hyperbole about HFT practices threatens to derail this effort and refocus attention where the problem isn’t. Real work is necessary to improve and safeguard a complex and still reasonably new system. We shouldn’t get ourselves dragged into a hyped-up war over a matter that doesn’t affect investors very much—and where, to the degree that it does, we’d argue that the effect is easily a net positive.

So why are so many people so loudly certain about the problems of high-frequency trading? Again, look to interests. Making mountains out of molehills sells more books than a study of molehills. But some traditional asset managers are also HFT critics. These managers are institutional investors like us but with different investment strategies and trading methods.

Rather than embracing electronic markets, these managers have stuck with their old methods. They think HFT costs them money. Often when they try to trade large orders quickly, they find the trades more difficult to execute in a market that has gravitated toward more frequent trades in smaller sizes, and that the price moves away from them faster now.

We doubt that these old-school managers were truly better off in the pre-HFT world, but it’s hard to prove either way. And if they’re right, it may be only because HFTs have made the markets more efficient, eliminating some of the managers’ edge.

Well, sorry, but prices responding quickly—and traders not being able to buy or sell a ton without the market moving—is what is supposed to happen in a well-functioning market. It happens to us too. It may be that in the old days these managers were able to take advantage of whomever was on the other side of their trade, and that nowadays they find it far more difficult to gain that advantage. A more efficient market shouldn’t be mistaken for an unfair one.

These big, traditional investment managers represent a business opportunity to anyone who can offer them new market venues, like IEX, that might conceivably avoid the perceived ill effects of high-frequency trading. We wish them well in that effort, and if they succeed these new exchanges and their clients will benefit. But let’s allow the issue to be decided by open competition, not by politics, demagoguery and rules born of crony capitalism.

Our bet is that high-frequency trading comes out on top as it offers more investors better execution. But we have zero problem being proven wrong by the marketplace.

How HFT has changed the allocation of the pie between various market professionals is hard to say. But there has been one unambiguous winner, the retail investors who trade for themselves. Their small orders are a perfect match for today’s narrow bid-offer spread, small average-trade-size market. For the first time in history, Main Street might have it rigged against Wall Street.

Mr. Asness is managing and founding principal of AQR Capital Management, where Mr. Mendelson is a principal and portfolio manager. Aaron Brown, chief risk officer at the firm, also contributed to this op-ed.

High-Frequency Hyperbole – WSJ.com.