“How would you take advantage of homogenous institute investments?”
This refers to one of my far-fetched ideas I wrote yesterday:
Systemic risk would rise for everyone due to the increasing homogeneity of holdings. There will be parties that will take advantage of this homogeneity, although they will be the “1%” of the general population of investors. Those who are able to do so will be able to reap much higher returns, at the expense of the rest of the investors who are generally index-bound. Hence, expect increasing inequality of returns.
Researchers have made the provocative discovery that the U.S. stock market has become more vulnerable over time to unanticipated events (e.g., see Kamara, Lou, and Sadka 2010). Here, researchers point to a variety of factors, including the rise of systematic market risk (beta) in recent decades.
In this paper, we pinpoint one possible culprit for the observed increase in market vulnerability; the rising popularity of passively managed assets. In this connection, we offer new insights on the market impact of basket trading associated with the rise of passively managed index mutual funds and ETFs.
In particular, we show that the increased commonality of trading constituent stocks associated with index trading is consistent with a more synchronized market and, thus, rising levels of systematic risk. This, in turn, reduces the benefits of diversification across the equity market.
A synchronised market allows certain things to be predictable. This predictability makes it easier for some agents to profit from it.
Imagine for example, that one is a desert trader, a member of a caravan who has to travel through a regular trade route every couple of months or so. An enterprising bandit therefore, can park himself along the route and ask for an amount of ‘tax’ before he can proceed on with his journey.
But of course, that is illegal. Or is it? According to the Bank Underground’s blog today,
This is all good, except that not everybody is happy: some institutional investors, who typically execute larger orders, complain that their execution costs have gone up. And they blame the HFTs.
- Order anticipation
So what’s going on? The short answer is nobody knows for sure and further research is in order. One potential explanation, brought home in Michael Lewis’s “Flash Boys”, is illustrated in Figure 3. If you are a large investor, chances are that, in the modern fragmented trading landscape, your order will be split and routed to multiple venues for best execution. This implies that not all your order messages will arrive simultaneously at the various venues, given the different cable lengths connecting your computer to these exchanges. This allows an HFT to spot the first message when it arrives, anticipate that other messages are on their way in other venues and pre-position itself in these other venues by buying low and selling to you at a higher price. Thus your execution cost goes up and you naturally blame the HFTs.
However, that is not the only way. One way is to trade against ETF flows at the stock level, based on the premise that uninformed, price-insensitive flow tends to drive prices away from fair value temporarily before reverting.