MONEY Investing

How Harvard and Yale’s ‘Smart’ Money Missed the Bull Market

Some influential investors have been on the sidelines for much of this surprising bull market.

The next time you want to give up on stocks for the long run consider this: Some of the world’s biggest investors did just that and have all but missed this bull market, proving again that the smart money isn’t always so smart and that trying to time the stock market is a fool’s game.

When the things looked bleakest in March 2009, the stock market began a torrid run that has carried into this year. That’s the way the market works. Gains come when you least expect them. You have to be there through thick and thin to consistently reap the benefits. But even big investors (or should I say especially big investors?) get scared and run.

So while the typical large stock has nearly tripled from the bottom, managers of the massive endowments at Harvard, Yale, and Stanford along with legions of corporate pension managers at places like GM and Citigroup were not there to collect. They were too busy sitting in bonds and other “safe” securities, which have woefully lagged the S&P 500’s five-year gain of 187%.

The Harvard endowment, the world’s largest with assets of $33 billion, missed the mark by the widest margin of the big universities. The stock market saw its steepest climb the past three years, a period when Harvard’s fund posted an average annual total return of 10.5%—well behind the 18.5% for the S&P 500. Yale’s $21 billion endowment returned 12.8%; Stanford’s $22 billion fund returned 11.5%. Harvard Management’s CEO recently said she would step down.

How did this happen? Well, the average college endowment has just 16% of its investment portfolio in U.S. stocks—half the exposure they had a decade ago. In the years following the Internet bust and then the financial crisis, managers steadily shifted assets to alternative investments like hedge funds, venture capital investments, and private equity. Corporate pension managers have done much the same, cutting their exposure to stocks, on average, by about a third.

Alternative investments have performed fairly well over the past decade, even outperforming the S&P 500 over that long period including the devastating collapse of 2008-2009. But there is no denying that the smart money was playing it too safe when the economy started showing signs of a rebound. Pension managers missed out on the deep value that had been created in the market.

The lesson is clear enough for individuals, who have limited low-cost access to things like private equity and venture capital anyway. Staying the course over the long pull is the best way to reach your financial dreams. Just three years after one of the worst market slides in history the average 401(k) balance had been totally restored, in part owing to the market’s recovery.

And you can give pension managers an assist. Their reluctance to bet on stocks near the bottom left prices depressed longer and allowed individuals putting a few hundred dollars into their 401(k) every month more time to accumulate stocks at the lower prices. That’s not great for those counting on a pension that, like so many, remains underfunded. It’s also not great for teacher salaries and student scholarships at major universities where endowments may fund a quarter of operating expenses. But don’t worry about all that. Just stick to your investing regimen, don’t panic, and know that you are the smart money more often than not.

TIME Wall Street & Markets

The Beauty of High-Speed Trading

Michael Lewis's 'rigged against the little guy' story depends on some rather convoluted reasoning. Here are the benefits of high-frequency trading I've found in my research.

As an academic, you often study things that your friends and relatives are vaguely aware of, but never ask you about. Sometimes, however, you get lucky. Sometimes you wake up and find that a famous author has written a book covering one of your research topics, instantly making it relevant and a topic for dinnertime conversation. On Monday, this happened to me.

For those who may not have heard, Michael Lewis, of Moneyball fame, has written a new book on high-speed trading entitled, Flash Boys: A Wall Street Revolt. It’s currently the number one seller on Amazon.

What exactly is this high-speed trading that Lewis is talking about? In short, it is completely automated (computerized) trading that seeks quick profits using extremely fast connections to markets. It’s big, making up about half of all trading in the market. It’s also tiny, being dominated by a handful of small (relatively speaking) proprietary trading firms.

What does Lewis have to say about it? Well, Lewis thinks high-frequency trading (as high-speed trading is often called) is bad — I mean really, really bad — and that high-frequency trading firms, in collusion with market exchanges, have rigged the market against you. Strong claims, no doubt. But is he right? I’ll get to that in a second.

First, let me share with you a little about my research (for more, see here). Most academics find beauty in what they study, no matter how ugly it is, and I’m no different. I want to describe for you the beauty I’ve found within the beast that is high-frequency trading. Put simply, it is the following: High-frequency trading synchronizes prices across global financial markets. It knits exchanges together into one gigantic marketplace where the prices of financial securities move in unison, much like a school of fish (see the movie below where the prices of 40 securities are tracked over one day). Why does that matter, you say? Let me try to explain.

When you trade in a financial market, something quite amazing happens. Information about your trade travels at nearly the speed of light outwards from the exchange; it traverses through mountains, under seas, across microwave towers, and along other telecommunication routes on its way to nearly every other major exchange on the planet. As the signal ripples outward, these other exchanges become active — they “light up.” Why? Because, high-frequency trading firms are updating the prices of all other related securities in response to your trade.

The ripple that I’m describing reaches everywhere across the globe, and it is spectacular to watch. Brad Katsuyama, the hero of Lewis’ book, was awestruck when he first saw it. As the signal from one of his trades hopped almost instantaneously from one exchange to another, he told his colleagues, “You see. I’m the event. I am the news.” It was his eureka moment, the moment when he first came face to face with the soul of high-frequency trading.

Interestingly enough, Lewis and Katsuyama interpret the rippling effect of high-frequency trading as evil. Based on the 60 Minutes segment on the Flash Boys book and on the NY Times excerpt, it seems to be the focal point of their “rigged” claim. I’ll explain why they think rippling is bad later. Right now, I want to show you how it can be good, extremely good, perhaps even elegant and beautiful. I also want to show you how it can be very scary, bad even, but not at all in the way that Lewis and Katsuyama state. To do so, I want to revisit the fish.

Why exactly do groups of animals, such as fish, synchronize their motions? It is because synchronization allows them to link together, forming one giant organism that can observe its environment with “many eyes.” If one fish spies a potential food source and darts after it, the rest will follow. If another sees a predator approaching and moves out of the way, the rest do so as well. In ecology, the benefits of synchronization are well-known: Groups that synchronize make more accurate decisions, and they spend fewer resources on information gathering.

I think financial markets are similar, and I have good company in that opinion. In markets, the state of the economy is monitored by a large number of investors who broadcast changes to each other and the rest of society via price movements. Just as in animal groups, synchronization aides in this process. It allows the group to make more accurate decisions and to spend fewer resources on information gathering.

In practice what does this mean? It means that synchronization should increase the accuracy of prices and decrease the costs of trading for average investors. Lo and behold, this is exactly what has happened in markets as they’ve become more synchronized. For a single transaction in a liquid US stock, pricing inaccuracy reduced by 30% from 2000 to 2005 and a further 40% from 2005 to 2010. The cost of a single transaction reduced by a whopping 70% from 2000 to 2005 (partly due to decimalization and smaller order sizes) and a further 50% from 2005 to 2010. Large orders by passive mutual fund companies are also paying less. Vanguard has reported a drop in their transaction costs of 35% to 60% over the last 15 years. Pretty nice results for your average investor.

So what is Lewis’ beef? Well, this is where it gets interesting. Lewis and Katsuyama claim that high-frequency trading front-runs large traders. What does that mean? It means that when a large trader comes to the market and places an order, high-frequency traders try as hard as they can to propagate information about that order quickly throughout the market. It’s the ripples thing, which I’ve claimed is generally good.

So why do Lewis and Katsuyama claim it is bad? Well, because it means that the large trader’s information has leaked to the market quicker than they wanted it to and their transaction costs are higher. But here’s my take: You know that thing in animal groups about fewer resources being spent on information gathering? You’re seeing that in practice here.

This is why Lewis’s “rigged against the little guy” story depends on some rather convoluted reasoning. Basically, it goes like this: Actually mom and pop are okay when they trade in the market, it’s the large hedge funds and institutional traders who are being front-run. But, hold on, that’s bad for the average guy because their pensions and retirement funds are actively managed by institutions.

I’m not quite buying it. There is little to no evidence that actively managed funds benefit average investors. In fact, there is a well-known academic paper that suggests any excess returns earned by these funds are optimally extracted by the fund managers. To be honest, I’m not overly concerned if fund managers make less money. (By the way, mom and pop, you have put your retirement money in an index fund, right?)

Okay, so I don’t quite buy Lewis story, but I also believe ripples can be bad. How so? Well, let’s think about fish again. If a small group of fish get a wrong signal, that signal can propagate throughout the entire group and everyone converges on the wrong answer. Furthermore, who’s to say that high-frequency trading gets these ripples correct? Maybe they’re jiggling things the wrong way? Finally, how comfortable are you knowing that the entire financial system is connected by super-fast machines with little to no human involvement? The flash crash propagated throughout financial markets precisely because the markets were being run by machines.

One last note: If there’s one thing that everyone tends to agree on, it is the following: Current financial markets are really complex, perhaps overly complex. When you have myriad order types that not everyone understands, two different ways of obtaining market data and pricing orders, and outdated regulation, there certainly can be room for questionable activity, such as quote stuffing or regulatory arbitrage. My story above is a bit of an oversimplification. But so is the idea that high-speed trading can only work to the detriment of the little guy — clearly the little guy, so far, has seen some significant benefits.

Austin Gerig is a Senior Research Fellow in the CABDyN Complexity Centre, Said Business School, University of Oxford.

TIME Wall Street & Markets

Markets Rebound as Putin Dials Down Heat in Ukraine

Russia's President Vladimir Putin attends the opening ceremony of the Russian Pilgrims' House at the Jordanian side of the Jordan River
Ali Jarekji—Reuters

After stocks tumbled amid rising tensions Monday

Stock markets around the world rallied Tuesday as fears of impending violence in the ongoing crisis in Ukraine cooled slightly.

The Dow Jones Industrial Average rose 200 points, or 1.2 percent, after falling 154 points Monday. The index had at one point been down as much as 250 points in intraday trading as investors became skittish over the standoff in Ukraine. The S&P 500 climbed 23 points and the Nasdaq rose 68 points, but up more than one percent, on the news of eased tensions.

The rebound followed news that Russian President Vladimir Putin defended his decision Tuesday to send troops into Ukraine’s eastern Crimea region while insisting that military force would only be used when all other options had been exhausted.

“As for bringing in forces: For not there is no such need but such a possibility exists,” he said. “What could serve as a reason to use military force? It would naturally be the last resort, absolutely the last.”

TIME Wall Street & Markets

Wall Street Rally Erases 2014 Losses

Traders work on the floor of the New York Stock Exchange
Traders work on the floor of the New York Stock Exchange, Feb. 24, 2014. Brendan McDermid—Reuters

The S&P 500 was up more than 1 percent to 1,855.22 mid-Monday afternoon, surpassing a high of 1,848.38 that it reached on Jan. 15. The Dow Jones Industrial Average was also up more than 1 percent

Stocks rallied on Monday with the S&P 500 reaching a record high and erasing losses from earlier in the year, as investors signaled a willingness to write off recent sluggish economic data to the winter weather.

The S&P 500 was up more than 1 percent to 1,855.22 mid-Monday afternoon, surpassing a high of 1,848.38 that it reached on Jan. 15, according to Bloomberg News. The Dow Jones Industrial Average was also up more than 1 percent.

“I do think the economy is a lot stronger than the recent data has suggested,” Bruce Bittles, chief investment strategist at RW Baird & Co, told CNBC. A report early Monday showed that growth in the service sector slowed in February.

Federal Reserve Chair Janet Yellen said earlier this month the central bank will continue to scale back its stimulus program amid an improving economic outlook. She will testify before a Senate panel on Thursday.

TIME

Stocks Plummet on Manufacturing, Stimulus Blues

Traders work on the floor of the New York Stock Exchange
BRENDAN MCDERMID / REUTERS

Fears about the economy shake markets

Widespread angst over the global pace of recovery from the financial crisis has sent markets into a tumble, with the Dow Jones industrial average plummeting more than 300 points in trading Monday, and the S&P 500 hitting lows not seen since October.

The immediate catalyst for the stock drop was a sharp fall in the U.S. manufacturing ISM index from 56.5 in December to 51.3 in January, reflecting a steep slowdown in growth. The S&P 500 dropped by 2.3 percent after the news was announced to 1741.92 points while the Dow Jones sank 325.92 points to 15,372.93 by closing Monday.

Traders are worried about the Federal Reserve’s taper of its stimulus program, which involves monthly purchases of billions of dollars of mortgage-backed securities and Treasury bonds to prop up the economy. The Federal Reserve has begun reducing its monthly purchases by $10 billion each month, and announced last week it would buy $65 billion of U.S. government debt and mortgage bonds.

Adding to the unease was official Chinese manufacturing data that showed factory output grew at a slower rate in January compared with December, while an HSBC survey showed a contraction in manufacturing in the world’s second-largest economy, according to the Associated Press.

[AP]

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