Faster trading need not always be better, investors warned

Faster trading need not always be better, investors warned
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First Published: Mon, Apr 02 2007. 12 04 AM IST
Updated: Mon, Apr 02 2007. 12 04 AM IST
In the time it takes to read this sentence, you could be making big money in the markets. In theory.
Technology is being introduced to allow professional traders in New York to buy and sell stocks in a single millisecond. Users of the new system apparently think it will give them an edge over competitors stuck with old, creaky hardware that requires 10 whole milliseconds to get a transaction done.
Cynics will gleefully smirk at the idea that there are operators on Wall Street who worry that their progress is being impeded unless they can trade stocks faster than they can think.
It makes sense in a world in which short-term is the new long term. Financial markets run all day and night. Media services dispense continuous information to trade on, only a small fraction of which should really qualify as news.
Brokerage analysts front-load their research, putting the next quarter under a microscope and all but ignoring anything beyond.
Millisecond execution will be available only to professionals, not to ordinary investors, even those with a yen for day trading. That is probably for the best.
Richard Bernstein, chief investment strategist at Merrill Lynch, sees an ill omen for the markets in the insatiable need for speed.
“Financial historians often point out that one common characteristic of speculative periods in financial markets is the desire to trade more frequently,” he said in a note to investors. “In other words, market participants can’t get enough of a good thing.”
Just how good a thing is short-term trading? Not very, in Bernstein's opinion.
Trolling through data for the Standard & Poor’s 500-stock index, he found no 10-year periods, whenever the clock is started, in which the index lost ground during the 20 years through last June.
Shortening the horizon to rolling periods of one, three or five years, it gained more than 80% of the time. Over any given month, investors stood a 65% chance of coming out winners. But when the investment period shrank to a week or a day, the odds of scoring a gain were little better than calling a coin flip: 58% and 54%, respectively. The reason that very long-term investing is usually a winning proposition is that companies—good ones, anyway—can produce better returns on our money than we can over the long haul.
Corporate fundamentals “do not actually change in very short-time periods,” Bernstein said. “Short-term trading is often largely based on meaningless noise.”
Fundamentals may change slowly, but some portfolio managers change their minds often, continually buying and selling in an unceasing quest for some edge. Evidence suggests that such trading does more harm than good.
Mark Komissarouk, an analyst at the research firm Morningstar, looked at actively managed funds—no index trackers—that specialize in shares of large US companies and that have no bias towards growth or value.
He compared one-year returns for the 10% of funds with the highest portfolio turnover—the ones that do the most trading—and the 10% with the lowest turnover.
The high-turnover funds had an average total return in the year through 28 February of 9.46%, a figure that was better than only 36% of their peers. They lagged well behind their low-turnover counterparts, which were up 11.02% and beat 56% of their peers.
One reason for the weaker showing is that trading costs money. But the average expense ratio was just 0.51 percentage points higher for the wheeling-dealing funds, Komissarouk said.
That leaves more than a full point of underperformance that must be accounted for by friction—the pennies that are lost here and there when trades are executed—and by the investment decisions themselves.
Some perpetually active traders on Wall Street are extremely successful; their bosses at investment banks and hedge funds would not pay them millions in bonuses if they were not. But they possess qualities, like bravado mixed with discipline, that most of us lack when serious money is on the line. Having immense balance sheets to work with and compliance departments looking over their shoulders must help, too.
For everyone else, better returns are likely to be achieved in the time-tested way—by picking the right stocks, ones with the strongest growth prospects relative to their valuations, and holding them for as long as those conditions apply, not a millisecond more or less.
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First Published: Mon, Apr 02 2007. 12 04 AM IST
More Topics: Money Matters | Global Markets |