Posted on Friday, February 4, 2011
In the late 1990’s and early 2000’s, the number of individual investors surged thanks to the rise of the Internet. As information became instant and ubiquitous, and the fees associated with making trades decreased, people took advantage of their ability to do their own research and retail trading peaked.
With the increased activity, however, it became clear that the hedge funds, brokerages and analysts that make up Wall Street’s inner circle still had a huge advantage over retail traders.
Under pressure to even the playing field, the SEC enacted Regulation Fair Disclosure, which required companies to disclose market-moving information to everyone at once. It was a noble effort that did break up some of the monopoly on information that Wall Street professionals once enjoyed. There is little doubt, however, that more than ten years after “Reg FD” the trading game remains tilted toward Wall Street.
Following are the ten biggest advantages institutional traders have over the common investor:
(1) Access to Management
The SEC adopted Reg FD to combat the backroom sharing of information between corporations and analysts. Analysts would then share what they heard with those who could afford to pay for their research. Corporations allowed analysts to keep their seat in the conference room, of course, so long as they said what the corporations wanted the public to hear; conflicts of interest abounded. The now famous “global settlement” in 2003 saw ten of the largest brokerage firms paying combined penalties of more than a billion dollars for such conflicts. Has everything changed? No. Last August, the Financial Industry Regulatory Authority (FINRA) fined Morgan Stanley $800,000 “for failing to make public disclosures required by rules governing research analyst conflicts of interest.” The investigation covered a four year period.
(2) High Volume Research
“First Call” is a product offered by Thomson Reuters that aggregates hundreds of thousands of earnings reports from analysts all over the globe. Similar products are offered by rivals including Bloomberg News and Capital IQ, which is owned by Standard & Poors. The scope, depth, and reach of these pools of information is vast. They are also hugely expensive. At tens of thousands of dollars per year, this information is available to the individual investor only in theory. They can access the consensus estimates but not the individual reports that make them up. Yet for a Wall Street institution, it’s just another bill.
Ever since Bobby Fischer famously challenged the MIT Greenblatt computer program in chess, man versus computer has had a special place in the popular imagination. Fischer beat the computer, but if a robo-reader were properly optimized, it’s hard to imagine a human competing against it. Robo-readers are computers that scan thousands of articles, reports, Twitter feeds and myriad other sources that discuss companies, and then use an algorithm to synthesize the data and observe trends. The programs have a surprising sensitivity to variations in words and usage. Even obscure blogs can no longer be a retail trader’s secret advantage—robo-readers will find them and incorporate their information into its projection before an individual can get past the first paragraph.
(4) High-Frequency Trading
Imagine a computer making chess moves at such a high-speed that the board is a blur. This can be what high-frequency trading is like. Stock prices can dip for fractions of a second—plenty enough time for a computer to recognize the drop in price and pounce on a stock before it rises again, seconds later. The idea here is that if the computer can earn pennies, or fractions of pennies, on enough stocks at a fast enough rate, it could wind up with a lot of extra pennies at the end of the day. In this kind of trading, as computers compete against each other, having the faster computer is a real advantage. Companies invest heavily in IT and hardware accelerators, and some computers can now carry out trades in 10 milliseconds. Some high frequency trading firms have gone even further, renting space near exchanges so they can park their servers closer and thereby increase the speed of electronic orders by microseconds.
(5) Expert Networks
Investors often need to create forecasts around products and companies they know nothing about. In comes the professional Expert Network, a group of professionals and former professionals in the field of interest. Investors don’t only tap these networks for information the experts have stored in their heads after years of experience in a given field, they commission the experts to do additional research. Given the former private sector roles of many of the experts, however, the information obtained can be proprietary, and the arrangement can reek of insider trading. It hasn’t been enough to slow the networks down, however, despite a few high-profile cases. Brokerages get a kind of scale advantage with expert networks—for massive investments it can be worth paying experts, but for the individual it’s simply too expensive.
(6) Floor rumors
The more things change, the more they stay the same. Although news has evolved to become nearly instantaneous, especially with Twitter, traders on the Stock Exchange floor still hear rumors first. When news hits the internet, brokerages have already acted upon it—in fact, it’s typically the institutional traders’ actions that spur stories. And by the time the individual investor purchases a stock that is trending upward, floor traders have typically already begun to sell it again. The late Philip Fisher referred to these rumors as “scuttlebutt” and found it to be some of the most valuable knowledge available.
(7) Insider Trading
Every year the SEC vows to redouble efforts to curb insider trading, and every year high-profile cases continue like clockwork. And those are just the ones you hear about. Last month, employees of Dell Computer, Advanced Micro Devices and Apple Inc. were collared for receiving nearly half a million dollars in exchange for proprietary sales and product information. Not only do insiders’ own investments benefit, but their activity typically affects the stock price at the expense of the retail investor. The kicker? Nearly half of those given jail sentences for insider trading over the last eight years never served a day of the sentence.
(8) Time-Zone Arbitrage
Stock prices are set for the day when an exchange closes. Investors can buy a given stock in after-hours trading at its set price and then sell the stock in an exchange in another time zone that is still open, where the closing price has not yet been established. This technique is referred to as Time-Zone Arbitrage, and institutional traders are more equipped to take advantage than individuals. With more resources and personnel on hand, institutional investors are better able to monitor dozens of stock prices in exchanges worldwide.
(9) Flash Orders
Institutional investors sometimes “flash” orders that they don’t expect to fill in their entirety to exclusive member networks. This allows them to see if another party wishes to fill the other side of a given order. They have stirred a fair amount of controversy—notably from Sen. Charles Schumer last year, who demanded they be banned – because of the fact that member networks are seeing a price offering before it is displayed to the public. The member networks have as much as 500 milliseconds to fill the order before it is shown in market centers, which is plenty enough time to get in front of an unsuspecting, and therefore disadvantaged, individual investor.
(10) Sub-penny Trading
Sub-penny trading allows investors to buy and sell stocks in increments of less than a penny. This allows them to get their orders in front of other investors even though their bids are only fractions of cents larger, a seemingly insignificant difference. Many view it as a clever way for professional investors to game the system, especially considering that individual investors are not allowed to place sub-penny orders on stocks valued above$1.00 according to SEC Rule 612.
–Jack Campbell, 24/7 WALL STREET