The recent flash crash in US markets showed value fund managers are now the only thing preventing total market chaos.
You might remember the infamous ‘flash crash’ back in 2010.
Well it happened again recently on Monday August 25. The S&P500 crashed more than five per cent in the first minutes of trading after computer and high-frequency traders (HFT) triggered a sharp sell off.
S&P500 Flash crash
Figure 1. S&P 500
Source. Thomson Reuters Datastream
HFTs use extremely high-speed speed computers and networks to place trades in fractions of a second. That allows them to get in first and gain advantages over retail investors. They often do so with minuscule amounts of shares.
Essentially the computers sold the market down on minuscule volumes and value investors entered the fray – as real buyers of quantity – but no volume was on offer.
A battle between human logic and computer driven manipulation occurred and it was repeated across the world, including in Australia.
The real thing that stabilised the market in the first 15 minutes was the true investors in the market.
But in the world today true investors are becoming scarcer.
Indeed, recent events show that well-funded value investors may be the only barrier standing in the way of total market chaos.

What lies ahead?

The August meltdown in America was a forerunner of what could happen if computers take control of the market.
It also gives us an insight into what could happen if value fund managers disappear. A black hole could be created that could send the financial system into a crash and economies would follow.
HFT and computerised trading, hedge funds, and shorting don’t enhance liquidity as some argue. Indeed it is common to see trading conducted with minute quantities of stock which are designed to create a false price indicator for stocks and the whole index. This is important to understand because it is derivative and futures trading that appear to have more depth than the physical markets.
We therefore need to be careful about saying that long-only value fund managers don’t add value or that their fees are excessive. It is they who create real buying support in times of chaos and they are a line of defence against market manipulation.
We also need to be very cautious about pushing computer trading and high-frequency trading – they are clearly not a provider of long term capital and they can push up the cost of capital for legitimate companies. These trading activities are not designed for the greater good.

An Australian problem too

This is not an America-only problem.
There are instances in Australia in the week starting August 25 where markets opened decidedly weaker, yet the liquidity of major stocks was non-existent.
Some stocks slumped 5 to 10 per cent on minute volume. When our fund managers at Clime tried to step in and buy a range of quality stocks they couldn’t. The computers withdrew their offers and mysteriously disappeared.
In whose interest is it for computers to create false prices?
There are rules preventing the manipulation of stock prices; yet regulators say they can’t regulate or prosecute computers.
But they should fine the owners of the computers or the trading entity controlling these computers. Indeed the offering of minute quantities on shares should absolutely be outlawed. It is time for Australian regulators to show some fortitude and not duck behind international practices that are flawed.
Being a computer isn’t an excuse for market manipulation.

Another solution

Estimates now suggest HFT makes up half of Wall Street trading volumes, but local regulator ASIC has said HFT is not a problem (yet) in the Australian market because of different regulations. We dispute this view given recent events.
Industry Super Australia, which represents industry funds, says HFT is costing large investors $2 billion a year, and it wants a tax on financial speculation to lower trading speeds.
Finally we suggest that a tax – preferably a tax that is weighted on computer based financial transactions – would also help address Australia’s so-called budget crisis.
A mere 0.2% duty on all ASX transactions would raise $2 billion annually for the Australian population. A higher tax on mindless minute transactions would swell this further.

Myopic funds

What happened in August was another an insight into the chaos that computers wreak in markets when left unchecked.
It’s a volatile world where investors fall prey to algorithmic sleights of hand, and prices become disconnected from the real value of businesses.
It’s a world where the role of value investors like Clime, who step in and buy based on value and for the long term, become vitally important.
What is truly amazing is that more long-term funds that must meet long term liabilities are being devoted to short term trading activities.