A recent report by the U.K.’s financial regulator, the Financial Conduct Authority (FCA), found that high-frequency traders make nearly $5 billion a year by taking advantage of latency arbitrage opportunities. These arbitrage opportunities take advantage of any information that can be used to execute trades a fraction of a second before anyone else. The information used for latency arbitrage can include economic news, corporate reports, or price fluctuations in the stock. These price fluctuations can be directly related to a large trade placed by an RIA firm.
The Impact of High-Frequency Trading on Advisors
Even investment advisors who take a long-term approach to their investment strategies can be impacted by high-frequency trading (HFT). One approach to performance looks at alpha, which is a measurement of how an investment compares to an index during a specified time frame. As an advisor, you may be investing in the same exact securities as another firm, but because of your trading capabilities, your strategy could outperform or underperform. This performance also translates to the value of your client’s investments and is impactful as it compounds over time.
Utilizing Trade Execution Algorithms
One of the simple ways to reduce the impact of high-frequency trading is with the use of execution algorithms. There are many different trade execution algorithms; some are relatively simple and others can be very complex.
An example of a simple execution algorithm is a VWAP, or volume-weighted average price algo. A VWAP trade execution algorithm estimates the average volume traded during many short intervals, such as five minutes, and then adjusts the order quantity placed based on historical trading information. Its goal is to split the order into smaller pieces based on an average weighted volume.
While it is possible to break up a large trade over many days or weeks by manually selecting a few accounts for trading at a time, this will have other consequences. The largest consequence is that clients will be getting a wide variety of execution prices for the same securities. Not only is this more difficult to explain to clients but there is a possibility the price of a security may move significantly before your desired trade is completed. Trade execution algorithms can fully automate the placement of small slices of a larger order and help to reduce the impact of high-frequency trading.
Reducing the Impact of High-Frequency Trading
As high-frequency trading has expanded over the years so have the number of execution algorithms that are designed to complete orders quickly while reducing hidden intentions of trading a large block. Some of the more advanced algorithms can incorporate real-time liquidity data from multiple venues and news data. Buy-side firms now have many options to choose from when considering execution algorithms. Still, brokerages and execution venues have work to do if they want to reduce the opportunities for arbitrage and reduce the $5 billion a year that goes to HFT firms.
The good news is that even simple strategies can have some positive impact on your execution price, and it is easy for RIA advisors to get started with execution algorithms right away. Your current custodian or executing broker may have many algorithm options to choose from that you may not be aware of. With Blaze Portfolio, our clients can select from any available algorithms directly from within the platform and route the orders electronically to their custodians and brokers. That is Simply Better Trading.