Investors Should Worry More About Payment for Order Flow than HFT

Long gone are the days of the buttonwood tree.  On May 17th, 1792, twenty- four brokers gathered on Wall Street under a buttonwood tree and signed the document that would establish the guidelines for buying and selling stocks and bonds, and held members to adhere to a 0.25% commission rate.  Deals were done with handshakes, not high speed computers.

Buttonwood Tree from Museum of the City of NY

Wall Street Brokers Under the Sycamore Tree – Source: Museum of the City of New York

Things must have gotten a little crazy over 200 years, because by the time I started in the business at Dean Witter in the early 1990’s, we collected several hundreds of dollars in commissions for small stock trades (um, most of which the company kept, I received only about 1/4).  Then along came one of my heroes, Charles Schwab, who had railed against high fees and was instrumental in the deregulation of commissions which was mandated by the Securities and Exchange Commission in May of 1975.  The mandate eliminated high fees and allowed lower cost providers such as Schwab to force market competition to set commission rates.  By the time I was working at Schwab in 1995, online trading was launched, driving down commissions.  Technology has revolutionized the stock markets, and expanded access that was previously limited to exclusive groups.

In 2004, Schwab sold its capital markets business to UBS and, as part of that agreement, sends the majority of stock trades (known as “order flow”) to UBS.  In exchange, UBS pays Schwab.  Over 90% of orders are sent to UBS from Schwab to be fulfilled (see link below for details).  In his 2000 testimony to the Senate Banking Committee, Schwab himself stated “I worry…about payment for order flow” and went on to explain that Schwab continued the practice due to competitive pressures (see the full testimony below).  Firms like Schwab, E*Trade and TD Ameritrade bring in hundreds of millions of dollars every year from this practice, enabling them to offer low commissions to their retail customers.  The proliferation of trading drove down commissions, but forced firms to seek out revenue in other areas.

This is what enables financial firms to also offer what appear to be ridiculously low-cost Exchange Traded Funds and Index Funds.  How could a fund with expenses below 0.25% be a sustainable business model for an investment company?  Investors are paying the price elsewhere.  We may see an upheaval with respect to this, because it affects a huge aspect of the markets – the expanded ETF market and mutual funds held in 401(k) plans.  If you have investments in a 401(k), it is likely that the fees are quite high, you just don’t necessarily see that despite recent legislation to improve disclosures.

The real issue is this: how can investors truly know what they are paying so they can objectively evaluate their after cost returns on an annual basis?  This issue of excessive fees and a lack of transparency has always lit a fire under me, and led to my launching of the Pawleys Dividend Fund and Pawleys Growth Fund, two privately offered funds organized under Rule 506 of Regulation D.  My advisory fee is 0.75%, and I publish the holdings to all investors to ensure complete transparency, as any shareholder can audit the performance.

Online trading added unprecedented volumes to the stock markets, and as commissions dropped firms worked to find revenue in other places.  In the meantime, they leveraged the public loathing of high commissions and fees, and cleverly built this into their marketing of “low cost” investments.  Low cost does not equate to performance.   There are many great choices for investors that offer reasonable expenses and solid performance.  Establish a procedure where you evaluate the after-cost performance of your investments versus the appropriate benchmark.  For those who are lured by the discount broker advertisements that say you can make money trading (bumping up the commissions and payments they receive for order-flow), you can, if you learn about technical analysis and enter with a specific trading strategy.  Scalping and front-running are two practices that disadvantage investors and are prohibited (it is like someone taking money from you or cutting the line in front of you).  These practices existed long before HFT came along.

If you are truly worried about HFT and how they are rolling in the dough, take a closer look at what happened to Knight Capital.  Knight, based in New Jersey, used HFT algorithms and was the largest trader in U.S. equities until an accidentally released set of code led to the company taking a loss of almost $500 million and their downfall.  So much for HFT.

© 2014 Pawleys Investment Advisors, LLC. All rights reserved.

Schwab Order Routing:

Testimony to Senate Banking Committee:


March Madness – Survival of the Fittest

Investing is a competitive arena where the fittest not only survive, but thrive.  The NCAA basketball tournament brackets were released Sunday and the playoffs start today – the men’s and women’s teams are ranked 1-16 in 4 regions respectively.  In the stock markets, there is always someone in first place and someone in last place at the end of the trading day.  On April 8&9, those 64 teams will have been reduced down to one winner each.  On any given day, you can rank the daily returns of each stock within a given index.  Investing is not a zero-sum game like most gambling or trading of options or futures contracts.  Wealth can grow within the stock market, but score is still kept on a relative basis.  If you evaluate a group of investors or mutual fund managers, someone always ends up in first place, either making the most money in the up market, or losing the least in the down market.  There is also always someone in last place, and everyone else who falls in between.  In a world of buyers and sellers, there are 2 sides to the trade, and being on the right side at the right time is critical for success.  People invest for one reason: to make more money.

Each investor has a limited number of dollars to put to work, so it is critical to develop a selection strategy that will single out the best performers within a given asset class.  For everyone who makes money, generally there is someone losing (unfortunately it is often the individual investor – look at how many people sold their stocks and funds at the bottom of the market in 2009 locking in losses, sat on the sidelines in cash, and missed the recent 100% returns!).  America was born on capitalism, free-markets and competition.  Stocks, bonds and derivatives are merely tools for the transfer of assets, obligations and currencies.  Aside from our health and physical well-being or spiritual state, our financial condition is often the most significant driver of our quality of life.  Most people do not need gobs of money to effectively care for their families, but after the turmoil of the markets over the past two decades, I have seen families shattered and emotionally devastated by a few wrong moves.  Lack of knowledge can cause us to be on the wrong side of the trade at the wrong time.  An objective strategy, discipline, and a focus on quality investments can put the odds in your favor.  Many NCAA teams focus on fundamentals and stick to basic strategies, and just wait for their opponent to slip up.  That consistency often separates the winners from those who fail to advance.  And always beware the bracket-busters – which is why diversification is critical for even the highest quality portfolio.

© 2012-2013 Pawleys Investment Advisors, LLC.  All rights reserved.

2012 PGA Championship at Kiawah and Stock Picking

After several hours watching the world’s best golfers at the Kiawah Island Ocean Course here in South Carolina, it again hit home how difficult it is to deliver consistent, top-level performance.  The professional golf scene this week at Kiawah is akin to investors selecting a portfolio of quality stocks that will deliver solid financial performance in the long run.  Sponsor advertising from corporate consulting firms, investment banks, and even luxury watchmakers, messages this theme to golf fans.  When VJ Singh, one of the leaders during the week, worked at the driving range, he used a shaft embedded in the ground to the side of his body.  The purpose of this tool is to check the plane of his swing and eliminate variation.  Use of such a tool is an attempt to develop swing consistency and rhythm.  Kiawah Island and the links-style Ocean Course is known for extreme weather conditions coming off the Atlantic.  Similarly, the equity markets are riddled with extreme conditions.  Investors should also use such tools to develop consistency in basic skills to master the science of stock selection.  Using a well-defined structure for the portfolio, combined with a consistent process for selection and for both buying and selling decisions (not to mention the timing,) will better position investors to minimize the variations that can lead to poor performance. 

The weather on Friday, which included howling winds, led to poor scores overall, but four players excelled and delivered under par numbers.  A few select investors have continued to deliver solid performance this year, even as the howling winds of the European debt contagion have swept over global equity markets (including the Pawleys Dividend Portfolio and the Pawleys Growth Portfolio, see the Q2 update for specifics).  Stay tuned for more tips and learn how to master the basics (the “science”) and eventually, with experience, hone your ability to use “art” to supercharge your results.  Golfers refer to this as “feel” or “touch” and it is what helps these professionals stay at the top of the leaderboard.  Enjoy the PGA 2012 Championship tournament and the hunt for the Wanamaker trophy!  The golfers all have diverse styles that they each own.  You can use a putter, a driver or a seven iron off the fringe of the green, and each can be used with success.  Think about how the tournament environment can help you hone your strategy and processes in managing your stock portfolio.  Stay tuned for more as I share the specifics of equity portfolio construction…and be sure to watch for the alligators snatching the ground television microphones off the tee boxes!

© 2012 Pawleys Investment Advisors, LLC.  All rights reserved.