One of our clients recently asked what we thought about high frequency trading in regard to the risk embedded in markets. I responded that dark pools and high frequency trading are not well understood, and in my opinion exacerbate very short term volatility — sometimes at particularly stressful periods in the market. The question is, what to do with this risk? Maybe some of this will eventually be regulated away, but while it’s here the only thing we can do is understand it as part of the current structural environment, hedge our portfolios accordingly, and occasionally try to use it to our advantage.
We diversify by running diversified portfolios with very moderate position sizes, and we hold hedges for all sorts of different scenarios. When the May flash crash hit and exchange traded funds (ETFs) went haywire, we used the event to our advantage and added a little ETF exposure onto a position that had gone out of balance with the Indicative Net Asset Value.
But apart from this being a new form of structural risk, I would argue that it has little to no affect on the underlying trends in the market, and that the longer, more material moves will still be driven by fundamentals, technical conditions, and valuation. So our process is still geared to capture the larger trends and protect against extreme loss environments — that doesn’t change because of computers skimming fractions of pennies or algorithms triggering trades off of short term correlations. This fast-frequency money is but one of many structural risks that sit in the backdrop right now. I would love to see it go, but it’s a money maker for big firms that contribute a lot to certain political parties. As a result, crony capitalism may keep it around longer than Pinnacle (and many others) would like to see.