It may have all started with the 1968 epic film 2001: A Space Odyssey–the iconic battle between man and machine. With their ability to make calculations at lightning speed, computers have led to vast improvements in the human condition and have even replaced humans in many areas as tasks have grown ever more complex. It was inevitable then that we would see the proliferation of computers extend into how investors trade, giving birth to what is widely known today as algorithmic trading.
What is Algorithmic Trading?
According to a broad definition in Webster’s Dictionary, an algorithm is a “step-by-step procedure for solving a problem or accomplishing some end.” In trading, algorithms, or “algos” for short, are computerized programs instructed to automatically buy or sell particular securities once certain predetermined rules or conditions are met. The only time human intervention comes into play is when those rules and conditions are first programmed into a computer system.
Program trading on the New York Stock Exchange dating back to the 1980s paved the way to an explosion in the use of algorithms in the early 2000s. By 2017, it was estimated that algorithmic trading accounted for about 70% of overall trading volume in the U.S., according to Experfy.com. In a Financial Times article last January, J.P. Morgan estimated that “only about 10 percent of U.S. equity trading is now done by traditional investors,” such as pension funds, mutual funds and individual investors.
What Are the Pros and Cons of Algorithmic Trading?
Computers can accurately process trades at an astounding speed and frequency, unmatched by any human trader. As such, it can be argued that financial markets have benefited from the automation of trading through higher efficiency and increased liquidity. Computerized trading also removes human emotions from the decision-making process and can allow for better execution with less disruption to markets.
Despite the advantages, computerized trading has a downside. Critics of computerized trading cite shortcomings that tend to be highlighted during periods of market stress.
A common perception is that algorithms have increased market volatility due to the mind-boggling speed with which computers can execute trades. A type of algorithmic trading called “high-frequency trading” has been blamed for wild market swings over short periods of time, contributing to the kind of “flash crash” that investors experienced in May 2010. These programs take advantage of their speed to undercut other investors and are criticized as being unfair. In addition, these programs influence stock prices based not on company fundamentals but solely on their ability to move in and out of the market more quickly than other traders can.
What are the longer-term consequences as these programs develop further and become more pervasive? It’s hard to guess at this point, but these types of programs could lead to more volatility and uncertainty.
Of course, others argue that the machines are not to blame. Rather, it’s the large financial institutions using this enormous computing power to carry out transactions that are the real culprits behind market mayhem. The machines are but a means to the end of human endeavors, and during market downturns, they only throw gasoline on a fire already stoked by human fear.
What Does Algorithmic Trading Have to Do with FSA?
While FSA takes no side in the argument for or against algorithmic trading, we can’t deny the existence of increased volatility in today’s marketplace. But we can help reduce the effect of this increased volatility on client portfolios through the use of investment vehicles such as open-end mutual funds.
Since open-end mutual funds are priced once a day, at the end of the day, client portfolios with this kind of investment vehicle are not subjected to the same kind of intra-day gyrations that individual securities can produce. This is one reason mutual funds have always been FSA’s preferred choice for managing portfolios. While we also use exchange-traded funds, or ETFs, which do price throughout the day like individual securities, we tend to use ETFs as a complement to our core use of mutual funds.
For now, the idea of an artificial-intelligence computer like the HAL 9000 from that 1968 iconic film taking over the world’s trading is best left to the creative minds of Hollywood. But where algorithmic trading takes market participants in the future could be quite interesting. In a February 2018 Washington Post article, Silicon Valley designers were believed to be “building algorithms to gauge the speaking tone and inflection of Federal Reserve officials, looking for signs of how people will trade.” One day, truth might actually catch up to fiction.
While we don’t use so-called algorithmic trading at FSA, our process is fairly systematic. So as stocks reversed course in May from their strong rally, a number of our intermediate exit triggers were hit. As a result, you may have noticed some sales in your accounts last month. The 6% drop in the S&P 500 index was not enough to push our strategies into a heavy cash position, but we certainly trimmed back a few areas. Those of you in Core Equity and Tactical Growth would have noticed the greatest increase in cash, since those strategies had the highest allocation to stock funds. With stocks rebounding strongly in the first week of June, we stand ready to reinvest that money if stocks can retake the highs from April.
Enjoy the summer months!
Mary Ann Drucker
Assistant Portfolio Manager
Disclosures: Past performance is no guarantee of future results. Different types of investments involve varying degrees of risk. It should not be assumed that future performance of any specific investment, investment strategy or product (including the investments and/or investment strategies recommended and/or undertaken by FSA or the FSA Safety Net®), or any non-investment related services, content or advice, will prove successful or profitable, or equal any historical performance level(s).
The FSA Safety Net® is designed to represent an exit point for securities within a portfolio to help reduce losses during sustained downward trends. The FSA Safety Net® is not effective and will not protect assets in periods leading up to and including abrupt/sudden market declines. Examples of such occurrences include, but are not limited to, the market crash of October 1987, the market drop in October 1989, the market disruption caused by the terrorist attacks of September 2001 and the flash crash of May 2010. Similar future occurrences could reduce the effectiveness of the FSA Safety Net®. In addition, the FSA Safety Net® will not protect assets in the event that the account custodian, mutual fund sponsor or manager, annuity sponsor or manager, a specific security itself and/or the stock exchanges, at their discretion, suspends, disallows, or fails to conduct trades, exchanges, redemptions or liquidations requested by FSA or you.
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