What is moving the markets? Computers (WSJ)

JUNE 18, 2009, 9:00 A.M. ET Automated Funds Now Dominate Stock Market; Other Traders Wary
By Rob Curran and Geoffrey Rogow
Of DOW JONES NEWSWIRES
NEW YORK (Dow Jones)--The U.S. stock market is increasingly switching to automatic from manual transmission, forcing investors to relearn how to drive.

Investors and pundits are left clutching at straws to explain big moves in the stock market, such as attributing a June 8 bounce to rehashed comments from Nobel Prize-winning economist Paul Krugman. The difficulty in divining a fundamental explanation stems from a structural change in the U.S. stock market: The majority of stock trades now originate with fully automated "high frequency" funds, a phenomenon that has accelerated during the market turbulence of recent years because of the relative success of the strategy.

These funds employ no traders in the conventional sense. They employ no economists or chart trackers. Rather, programmers at funds such as those operated by Citadel Investment Group and Renaissance Technologies outfit computers with strategies based on obscure mathematical correlations. Then the machines trade in and out of stocks at light speed without human intervention, a departure from the "fundamental" investing model that dominated trading for the last century.

The growth of these funds is such that institutions whose names have never appeared in the newspaper are now trading hundreds of millions of shares a day. Major hedge funds that have put other strategies on ice are opening new funds devoted to high-frequency strategies and hiring the mathematicians and computer programmers that run them. Some of the fastest-growing market makers, such as Global Electronic Trading Company, or Getco, also use the automated strategies.

With the rise of these automated funds, the stock market is more prone than ever to large intraday moves with little or no fundamental catalyst. Computers don't analyze the news (although some strategies use headlines as triggers) or seek to justify their buying and selling. Even in the relative quiet of the last three months, investors have often watched individual stocks or sectors move by 10% or more without explanation.
Two-Thirds Of Total Volume
Five years ago, less than one-quarter of U.S. stock-trading volume was generated by "high-frequency" traders, and few considered the funds more than a niche strategy, according to Matthew Rothman, an analyst of quantitative funds for Barclays Capital.

That percentage has since more than doubled even as overall volumes increased, with some estimating as much as two-thirds of daily volume now stems from these funds. The niche's role now overshadows that of mainstream brokers, mutual funds and hedge funds.

In 2007, when the bear market started, the popularity of the funds "started to take off (and went) parabolic when volatility spiked," says Bill Cronin, head of electronic sales for Knight Capital Group Inc. (NITE), a broker that serves many of these funds. High-frequency funds, whose average stock-ownership tenure is counted in seconds or even thousandths of a second, became more profitable the more stocks moved during the session, and it was one of the few areas that saw some profits even during the crash. Their success drew more capital into these model-makers, extending their reach just as other money managers lost assets and reduced trading.

For almost every other category of hedge fund and money manager, what Cronin calls the "ungodly" swings of the market caused losses.

"The volatility opened up the door to make money more easily" for the high-frequency funds, Cronin said. "Now, they're popping up like mushrooms all over the place."

Gaming The Market
Traditional money managers face the increased likelihood of seeing orders "gamed," or deliberately gouged. High-frequency funds have myriad strategies, but many depend on sniffing out "order flow" - or what hedge funds, mutual funds and pension funds that hold stocks for fundamental reasons are buying and selling.

Some conventional brokers such as Joseph Saluzzi, a founder of boutique trading house Themis Trading, consider the high-frequency funds troublesome "locusts...feeding off the equity market." Saluzzi believes the current market structure makes it too easy for a high-speed computer to expose a large order before it's fully executed.

"You have to be cognizant of the fact that these people are out there and they're making a lot of money," said Rich Gates, a portfolio manager for TFS Market Neutral fund in West Chester, Pa.

The Securities and Exchange Commission believes institutional money managers are "sophisticated" enough to trade against the machines without further regulation.

"We don't want to curtail liquidity," said Gene Gohlke, associate director for the SEC. Gohlke said it's up to the managers themselves to make sure other traders aren't manipulating their models.

Saluzzi considers the high-frequency trades "phantom volume." He questions whether the increased volumes from the funds in the last couple of years have mitigated volatility as "liquidity" is thought to do, or increased it.

The popularity of these strategies has spawned a cottage industry called "co-location," or "proximity hosting." Exchanges sell the funds "rack space" in the data centers where their servers process trades to gain an extra couple of milliseconds on the competition. Most exchanges have had to turn customers away because rack spaces are full.

To gauge the prevalence of computerized trading, the SEC may soon tag orders executed by "algorithms." Algorithms are computer programs used to slice and dice many kinds of stock orders.

The regulator did the same thing with program trading - a system of executing batches of orders in tandem. But Cronin, of Knight, said algorithms are ubiquitous for both manual traders and automated traders. The algorithm is not a strategy but an electronic method of executing a trade. Even floor brokers at the New York Stock Exchange use algorithms to trade stocks. Tracking them won't reveal the role played by automated funds in the stock market.

-By Geoffrey Rogow and Rob Curran, Dow Jones Newswires; 212-416-2179; geoffrey.rogow@dowjones.com