Some of the links below point to fairly technical discussions of automated trading systems on Wall Street. I’d recommend you read them, anyway. They’ll help you become a better investor in two ways: (1) by giving you a visceral understanding of the dark side of institutional investing on Wall Street, and (2) prove that most of what goes on in the market these days is, quite simply, noise.
High Frequency Trading is proprietary computer trading with the goal of collecting rebates, and/or detecting real order flow (i.e. institutional flow) and frontrunning it and making pennies.
And, yes, frontrunning is illegal, thus explaining why the blogosphere (or at least the geeky investing parts) are aflutter these days with questions about High Frequency Trading.
1 – A quick, simple intro to HFT. Source for the quote above.
2 – Toxic Equity Trading Order Flow On Wall Street. An excellent primer.
3 – Goldman Sachs Loses Grip On Its Doomsday Machine. The theft that launched a thousand blog posts.
4 – What’s The Frequency, SEC? The mainstream media starts asking questions.
5 – Automated Front Running On An Unfathomable Scale. That about sums it up.
Hat tip to ZeroHedge.
Island Investing
Cale Smith, MBA
July 18, 2009
KeysWeekly.com
Q. What are derivatives and why should I care about them?
A. Consider yourself warned: reading about derivatives can make you narcoleptic. Usually the phrase “collateralized debt obligation” is followed by the drool that comes only from deep REM sleep. But to understand the credit crisis we just went through, you need to know more about derivatives. So I’ll answer this question in two columns.
A derivative is a financial instrument whose price depends on something else. That could be an asset, like a barrel of oil, a share of stock or a resold mortgage, or in the case of credit derivatives, it could be a loan or bond. Derivatives exist only on paper and come in an exotic range of acronyms.
One class of these derivatives effectively separated the issuing and pricing of a mortgage from the evaluation of its underlying risk. In other words, derivatives marginalized the role the local banker used to have in loan approval. Mortgages used to be issued by lending officers who knew both borrower and property. Derivatives enabled them to be mass-produced like widgets on an assembly line.
Picture the entire multi-trillion dollar mortgage market as a three-story building in a flood zone.
The most conservative investors own the top floor of the building, and earn reasonable
rent from their tenants. More aggressive investors own the middle floor and can charge
more rent because their tenants are slightly less dependable when it comes to writing
checks every month. The most aggressive investors own the ground floor and charge
the highest rent of all because their tenants sometimes do not pay rent.
Whenever a storm comes in, the ground floor (representing the most risky mortgages)
will flood. The investors that own those floors get nothing. But they’re not stupid. They
know a flood zone is probably going to be a poor place to invest.
So who on earth who would buy a high risk mortgage?
For a long time, nobody would. But then Wall Street created an answer – one that ultimately destroyed our economy. Next week I’ll discuss how exactly it happened.
Cale Smith is the portfolio manager for the Tarpon Folio and Gecko Folio. His firm’s website is www.islainvest.com and his blog is www.caleinthekeys.com.
Island Investing
Cale Smith, MBA
July 11, 2009
KeysWeekly.com
Q. What’s a hedge fund?
A. Think of a hedge fund as an unregulated mutual fund. While the word “hedge” might lead you to believe these funds cautiously hedge their bets, that is rarely the case.
Like a mutual fund, a hedge fund is a pool of investors’ money managed by a professional portfolio manager. Unlike mutual funds, however, hedge funds are not regulated by the S.E.C. and cannot advertise.
Because hedge funds have few restrictions, their managers are free to take many more risks than a mutual fund manager, often investing aggressively in options and futures, buying on margin, betting on currencies or shorting stocks. Most trade quite frequently and offer little transparency to their investors. Hedge fund managers don’t have to hold any certifications or registrations to start a fund, either.
Hedge funds are also only open to “accredited investors,” or people earning more than $200,000 a year or with a net worth of more than $1 million. These funds may also require very large initial investments and prohibit withdrawals for years.
In 2008, there were approximately 8,200 hedge funds in the world managing $2.5 trillion. Along with private equity firms, investment banks, and other specialized investment vehicles, hedge funds comprise a significant portion of the “shadow banking system” that helped create the recent global financial crisis.
To be clear, investing in a hedge fund run by a truly talented manager can be quite lucrative. Unfortunately, many hedge fund managers often appear more interested in enriching themselves than serving their investors. One manager described hedge funds as, “A compensation scheme masquerading as an asset class.” It’s easy to understand why, when even poorly performing managers take a large portion of a fund’s profits – usually 20%. In addition, regardless of performance, hedge fund managers typically receive an annual management fee of 2% of assets under management each year.
So while a small number of hedge funds are actually worth the exorbitant fees investors pay, most are not. Don’t believe the hype. You’ll likely outperform most Wall Street geniuses over the long-term with nothing more complicated than an index fund.
Cale Smith is the portfolio manager for the Tarpon Folio and Gecko Folio. His firm’s website is www.islainvest.com and his blog is www.caleinthekeys.com.
@PhilipEtienne Roger that. Will track it down. Thank you. in reply to PhilipEtienne 14 hrs ago
