Mutual-fund and other asset managers trying to get the best price on a stock purchase or sale face a formidable challenge from fast-moving high-frequency traders — but managers are not defenseless.
To be sure, it’s difficult to execute large trades when HFTs deploy sophisticated pattern-recognition software in search of order-flow information that they can use to their advantage. When an asset manager unintentionally leaves footprints that tip its hand to these HFTs, the price is often impacted to the detriment of the asset manager.
So what can an asset manager do to prevent this from happening? By answering this question, we can help institutional investors improve their execution, reduce transaction costs, and ultimately deliver better investment returns.
In a recent study, my colleague and I looked into this issue. Our goal was to provide a realistic analysis of the strategic interaction between investors trading for fundamental reasons, such as pension funds, mutual funds, and hedge funds, and traders seeking to exploit leaked order-flow information, such as certain types of HFTs.
We find that asset managers have a powerful weapon against HFTs that exploit order flow information: Randomness.
I recently testified at a Ways and Means Committee hearing about tax reform. While there is broad agreement about the need to reduce the U.S. corporate tax rate, which is now highest among the world’s advanced economies, Committee members asked how they could explain this to constituents. Would this be perceived as fair?
When businesses choose their legal form for tax purposes in the United States they have several options. The simplest option is that the owner can operate the business without a separate legal entity in which case the income is taxed directly to the individual on their tax return. This is known as a sole proprietorship. An alternative is a pass-through entity, which is not taxed at the entity level (generally) but instead “flows through” income to the owner(s) who are taxed on their individual income tax returns. These entities include partnerships, LLCs, and S-corporations.
The other common type of organizational form is the C-corporation, which is subject to an entity level tax. In addition, when dividends are paid, the shareholders are taxed on the dividend income. Thus, the C-corporation form of business organization may result in double taxation. Almost all publicly traded businesses are taxed as C-corporations, while many small business are organized as pass-through entities.
In recent years, parts of the financial sector have behaved badly — and holding the relevant executives accountable has not been a strong suit of the Obama administration. So financial reform is an important issue for the country, and whoever wins the Democratic Party presidential nomination will find that it resonates with many voters in the general election.
All of them also agree that the 2010 Dodd-Frank Act moved some issues in the right direction but there remains a substantial and important, unfinished agenda. The principal disagreement among the three camps comes down to this: what is the structural problem with our financial system, and how should we fix it?
Senator Sanders and Governor O’Malley correctly point out that in recent decades some banks became very large and the crisis did nothing to shrink their balance sheets. These banks are commonly and accurately regarded as “too big to fail,” meaning that they benefit from an implicit government guarantee. This is a dangerous and unfair subsidy.
Trying to predict currency movements is — as they say here in the U.K. — a mug’s game. Any economist, myself included, will tell you it’s virtually impossible to do.
And yet, movements in exchange rates are incredibly important. They affect a country’s competitiveness — influencing everything from export competitiveness to GDP growth. They affect the prices of items coming from abroad, from oil to oranges to iPhones. They make it harder, or easier, to repay foreign debt and they affect earnings on foreign investments.
Currency movements also have big implications for the outlook for inflation. This relationship is known as “pass-through,” because it captures how changes in the exchange rate “pass-through” to import prices and then inflation.
So even if we can’t predict exchange rate movements, we need to understand how exchange rates will affect the economy. And for those of us tasked with setting monetary policy, understanding how currency movements pass-through into inflation is critical to our decision on when to adjust interest rates.
The problem is, much of what we thought we knew about pass-through has not been holding up well.
A major shift in American politics has taken place. All three of the remaining mainstream Democratic presidential candidates now agree that the existing state of the financial sector is not satisfactory and that more change is needed. President Barack Obama has long regarded the 2010 Dodd-Frank financial-reform legislation as bringing about sufficient change. Former Secretary of State Hillary Clinton, Senator Bernie Sanders, and former Governor Martin O’Malley want to do even more.
The three leading Democratic candidates disagree, however, on whether there should be legislation to re-erect a wall between the rather dull business of ordinary commercial banking and other kinds of finance (such as issuing and trading securities, commonly known as investment banking).