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For Longer-Term #Investors, Following Aggressive #HFT Pays

By Irene Aldridge

Long-term buy-and-hold investors would improve their 2015 portfolio allocation decisions by increasing allocations to stocks frequented by aggressive high-frequency traders (HFTs), latest AbleMarkets research shows.  An illustration is a value-weighted $100 million buy-and-hold portfolio of the S&P 500 stocks formed at the end of December 2014 and held through December 2015 without any activity. This portfolio would have generated $4.6 million, a 4.6% return. The same portfolio where holdings were increased in proportion with aggressive HFT participation delivered $4.9 million, or a $300,000 improvement. Click here to find out what your portfolio would have made when adjusted with AbleMarkets Aggressive HFT weights. The allocations were once again completely passive: the aggressive-HFT-adjusted weights were selected in December 2014, according to the average values of aggressive HFT reported by the AbleMarkets aggressive HFT index, and left unchanged for 1 year. This article discusses the dynamics behind the strategy.

What is aggressive HFT and why does it help passive buy-and-hold investors? All HFT is short-term in nature, however, not all HFT is the same. Roughly speaking, HFT can be divided into aggressive and passive. Passive HFTs tend to use limit orders in market-making and related strategies. Aggressive HFTs, on the other hand, use ultra-fast infrastructure and market orders to capitalize on the latest information, such as macro and earnings announcements, and other news.

In the process of trading, aggressive HFT algorithms generate considerable volatility, as shown by many studies. Most of the volatility is a direct result of the aggressive HFTs’ mode of execution, namely market orders. A concentrated stream of market orders erode liquidity, widening the bid-ask spread and inducing the so-called bid-ask bounce, increasing volatility. More volatile stocks are more risky, and in the long term, require higher risk premium on return to compensate long-term long-only investors for holding the risk. Hence, long-term long-only investors in stocks preferred by aggressive HFT reap the extra return award.

What about portfolio risk? It turns out that the stocks favored by the aggressive HFT strategies have higher stock-specific risk and lower market risk than their peers. Stock-specific, or idiosyncratic, risk is relatively easy to diversify away in a portfolio. At the same time, the market risk, commonly known as beta, is often harder to diversify, and its relatively low occurrence among the stocks favored by aggressive HFT is welcome by institutional portfolio managers. On average, for every 1% increase in aggressive HFT participation among the Russell 3000 stocks, the beta decreases by 0.4%.

Since all HFTs are profit-maximizing agents, and since it takes months, if not years, to build successful trading systems, HFTs will naturally gravitate toward the stocks where their profitability is reliably higher. When a HFT strategy in a particular stock is profitable, it is likely a result of the stock’s idiosyncratic propensity to predictably respond to news. Profitable HFT systems, once built, tend to hang around for a long time, as the operating costs of the systems are low. Even when profitability eventually begins to decline, it does so gradually and can keep the systems afloat for months. Therefore, long-term investors can be assured of the considerable longevity of their strategies, even though the underlying nature of the strategy is very short-term.

Buy and hold investors should enhance their core strategy by including a rebalancing adjustment based on aggressive HFT participation.

Click here to access free AbleMarkets ‘what-if’ scenario tool for calculating the impact of aggressive HFT on an equity portfolio.