‘Victims’ of churn are accessories to the crime

High-frequency trading is not the main problem; the myth that all this trading is needed is

Michael Lewis’s new book, Flash Boys, is a brilliant and entertaining indictment of Wall Street’s corrupt practice of taking advantage of investors by raking off a portion of their trades. However, it ultimately aims at the wrong target. The target should be the myth that all this trading needs to be done in the first place.

The original purpose of investing was to provide capital to companies to create or expand businesses, in return for a share of their future profits. This is still its bedrock function. A secondary market arose where those who had new money to invest could purchase shares from shareholders who needed to cash in.

However, the money management industry has succeeded in convincing investors that it is much more important to “churn” their investments – to constantly sell shares in one company to buy shares in other companies – in order to beat the market.

As a result, what would normally be a need for an individual investor who invests in, say, shares of IBM, to purchase those shares only once and sell them only once in a lifetime, becomes a need to buy and sell them in exchange for other companies’ shares as many as hundreds of times over.

By convincing investors of this need through doubletalk marketing pitches, high-cost managers of mutual, pension and endowment funds have grown their industry’s revenues more than tenfold as a percentage of US gross domestic product in the past 35 years, from 0.24 per cent of GDP in 1980 to 2.44 per cent in 2007, according to a paper by Harvard Business School professors Robin Greenwood and David Scharfstein – and the percentage is higher now. The money management industry’s revenues are in the hundreds of billions of dollars in the US alone.

Repeated studies spanning decades have shown that the practice of churning stock holdings, often called active money management, results in returns to investors that do not beat the market but underperform it by an amount equal to the industry’s fees.

That fee, for mutual funds, averages 1.4 per cent, which is the expense ratio of the average fund plus trading costs. At current mutual fund turnover rates these trading costs have been estimated at an additional 0.5 per cent, hence the total average fee is 1.9 per cent. A fee of 1.9 per cent on assets every year will deplete the savings of an individual who is saving for retirement by nearly half. This loss is far greater than has ever been recorded in any major national stock market debacle over a similar period of time.

All this unnecessary and unproductive trading has, however, become so widely accepted and so commonplace that even as astute an observer of the financial industry as Mr Lewis chooses to take it as a given, directing his indictment elsewhere. But if the money management industry were not able to convince investors to pay them high fees to churn their funds constantly, it would not be a sitting duck for the high-frequency trading scam Mr Lewis justifiably places in his crosshairs.

Mr Lewis makes it sound as if the high-frequency traders’ moral crime is that they are feeding on small investors who are just trying to make the trades they need to make, by front-running their trades. This is good for dramatic effect, portraying the story as a Manichaean struggle between good and evil. It may even help to further Mr Lewis’s larger cause, which is undoubtedly to show how rotten to the core the whole financial industry is.

But, in this pursuit, Mr Lewis is willing to overlook the fact that the “victims” are actually accessories to the crime. The large funds and money managers are not victimised themselves, but pass the losses and costs on to the small investors whose money they are managing. All of this is because their marketing and advertising – which is of a deceptive nature that would never be allowed if a regulator comparable to the US Food and Drug Administration were overseeing financial products – has convinced investors that managers need to be paid large fees to trade constantly.

Mr Lewis’s book is to be roundly applauded for identifying and explaining clearly and in strong language one particularly egregious example of how the financial industry rips off the public. Unfortunately, the one he identifies is only the tip of a much larger iceberg. It can exist only because of a widespread and deeply embedded deception practised on the investing public. Investors should go back to the original purpose of investing and employ the practice that it implies – and the one that the most successful and most widely admired investor, Warren Buffett, advocates: buy and hold.

Michael Edesess is co-author of the forthcoming book ‘The Three Simple Rules of Investing: Why Everything You’ve Heard about Investing Is Wrong’

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