Merriman on High-Frequency Trading

If you’ve been tuned into financial news lately, you’ve no doubt heard about High-Frequency Trading (HFT). HFT is not new. In fact, it’s been around for over 20 years. Investopedia defines HFT as:

A program trading platform that uses powerful computers to transact a large number of orders at very fast speeds. High-frequency trading uses complex algorithms to analyze multiple markets and execute orders based on market conditions.

So why is it news now? Last week, a 60 Minutes interview with Michael Lewis suggested that the stock market was “rigged” by high frequency traders. I want to provide my thoughts, as Merriman’s Chief Investment Officer and as a hedge fund manager, on how HFT is affecting Merriman client portfolios. While we will monitor developments over time, the bottom line is that we believe HFT has minimal impact on our client portfolios.

Here’s why:

HFT firms are the new market markers in the stock market. Market makers, who’ve been active in markets ever since stock exchanges have existed, act to provide liquidity to stock trading by offering to buy stock at the bid price, and sell stock at a slightly higher ask price. While providing liquidity to the market, market makers have always strived to maximize their profits at the expense of institutional investors and the average person buying and selling stock in their brokerage account.

The transaction cost to investors can be viewed as an expense (paid to market makers) for providing liquidity, and has never and will never impact the fundamental value of the stock market. The cost only comes to bare when buying or selling a stock.

Two forces help protect us from market makers making excessive profits.  The first force is the competition among market makers.  As with any business, large profits attract competitors. iStock_000024621112SmallCompetition among market makers drives transaction costs lower as they fight amongst each other to provide this service. The battle among market makers is very similar to an ever increasing arms race, where whoever has the best technology wins. Over the last 10 years, computers have replaced the Wall Street traders and NYSE specialists – who in the old days were just as keen to profit from investors.

The second force limiting market maker profits are the countermeasures institutions use to trade large blocks for their clients. Attentive investors should be monitoring their trading and adjusting their investing/trading approach to minimize transaction costs. HFT is just the next story in the everlasting interaction between market makers and institutional investors. While the SEC and other government agencies will eventually catch on to illegal trading activities, the smartest investors generally take a buyer-beware approach to their trading.

In our MarketWise portfolios we take into account the sensitivity to trading costs when selecting investment managers. Dimensional Fund Advisors is obsessive in monitoring their trading costs and minimizing turnover. Their approach is to trade like a market maker by buying and selling stocks with limit orders and they are agnostic about what stocks they buy or sell (as long as a stock fits that fund’s investment approach). This trading approach is much less sensitive to HFT. Stock-picking active managers, and index funds, are typically demanders of liquidity when they trade stocks, which is much more susceptible to exploitation from market markers whether using HFT or via the old specialist system on the NYSE.

In our TrendWise portfolios, we also carefully track our ETF transaction costs to ensure that our approach is as cost -efficient as possible. And finally, individual investors, trading small quantities of stock in their own accounts, have benefited greatly from HFT as bid-ask spreads have narrowed significantly over the last decade or so.

If you have any additional questions about HFT or its impact on your portfolio, please don’t hesitate to speak directly with your advisor.

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All that glitters is not gold

Merriman does not include a specific allocation to gold in our standard portfolios. This article, by Bryan Harris of Dimensional Fund Advisors, discusses why gold has not been an ideal long-term investment. It includes the following key concepts:

  • Gold has done well since the year 2000 and in the 1970s, and can potentially be a safe haven during times of political and economic stress. However, for the entire period of 1971 – 2011 gold performed worse than the S&P 500, U.S. small-cap stocks and non-U.S. stocks on an inflation-adjusted basis.
  • From 1980 – 1999, gold experienced a negative return after inflation of -6.5%, vs. strong positive returns for stocks.
  • While gold has held its value against long-term inflation, there have been extensive periods when gold did worse than inflation. Gold is also much more volatile than inflation, and can add substantial volatility to a portfolio.
  • Unlike stocks, which are productive assets which generate growing levels of income and dividends over time, gold has no cash flow and costs money to own.

For more detail and some illuminating graphs, please see the article.

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Expiring Tax Provisions

It seems like every year there’s a slew of tax breaks in danger of expiring.  Sometimes Congress extends the tax break, other times they actually expire and fall by the wayside. 2011 is no different, with 3 potentially useful tax breaks on the cutting room table.  Those who may be able to benefit from these tax breaks should consider taking advantage of them soon, before it’s too late.

  • Sales Tax Deduction – Individuals who itemize their deductions can elect to deduct their sales tax or their state and local income taxes, whichever is greater.  There are seven states without a state income tax, so those residents would surely elect the sales tax deduction.  Residents of other states may find that they paid very little in state income taxes and may decide to elect the sales tax deduction instead.  For those who are taking the sales tax deduction and considering a large purchase, such as a new car, it may be worthwhile to complete the purchase this year in order to maximize this tax benefit while it’s still available.
  • Energy Efficiency Credit – Individuals can take a credit of up to $500 for making energy efficient improvements to their homes, including upgrades for roofs, doors, insulation, windows, furnaces, air conditioners, and many others.  There are limitations on the amount of eligible credit for the various improvements, and you can find a list of those here. It’s also important to note that unlike many other credits, this one is a lifetime credit–so if you’ve utilized all of the $500 credit in the past, you cannot take any more regardless of your qualified expenditures now.  However, if you haven’t benefited from this tax break yet, and are considering making energy efficient improvements to your home, you may want to do so before year end.
  • Qualified Charitable Distributions from IRAs – Individuals older than 70 ½ can make tax-free distributions from their IRA to qualified charities.  The distribution is not includable in the donor’s income, but it is not deductible as a charitable donation either.  This provision primarily benefits individuals who are charitably inclined but don’t have enough deductions to itemize.  The qualified charitable distributions will count towards an individual’s required minimum distribution (RMD) for the year, allowing those who don’t need the money from their IRA to donate it without being taxed on it.  With year-end fast approaching, individuals who have yet to take their RMD may want to consider this option.

Each of the tax breaks above had been due to expire at some point in the past but was subsequently extended at the last minute.  It is possible that Congress will extend these breaks again, but nothing is certain given the deficit and debt problems currently facing our country.

If you think you may benefit from any of these tax breaks, please be sure to consult with your accountant to see how these tax savings may apply to your specific situation.

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How to invest so your money lasts in retirement

Editor’s Note: Below is an article published first on MarketWatch.com that was written by Larry Katz, CFA – Director of Research at Merriman.

A major concern of many people is whether their savings will last for their entire retirement. If the savings do last, it’s a success, but if the savings don’t last it could be considered a failure.

Key factors which influence whether savings will last for your entire retirement include the size of your portfolio at retirement (bigger is better), the amount of periodic withdrawals (the lower the withdrawals the greater the chance of not running out of money) and longevity (the longer you live, the more you need at the start of retirement).

Another consideration is the diversification among various asset classes within the portfolio. The greater the diversification and exposure to beneficial asset classes, the lower the portfolio risk, and the greater the chance of financial success in retirement. (more…)

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Evaluating new investment products

“People calculate too much and think too little.”

This is a quote from Charlie Munger, Warren Buffett’s right hand man, and a world-class investor in his own right.

It is one of my favorite quotes and has rung true throughout my investment career. In my experience, many financial professionals accept numbers too easily without fully understanding assumptions, sensitivity to inputs, and general rules of economics and competition.

We are always looking for ways to better design client investment portfolios. Every year, we are bombarded with new investment approaches, new products and new trading strategies to beat the market. Most new products can be tossed aside immediately, but a few require more detailed investigation. (more…)

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We’ll say it again: The choice of assets can make a big difference.

There was an interesting article in the Wall Street Journal from March 8, 2011 called “Why Small-Cap Funds are Lagging.” It cites a study by Credit Suisse showing that “small-cap funds have increasingly been investing in companies larger than their category name would indicate—and the average fund is underperforming its benchmark.”

The article goes on to say “The average market capitalization of a company in a small-cap fund was about $3.1 billion at the end of 2010, compared to the average market cap of the benchmark Russell 2000 index of about $1.3 billion. The $1.8 billion gap between the two is the largest since September 2008.” (more…)

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2010 year in review from Dimensional Fund Advisors

Dimensional Fund Advisors, the manager of many of the mutual funds in our client portfolios, wrote this comprehensive economic and investment review of the year 2010. We hope you find it as interesting as we did.

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Are dividend-paying stocks good bond substitutes?

A rose by any other name would smell as sweet.

With bond yields so low, is it a good idea to substitute dividend-paying stocks for bonds? Some would say yes, since dividend-paying stocks yield more than some bonds, and have more upside potential.

However, I don’t think this is a good strategy.

Obviously, dividends are an important component of stocks’ total return. From 1930 through October 2010, for example, dividends provided 45% of the annualized percentage gain of the S&P 500. Dividends also help sustain portfolio income when interest rates are low.

But there’s no getting around the fact that stocks, including dividend-paying stocks, are generally more volatile than bonds. Substituting dividend-paying stocks for bonds will lead to a higher risk portfolio.

Let’s take an example of how volatile dividend-paying stocks could be. We’ll look at three exchange traded funds (ETFs). The first is SPY, which tracks the S&P 500. (more…)

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Inflation and our Merriman bond portfolio

Here’s an article we recently mailed to Merriman clients, addressing some inflation questions that we felt our FundAdvice readers may also be interested in:

Some investors are concerned about the prospect of future inflation, based on fiscal and monetary measures the U.S. government has taken to respond to the recent market crisis. However, other metrics suggest that moderate inflation will continue. These include current inflation, bond market indicators and worldwide excess capacity.

Merriman’s recommended bond portfolio is structured to provide a reasonable level of protection against inflation.

The Fed’s view

The Federal Reserve, in a statement on April 28th said, “With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.”

Notwithstanding this reassuring if somewhat abstruse statement, there is considerable debate about whether higher inflation will result from the fiscal and monetary actions the federal government used to curtail the market plunge from October 2007 to March 2009. Inflation is the nemesis of bond investors. An increase in inflation will cause an increase in interest rates and decrease the value of bonds. Conversely, if interest rates were to fall because of lower inflation, bond prices would rise.

What factors impact inflation and how is our bond portfolio structured to handle inflation risk? (more…)

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Roth IRAs: To convert or not to convert

As a financial advisor and CPA, I often receive tax questions from my clients.  One that has been coming up a lot in the past year is: “Should I convert my non-Roth retirement plan (401(k), traditional IRA, 403(b) or 457(b)) to a Roth IRA?”  The question isn’t surprising, given the new rules that took effect January 1 for Roth IRA conversions.

The short answer, which should not surprise you, is: “It depends.”

The issue is complex, and the answer for one person can be radically different from the answer for someone else. Converting might be a boon, a mixed bag or a mistake, all depending on your circumstances.

It’s worse than that, because the only way to make sure you’re making the right choice is to know some variables of the future which simply cannot be known.

My bottom-line advice is to seek professional advice from your tax advisor, your financial advisor or your tax attorney before you take the plunge.

A word of caution

The difficulty with Roth conversions, like the difficulty for many tax strategies, is that the right answers cannot be known in advance. You usually cannot know your future income for sure. You cannot know what Congress will do to the tax code. And you cannot know future tax rates. In each case, the best you can do is guess. (more…)

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