Rise of the Machine: The Digital Evolution of Investing (Part I)

This article was written in collaboration with the Dimensional Fund Advisors trading team.

When Tech and Markets Meet

Today, financial markets are evolving through globalization, competition and regulation, among other forces — but none more so than technology. And like any innovation, money managers must monitor changes in technology and trading diligently to ensure they are using those advances efficiently for the benefit of their clients.

We sat down with members of the trading team at Dimensional Fund Advisors — an Austin-based asset manager whose philosophy and mutual funds are a cornerstone of our investment approach — to discuss how the relationship between technology and the financial markets affects the long-term investor. But before we dive in, it’s crucial to cultivate an understanding of how we got here.

The Exchange: Then and Now

When you hear the words “stock trading,” what image comes to mind? Perhaps it’s the well-suited stockbroker strolling down Wall Street, or the specialist punching in orders on the floor of the New York Stock Exchange (NYSE). For as long as investors have been buying stocks to grow their wealth, there have always been intermediaries — the key players that exist in all markets, helping match buyers with sellers.

And to buy and sell at the best-possible prices, market intermediaries must be able to act fast, computing and communicating data at high speeds.

This need for immediacy has spurred many innovations in the markets over the past few decades. During the late nineteenth century, the stock ticker was unveiled at the NYSE, which made up-to-the-minute prices available to investors across the country for the first time.

The digital evolution of investing
Source: Museum of American Finance

The mechanical stock ticker was replaced in the 1960s by a digitized ticker with an electronic display, bringing even more automation to communication around price changes.

The digital evolution of investing
Source: Museum of American Finance
The digital evolution of investing
Source: Museum of American Finance

Flash forward to the 1980s and early ‘90s, which saw the arrival of program trading — computerized systems designed to buy and sell shares of baskets of stocks and their derivatives simultaneously to exploit price differences. This advancement further amplified speed and efficiency in the markets.

The digital evolution of investing
Source: Associated Press/Richard Drew

Why is this history lesson important? The point is that technological progress has long fostered advancement and competition in the markets. New platforms, programs and trading practices have opened the gateway for more participants to fulfill the “market-maker” function and provide liquidity for investors.

Over the past decade, the march toward tech has carried on, creating a new kind of key player: high-frequency traders (HFTs).

High-Frequency Traders: The New Kid on the Block

Intermediaries have always facilitated the trading of securities, because buyers and sellers may not always come to the market to trade the same security at the exact same time. Many years ago, specialists on the NYSE stood ready to buy and sell certain stocks to provide liquidity to buyers and sellers. Due to innovations in technology, this service is no longer provided by a specialist on the floor of the NYSE. Instead, intermediaries, such as HFTs, use computer algorithms and lightning-fast networks to provide liquidity to the market across many different trading venues.

The evidence suggests that the growth of HFT has been associated with lower trading costs and improved liquidity in markets. However, HFT has also been met with criticism, including Michael Lewis’s book, “Flash Boys.” Lewis and other critics suggest the markets are “rigged” by HFTs, and that the algorithms used to make trades at blazing speeds present an ethically questionable advantage, allowing them to “front-run” everyday investors. While academic evidence exists to the contrary12, Dimensional’s trading team helped us further separate the facts about HFTs from fiction.

Cost Implications for Long-Term Investors

Should regular investors be concerned that they are taken advantage of when trading? Part of the answer to that question lies in the difference between a long-term investor and a short-term speculator or trader.

Short-term traders, such as HFTs, are using technology to trade more quickly; this forces them to compete with other HFTs for profits in short time intervals. Long-term investors, on the other hand, should approach trading with discipline and patience to achieve the most favorable execution prices. This helps keep trading costs low, allowing for a more cost-effective investment experience.

Long-term investors should approach trading with discipline and patience to achieve the most favorable execution prices.

Since 1981, Dimensional has relied on academic research to guide its investment philosophy, focusing on the factors investors can actually control — such as broad diversification across asset classes; using market prices to focus on reliable drivers of higher expected returns; minimizing unnecessary turnover (that is, turnover that does not increase expected returns); and managing the cost-per-trade to be as low as possible.

Remember when we mentioned that long-term investors should focus on keeping trading costs low? Well, in the words of Dimensional Founder and Executive Chairman David Booth: “[One of Dimensional’s] principles is that we don’t want to see much turnover in the portfolios. The best way to save on trading costs is to not trade very often.”3

Reducing trading frequency can keep trading costs low, but should we worry that HFT might increase the cost of the trades we do execute? Dimensional doesn’t stop at keeping turnover low; the firm builds patience and flexibility into the trading process. This means that Dimensional rarely crosses bid/ask spreads to demand immediacy and is usually on the passive side of transactions. “One of our key differentiators,” explains a Dimensional trader, “is that we are not required to execute every share of an order candidate. We can — and frequently do — use the option to reach the end of a trading session with orders that are partially filled.”

Dimensional also continually monitors how it is trading, another reason we choose to incorporate its funds into our own portfolios. The firm examines explicit costs, which are easy to measure (think commissions and transaction charges), and hidden costs (for instance, does the market move between the time a trade is placed and the time a trade is executed?), which are much more challenging to measure, yet potentially much larger. According to one of Dimensional’s traders, the firm studies rich data on virtually every market price, order and trade in exchanges across the world, so it can monitor trading constantly and ensure that its funds’ investors are paying the most reasonable costs possible — regardless of who they’re up against.

Dimensional is in a unique position to trade efficiently, given their investment philosophy and integrated approach to portfolio implementation, which reduces unnecessary turnover and allows for flexibility and patience in the trading process. Ultimately, this translates into a more reliable and cost-effective investment experience for the long-term investor.

Click here to read Part II of our conversation with Dimensional’s trading team, plus answers to more questions about how technology has changed markets.
Wipfli Financial Advisors, LLC (“Wipfli Financial”) is an investment advisor registered with the U.S. Securities and Exchange Commission (SEC); however, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. Wipfli Financial is a proud affiliate of Wipfli LLP, a national accounting and consulting firm. Information pertaining to Wipfli Financial’s management, operations, services, fees and conflicts of interest is set forth in Wipfli Financial’s current Form ADV Part 2A brochure and Form CRS, copies of which are available from Wipfli Financial upon request at no cost or at www.adviserinfo.sec.gov. Wipfli Financial does not provide tax, accounting or legal services. The views expressed by the author are the author’s alone and do not necessarily represent the views of Wipfli Financial or its affiliates. The information contained in any third-party resource cited herein is not owned or controlled by Wipfli Financial, and Wipfli Financial does not guarantee the accuracy or reliability of any information that may be found in such resources. Links to any third-party resource are provided as a courtesy for reference only and are not intended to be, and do not act as, an endorsement by Wipfli Financial of the third party or any of its content or use of its content. The standard information provided in this blog is for general purposes only and should not be construed as, or used as a substitute for, financial, investment or other professional advice. If you have questions regarding your financial situation, you should consult your financial planner, investment advisor, attorney or other professional.
OneBite Editorial Staff

OneBite® is a Top 50 Financial Advisor Blog powered by Wipfli Financial Advisors. Founded in 2011, the digital magazine is dedicated to providing intelligent, in-depth coverage and analysis of the top financial and economic issues facing investors today.

No Comments Yet

Comments are closed

Rise of the Machine: The Digital Evolution of Investing (Part I)

time to read: 5 min