I am one of the 160,000 people who purchased Flash Boys by Michael Lewis during its first week of publication. The book is highly entertaining and provocative. It’s causing a “shitstorm”—to use Michael’s terminology—and rightfully so. To paraphrase what he said in an interview with Jon Stewart, the great American stock market, once perceived to be venerable and respected, is now a sham.
The real sham of the stock market, however, runs deeper than the farce that high-frequency trading makes of “best execution” (making sure clients get the best available prices for purchases and sales of stock). Throughout Flash Boys, high-frequency traders are treated as a breed of speculator distinct from “…an actual buyer of stock—a real investor, channeling capital to productive enterprise.” This distinction glosses over one unpleasant fact and a huge gray area.
Unpleasant Fact: Less than 1% of stock market activity actually channels capital to productive enterprise.
The stated purpose of the stock market may be to channel capital to productive enterprise, but that is not actually what is happening 99% of the time. Wall Street executives like to toss around lofty terms like “capital formation”. The fact is that more than 99% of the trading activity in US stocks involves “used stock”, shares that were previously issued and are now just moving from one owner to another (like used cars).
Less than 1% of all purchases are actually new stock that is providing capital to companies. The Clash of Cultures: Investment vs. Speculation, written by John Bogle and published in 2012, cites these five-year statistics: total equity IPOs (initial public offerings) averaged $45 billion per year and follow-on offerings averaged $205 billion, while total stock market trading volume averaged $33 trillion. That means you stand about a 1% chance of actually “channeling capital to productive enterprise” when you or your mutual fund or your account manager buys stock.
Gray Area: What’s the Difference between an Investor and a Speculator?
It follows from the above that most of us have never really channeled capital to an enterprise through our participation in the stock market, whether through direct purchases or through a manager or mutual fund. I suspect many of us have always assumed that we were investing in those companies whose stock we hold in our portfolios. Oops!
If buying stocks is not actually providing capital to companies, then how does it qualify as an investment? Perhaps buying stock in a company is a form of partnership with that company, an alignment of interests over the long term so that the saver can participate in the success of the economy and the company. If we’re not actually channeling capital, we might feel a long-term alignment with a company is a solid substitute.
Even this interpretation has serious limits. The average US mutual fund has a turnover rate of about 100%, which means that it’s possible that all of the stocks that begin the year in the portfolio have been replaced by the end of the year (or some stocks have been bought and sold many times during the year). For such funds, a “long-term” horizon is a period of weeks or months. At the lower end are index funds with average turnover rates in the single digits. At the higher end are mutual funds with rates in the 200s.
In Flash Boys, high-frequency traders are called out as speculators because they operate in milliseconds, and to be fair they don’t even claim to be investors. But even if a hedge fund manager or mutual fund portfolio manager operates in minutes or hours, he is still considered an “investor”. The irony is that most investment managers and funds that claim to be long-term investors still have such high turnover rates that they beg the question: are they investing or speculating?
Not at all surprised
When I worked at Salomon Brothers in the 1980s (with Michael Lewis and the crowd from Liar’s Poker), there were very few women on the trading floor. I went there because I wanted to succeed in a man’s world, which I did, until I couldn’t stand it anymore. In Flash Boys, a tale of Wall Street some 20-30 years later, I still counted just three Wall Street women and some fleeting references to a few wives.
At the end of Flash Boys, we meet the ultimate outsiders and arguably coolest people in the book, the 750-member Women’s Adventure Club of Centre County, Pennsylvania. The connection to the story is subtle, but it spoke to me. The group’s founder, Lisa Wandel, realized that “many women were afraid to hike alone in the woods.” So they got together and worked through fear and doubt—some learned to fly on a trapeze, won mountain biking championships, ran races, raced cars and plunged into ice-cold rivers.They happen to live along the route of the fiber cable that runs from Chicago to New Jersey and observed its construction as they scaled steep hills on their bikes. One wonders what they would have said about it had they known its purpose. These women are nowhere near Wall Street and seem to be all the better for it.
To put a fine point on it, I was not at all shocked by the revelations in Flash Boys. I’m sorry to have to say that, but it’s true. Start with a culture of avarice and ego based on money as the one and only measure of worth. Then, turn a bunch of young male technology addicts loose on a project that incentivizes them to go as fast as possible, beat everyone else, and make a lot of money in the process. What do we expect? Boys will be boys.