This blog post continues our expert analysis of complex investments.
Simple investments can be made more complex by changing market structures. In Michael Lewis’s Flash Boys: A Wall Street Revolt, he details how the biggest, most sophisticated money managers in the world, whom collectively managed trillions of dollars, were completely ignorant of how high frequency traders (“HFT”) were front-running their orders. Lewis writes:
By the end of 2010, Brad and Ronan between them met with roughly five hundred professional stock market investors who controlled, among them, many trillions of dollars in assets. They never created a PowerPoint; they never did anything more formal than sit down and tell people everything they knew in plain English. Brad soon realized that the most sophisticated investors didn’t know what was going on in their own market. Not the big mutual funds, Fidelity and Vanguard. Not the big money management firms like T. Rowe Price and Janus Capital. Not even the most sophisticated hedge funds. The legendary investor David Einhorn, for instance, was shocked; so was Dan Loeb, another prominent hedge fund manager. Bill Ackman ran a famous hedge fund, Pershing Square, that often made bids for large chunks of companies. In the two years before Brad turned up in his office to explain what was happening, Ackman had started to suspect that people might be using the information about his trades to trade ahead of him. “I felt that there was a leak every time,” says Ackman. “I thought maybe it was the prime broker. It wasn’t the kind of leak that I thought.” A salesman Brad hired at RBC from Merrill Lynch to help him market Thor recalls one big investor calling to say, “You know, I thought I knew what I did for a living but apparently not, because I had no idea this was going on.”  (Emphasis added)
(Lewis concludes) If an investor as large as T. Rowe Price, which acted on behalf of millions of small investors, was unable to obtain from its stockbrokers the information it needed to determine if the brokers had acted in their interest, what chance did the little guy have?
This confirms our previous reporting here, about how even the most sophisticated players in the financial markets frequently don't understand complex investments.
High Frequency Trading Firms
The HFT firms had set themselves up as broker-dealers and because of a speed advantage in seeing order flow, were able to intermediate themselves between buyers and sellers. While spreads had narrowed to a penny in many actively traded stocks, it was an illusion. As T. Rowe Price and Janus were finding, liquidity disappeared when they went to transact large blocks of stock.
It was costing their investors hundreds of millions per year but the managers had no idea what was going on.
Market structure is highly complex and spans multiple domains, including: investment regulation, technology, finance, and business models. It is also another form of complexity risk.
Auction Rate Securities
The now well-know risks in the Auction Rate Securities (“ARS”) market is another good example. Broker-dealers that issued ARS had traditionally backstopped the auctions and would step in if there weren’t enough bids to clear the (typically weekly or monthly) auction. However, when they became capital constrained due to the sub-prime mortgage crisis, they stepped away from the auctions and the entire ARS market became illiquid overnight.
This was an especially painful result because ARS had been marketed as “money market alternatives” and thus were funds that investors were relying on to be readily available for their cash flow needs.
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 Lewis, Michael, March 31, 2014. Flash Boys: A Wall Street Revolt (pp. 79-80). W. W. Norton & Company. Kindle Edition.
 Id. at 87.