This guest post is contributed by Ricardo Fernholz, a professor of economics at Claremont McKenna College. Some of his other work was profiled on this blog here.
The rise of high-frequency trading (HFT) in the U.S. and around the world has been rapid and well-documented in the media. According to a report by the Bank of England, by 2010 HFT accounted for 70% of all trading volume in US equities and 30-40% of all trading volume in European equities. This rapid rise in volume has been accompanied by extraordinary performance among some prominent hedge funds that use these trading techniques. A 2010 report from Barron’s, for example, estimates that Renaissance Technology’s Medallion hedge fund – a quantitative HFT fund – achieved a 62.8% annual compound return in the three years prior to the report.
Despite the growing presence of HFT, little is known about how such trading strategies work and why some appear to consistently achieve high returns. The purpose of this post is to shed some light on these questions and discuss some of the possible implications of the rapid spread of HFT. Although much attention has been given to the potentially destabilizing effects of HFT, the focus here instead is on the basic theory behind such strategies and their implications for the efficiency of markets. How are some HFT funds such as Medallion apparently able to consistently achieve high returns? It is natural to suspect that such excellent performance is perhaps an anomaly or simply the result of taking significant risks that are somehow hidden or obscured. Indeed, this is surely the case sometimes. However, it turns out that there are good reasons to believe that many HFT strategies are in fact able to consistently earn these high returns without being exposed to major risks.