The Normalization of HFT Profitability

As I discussed in my previous posts, "I Was Wrong" and "The SEC Should Ban High Frequency Trading", my stance on HFT has shifted over the past few months. Initially I, like many other fundamental investors, was worried about the dominance of HFT. A simple glance at the massive increases in volume and volatility, the explosion in the number of hedge funds employing quantitative strategies, their AUM increases, and the waterfall of profits they were generating, was an indication to me of the increasing success of their strategies. However, like many things in this world, it could not last forever. Markets are like a natural system, and HFT is part of that system. No matter how successful an element of a system is, it will always mean revert because nothing can escape the laws of physics and economics indefinitely.

As I mentioned in the last post, a lack of competitive barriers would eventually sap the abnormal profitability of HFT strategies as a whole. This seems to have occurred in the near term, as a recent WSJ article indicates that the average profit of HFT strategies has been cut in half from all time highs during the 2008-2010 credit crisis. This may be temporary, however, I believe it is a structural change in the industry that will continue, as evidenced by quants moving from equities to other asset classes. There are only so many active, liquid, and volatile asset classes (the ingredients for a successful HFT strategy). Thus, you can employ game theory to see the end result before it arrives. Too much capital chasing too few profitable trades results in less profit per trade and a normalized distribution of returns, with most players achieving a return within hailing distance of average. The quants will have their days in the sun, but they are no longer infallible.

I think there are very few real barriers to entry in most businesses, and HFT is no exception. All it takes is capital, infrastructure, and a handful of PHD's to put together these strategies. It turns out there is plenty of cheap supply for each part of that equation, and returns for HFT strategies will normalize in the future because of that fact.