Lower Liquidity And Higher Trading Costs
But there is a more troubling implication of this shift to longer investment horizons. The interplay in the equity market between short-term traders and long-term investors is valuable in terms of providing liquidity and keeping trading costs low. When there are many short-horizon investors in the marketplace providing ongoing liquidity, longer-term investors benefit by being able to easily transact when they choose to adjust their positions. In the new regime, this high level of liquidity, helped by the presence of high-frequency trading firms and short-term investors, is threatened and may result in higher trading costs for longer-term position holders when normal volatility levels return. There could also be a feedback loop that further reduces trading activity because of the higher costs, but this is most likely to occur when overall market volatility is higher than it is today.
Macro Events Could Trigger Steeper Declines
Another concern is that the market’s reaction to a major, macro event could be larger in magnitude and duration. With fewer tactical traders standing by to jump in to seize trading opportunities, negative news that impacts a broad group of stocks could lead to a large price impact as long-term investors attempt to reduce equity exposure in the face of greater uncertainly. A lower supply of trading capital from market participants trying to capitalize on short-term moves would mean less flows from tactical traders to step in to buy equities on a sharp down move to attempt to profit from investors’ overreaction.
Eventually, these tactical traders will return if opportunities persist, but the move up in measures like the VIX on a quick market sell-off and the decline in the riskiest, less liquid assets could be greater in the interim. While one would expect long-term investors to be paying less attention to market noise, it has always been surprising how quickly they shift into short-term gear when markets become turbulent, especially to the downside. A portion of the long-term investors may, in fact, become more risk averse and contribute to the sell-off by reducing equity exposure.
Bottom line, this regime shift to longer-term investing is positive from the perspective of stock issuers and for many market participants. However, it comes with some costs and risks—potentially higher trading costs and large price declines when major, unexpected macroeconomic news comes our way.
Joanne Hill, PhD., is chief advisor of research and strategy at Cboe Vest. Cboe Vest is dedicated to serving investment advisors and brokerage firms in bringing wider access to innovative Target Outcome Investment strategies, including managed account offerings and a series of mutual funds designed to provide greater certainty over risk protection, enhanced returns and consistent income.