Don't worry, the market is rigged

John Addis explains why the market is rigged, and why you don't need to worry.

Too frequently the interests of insiders like institutional shareholders, banks and boards prevail over those of ordinary retail investors.

Elizabeth Warren, chair of the US Congressional Oversight Panel in the aftermath of the Global Financial Crisis, said that even her panel 'couldn't change a system that seemed hell-bent on protecting the big guys and leaving everyone else by the side of the road.'

That's true, with one caveat. Despite the rigged system, you'll still do better in stocks than anything else because cash and bonds simply won't deliver the returns you need over the long term.

Plus, there's a a few things that give you the edge over the big guys. Before explaining what they are, let's get the issue of the 'big guys system' out of the way first.

Michael Lewis's Flash Boys exposed the issue of high frequency trading (HFT) earlier this year. Over 40% of all ASX orders are believed to be HFT-driven, with almost half existing for one second or less.

HFT is a kind of info-arbitrage. If computer traders can get advance warning of other trades, or just get an order in faster, they can profit by skimming a tiny slice from every trade. Charlie Aitken of Bell Potter calls it 'legalised scalping' and many, including Intelligent Investor Share Advisor analysts, view it as front-running.

HFT should be banned but its continued existence shouldn't discourage you from investing. High frequency traders may be skimming 0.0001% from each of your trades. With hundreds of thousands of trades an hour that's a good business. But if you're trading only a few times a month, why worry? The amounts are all but meaningless.

A bigger concern is how institutional investors are preferenced over retail investors in capital raisings and floats.

Take the example of the $350m capital raising by Virgin Australia last year. The offer was not renounceable, which meant shareholders couldn't sell their right to participate to someone else. And retail investors that did participate could only do so up to 40% of their existing holding.

So the offer was structured to deliver a retail shortfall, which Virgin's major shareholders – Singapore Airlines, Etihad and Air New Zealand – took up.

Major shareholders increased their stakes at the expense of retail shareholders, who were diluted from 19.7% of the company to 15.8%, without compensation. Retail Food Group and Spark Infrastructure are but two more recent examples.

A similar favouring of institutions over retail investors occurs in some floats. OzForex, which jumped 28% on the first day of listing, is perhaps a case in point, although there's no way of knowing for sure.

When the price of an IPO jumps like this it can be because the stock has been deliberately underpriced, allowing the broker's favoured institutional clients to make out at existing shareholders' expense. The ASX Bookbuild service addresses these problems but companies aren't rushing to use it.

Then there's the popular pastime of insider trading. A recent US study found that some form of insider trading probably accompanied almost a quarter of all merger and acquisition transactions.

It's a crime that's difficult to prosecute and when ASIC does make a case, judges appear lenient on the perpetrators, as John Gay, former CEO of Gunns, found to his good fortune. And insider trading is far more common than the tiny number of cases actually prosecuted suggests.

Another bias exists in the private briefings given by listed companies to institutional investors. The law dictates that all investors should get access to market-sensitive information simultaneously. Why bother with these briefings if not to learn something useful about a stock denied to other investors?

All these activities, as Elizabeth Warren points out, favour the big guys at the expense of the small investor. The question is whether they're enough to make you close your broking account and give up altogether.

The answer is a resounding 'no'.

We're paying a very small price for activities with minimal impact on our long term overall returns. That's especially true of HFT but even the dodgy capital raisings aren't significant.

Traders are more exposed but if you're employing value investing principles and trading only occasionally, it's a small-price annoyance.

In fact, evidence suggests that the increase in activity from HFT and index trading increases volatility. And that increases the number of opportunities we have to buy low and sell high. Isn't that something we should welcome?

Finally, let's not forget the tax laws heavily weighted in the long term investors' favour. Dividend imputation and the halving of capital gains tax liability once the holding period of a stock passes 12 months easily offset the tiny costs imposed on us by insider traders, institutionally biased capital raisings and HFT.

These activities should make us angry but don't let them make you give up investing altogether.

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