Personal Finance: How computer trading affects buy-and-hold investors

Just as investors were starting to feel a little braver about stock mutual funds, a 1,000-point market plunge and concerns about wild computers tinkering with stock prices gave them pause once again. The question is: Are individuals being fed to the wolves?

And the answer is: Yes, and it can happen day in and day out, but the effect is more subtle than this month's giant drop.

Here is how computers that frantically buy and sell can affect the buy-and-hold investor:

When you invest in an actively managed mutual fund, a fund manager decides what stocks to buy and sell. To maximize your returns, the fund has traders who must be on their toes to buy stocks identified by the managers at the most attractive price.

But that's a moving target when the stock's price is constantly rising and falling - by pennies or dollars. Money can be lost by buying or selling. For example, if many sellers pile in while a mutual fund is selling stock, the fund might end up getting $48 a share rather than $50.

This process of buying and selling at the most advantageous price has always been tricky. But it has been made more so now that investors such as hedge funds use computers to constantly sniff the market for stocks moving up and down by pennies. If the computers detect that a mutual fund is trying to buy thousands of shares of a stock, a hedge fund might buy that stock first. When that happens, your fund will have to pay more for the stock than it would have. So you will make less money than if your fund's movement had been more inconspicuous.

While your fund was buying the stock for a long-term gain, the hedge fund that jumped ahead of the purchase simply was seeking a quick profit by scooping up the stock and selling it to your fund at a higher price.

Because buyers and sellers are always trying to snoop on one another so they can beat the other to the punch, mutual funds are not without their defenses. But while they also try to hide what they are doing with technology, the computers used by high-frequency traders are much more sophisticated. They can sniff out trading in an instant, causing a stock to rise or drop.

In fact, said Illinois Institute of Technology lecturer Ben Van Vliet, some are set to pick up on certain words in news stories and buy and sell based on whether that word would send a stock price up or down.

Does this matter? People who think they can get in or out of a stock or exchange-traded fund before the computers react to a shock are deluding themselves. And for mutual fund investors, the effect on the price you pay to get in and out of stocks can hugely alter the total gains your fund delivers to you.

"Looking at expenses is important," said Jay Keeshan of Mutual Fund Governance Consulting, of Stamford, Conn. "Three to 5 percent could be lost at the trading desk." In response, Keeshan said, mutual fund directors should pay more attention to "best execution," or buying and selling stocks while minimizing costs.

The Investment Company Institute, a mutual fund industry trade group, asked the Securities and Exchange Commission to consider more regulation of high-frequency trading before the plunge.

While the organization told the SEC that the trading practices can add liquidity to the market, or provide opportunities to find a ready buyer or seller quickly, it faults high-frequency traders for practices such as confusing investors with fake orders, or "pinging."