Dark Pools: Not as Creepy as They Sound

Here at Vista, we’re big on transparency. It’s why we’ve named our blog “The Simple Truth.” That said, some of the fund managers we favor—such as Vanguard and Dimensional Fund Advisors—sometimes execute trades in “dark pool” exchanges. This month, we want to shine a light on the role dark pools play in our portfolios.

Trust us, they are not as creepy (or nefarious) as they sound.

What Are Dark Pool Exchanges?

On a public exchange like the New York Stock Exchange (NYSE), real-time stock prices are available for anyone to see. Prices reflect the last trade in which a buyer’s “bid” and a seller’s “ask” are matched by a trading specialist. When a quantity of stock one investor offers to sell at a certain price aligns with the amount and price another investor is willing to buy that stock for, a trade occurs. This information—prices and quantities for bids and asks, not just executed trades—is publicly available and informs professional trading decisions.

In contrast, a dark pool is a private exchange that allows investors to submit bids and offers anonymously. Only when a trade is executed does the price, quantity, and other potentially revealing information become public.

Dark pools were initially created by large banks as a safe haven from predatory traders and front-runners—illicit traders acting on material information before it is made public. Around for decades, dark pools now account for roughly 40% of all U.S. stock trading. On a number of trading days during this year’s GameStop frenzy, off-exchange trading hit more than 50% of the daily volume.

Why would the average investor favor—or at least not object to—giving up the transparency and familiarity of public exchanges in favor of a dark pool? It has to do with “block trades”—really, really big trades—fund managers like Vanguard and Dimensional periodically place. If we look at what happens during a block trade, we can understand why a little privacy may not be such a bad thing.

The Life Cycle of a Block Trade

Let’s be honest. When you or I place a trade for our personal accounts, the investing world doesn’t really care. For example, say I buy or sell 10 shares of Apple, my trade becomes part of a rushing river of transactions that collectively leads to relatively efficient market pricing. But all by itself, it doesn’t put even a tiny dent in Apple’s share price.

But if a mutual fund manager needs to trade 100,000 or 1,000,000 shares of Apple—keep in mind, the Vanguard Total Stock Market Index Fund (VTI) holds about 430 million shares of Apple stock!—the very act of trading such quantities can materially impact the stock’s price. This is particularly true of small cap or other less liquid securities.

If it’s obvious to another trader that someone wants to buy a big block of shares, guess what? The bid price goes up, and the buyer must pay more as they proceed. If they’re publicly trying to unload a lot of shares, the asking price declines as those shares are sold. In other words, an investor’s own activity makes buying and selling large blocks of stock more costly.

What’s in It for You?

Since we, as investors in these large mutual funds, ultimately pay the underlying costs incurred by the funds in which we’re invested, we want our fund managers to fight for every penny. Dark pools can shield these managers’ trading intentions from the bright lights of the marketplace. In these instances, using reputable dark pool exchanges can lead to better pricing, execution, and returns to fund shareholders like you and me.

When it comes to trading, there is no single best way to execute every time. Rather, traders must juggle multiple factors in search of the best outcome for each trade. Whether that means using a dark pool, public exchange, or a combination of the two, fund managers will seek the best execution after carefully weighing the pros and cons of each trading venue.

While dark pools have earned some well-deserved scrutiny, they play an important behind-the-scenes role in the funds we often favor in portfolios. The name may sound nefarious, but the simple truth is dark pools can help “lighten” the costs of trading.