Via Barrons

The world has a way of making what was once controversial safe for consumption. For evidence, look no further than Lou Reed’s upcoming induction into the Rock and Roll Hall of Fame. The same holds true for Virtu Financial, which successfully completed its initial public offering last week.

That Virtu (ticker: VIRT) is now a publicly traded company is a marvel, considering the failure of its first attempt about a year ago. That coincided with the release of Michael Lewis’ book Flash Boys, which argued that high-frequency traders rigged the market in their favor. With so much venom being spewed in its direction, Virtu pulled its IPO.

Fast forward a year, and investors appear to have put those misgivings aside. Virtu went public this past Thursday, a day that also featured IPOs from online craft marketplaceEtsy (ETSY) and retailer Party City Holdco (PRTY). Shares of Virtu jumped 17% from the $19 offering price on its first day of trading. Though that fell short of Etsy’s whopping 88% gain and Party City’s 22% rise, it was none too shabby for a firm that few people understand.

VIRTU DESCRIBES ITSELF as a market maker, whose job it is to buy and sell individual stocks so that there are always shares available when an investor wants to place a trade. In the old days, that job would have been handled by a specialist, an actual human whose job it was to match buy and sell orders between customers. But the advent of electronic trading ultimately made the specialist obsolete. Now, it’s all handled by computers, which use algorithms that buy and sell automatically, according to preset rules. What hasn’t changed, however, is how market makers make money: by scooping up the difference between “the bid” and “the ask.”

The question is whether Virtu and other high-frequency traders have an unfair edge when doing their jobs. Virtu, in particular, raised eyebrows when it said in its prospectus last year that it suffered just one losing day in more than 1,000 trading days. At first glance, that seems preposterous. How could anyone go that many days without losing money?

But in a paper released last November, University of California, Santa Cruz, professor Gregory Laughlin looked into that claim—and found it not so ridiculous after all. The reason: the sheer quantity of trades Virtu makes each day. Using the information contained in Virtu’s original prospectus, Laughlin made some assumptions: that Virtu makes about 800,000 trades a day in U.S. stocks; that each trade was for about 200 shares; and that each trade made or lost one cent, or broke even. He also took Virtu at its word when it said 51% of its trades were profitable. Doing the math, he found that Virtu would make about $0.0027 on average for every share traded. In its most recent prospectus, Virtu now estimates that it’s profitable on 49% of its trades, and I asked Laughlin what that would do to his math. The answer: not much. Virtu would average $0.0023 per trade.

YOU WON’T BECOME THE NEXT GEORGE SOROS trading in this fashion, but then that’s not Virtu’s goal. In an interview on CNBC, CEO Douglas Cifu said the firm might trade two million shares of General Electric on any given day and make just $600 in the process. But Virtu makes markets in more than 11,000 financial instruments, so those small gains start to add up. Last year Virtu had net adjusted trading income of $435 million, and net income of $190 million.

Just because Virtu’s business is legit doesn’t mean its shares are worth buying. Laughlin notes that Virtu’s trading gains are almost directly correlated with market volume. That makes sense—the more trades taking place overall means more trades for Virtu. As long as Virtu keeps making that tiny profit on each share, it’ll do just fine. But if trading volumes decline, then it’s safe to assume that Virtu would make fewer trades as well, causing overall profits to drop. Virtu acknowledges as much in its prospectus: “In the past, our revenues and operating results have varied significantly from period to period due primarily to movements and trends in the underlying markets and to fluctuations in trading volumes and volatility levels,” it warned.

ALSO OF CONCERN: regulatory changes. While high-frequency trading is under less scrutiny today, it’s still being watched closely by regulators. Virtu’s prospectus notes several possible changes that could impact its business, including rules that would increase trading costs–and ultimately reduce Virtu’s profitability.

But perhaps the best reason to avoid Virtu is simply the fact that it’s an IPO, and IPOs just aren’t great bets, especially after you’ve missed the first-day pop. University of Florida finance professor Jay Ritter notes that the average IPO underperforms the market by 3.2 percentage points annually during its first five years once the first day is subtracted. And no one needs odds like that.