The Future of Self-Directed Investing May Not Be Self-Directed

Author(s):
William Trout

INTRODUCTION

Take from the rich and give to the poor. For a short while, the legend of Robinhood came to life in the form of a brokerage app. A bunch of amateur investors squeezed the pros who had bet big against Gamestop and AMC and their other favorite stocks.

Ultimately, the collapse of these stocks came as quickly as their rise. But who would have thought that shares (which had rocketed to nearly $350 a share by end January) in a strip-mall game purveyor or a half-shuttered theater chain could be so popular, even for a few days? And who could have imagined the extent to which the circumstances around the run-up would capture the public imagination?

The market frenzy was catnip for politicians and pundits. Representative Alexandra Ocasio-Cortez and Senator Ted Cruz were for the first (and perhaps last) time aligned, both condemning Robinhood for halting the purchase of Gamestop and other shares. Robinhood CEO Vlad Tenev was summoned to appear on Capitol Hill. Hedge funder and short-term presidential spokesperson Anthony Scaramucci likened the upheaval to the French Revolution.

The French Revolution analogy may have been hasty and overblown, in typical Scaramucci style, but “the Mooch” was onto something. Funds like Melvin Capital and Point72 did get their comeuppance, if only for a while. There may yet be a “let them eat cake” moment (featuring either Tenev or Point72 boss Steven Cohen) as more of the protagonists are hauled before Congress. Much detail remains buried in the rubble. For now, however, it is possible to extract some insights.

PARTY LIKE ITS 1999

First, some perspective. The Gamestop binge appeared to come out of nowhere. But such trading frenzies are hardly uncharted territory. Nor are the factors behind them invisible. As with all revolutions, pressure had been building up for a while.

Keep in mind that there have been three retail trading frenzies over the past quarter-century. A lot of the traders on Reddit were not even born when the term “day trader” first gained traction in the late 1990’s. In the booming, pre-crisis 2000s, the concept of the “wisdom of crowds”¹ marked the rise of the Internet as a vehicle for financial (and other forms of) self-realization. The thinking was that individuals acting independently will make better decisions than committees of experts, including in the area of investments.

The rise of social media platforms like Twitter in the 2010s gave voice to these individuals by making everyone a publisher. The amplifying (and polarizing) effect of these platforms has stood out in the realm of politics. Online brokerage firms also have tried to harness the mobilizing energy of social media, in this case to drive trading volumes. Social trading platforms like eToro that allow investors to mimic the trades and investment strategies of other users have been at the vanguard of this effort.

This decade has seen an expanded role for video in social communication. Breathy market commentary has given platforms like YouTube new life, while self-proclaimed investments pundits have talked up Gamestop and other favorite stocks on TikTok. Forums like Reddit represent the Wild West of the social media ecosystem, and the Reddit runup seems less a story of distributed wisdom than a case of crowdsourced rage. The Redditors, in this case, tapped into a vein of populist sentiment in a manner a wildcatter would envy. Unlike the Occupy Wall Street movement of a decade back, the target has not been a white-shoe firm like Goldman Sachs, but a secretive and lightly regulated corner of Wall Street, the hedge fund.

Investment Insight in Under 60 Seconds

Figure 1. Personal Finance Guru Humphrey Yang (@humbrpherytalks) has More than 1.5 Million Followers on TikTok

Source: TikTok (TikTok Link)

HEDGE HOG

The two-and-twenty salad days of the hedge fund may be a memory, but leading funds still pack institutional muscle. The money they direct would take CEOs lifetimes to earn. Hence the general apoplexy when Robinhood appeared to prioritize their interests over those of the retail punter.

The impetus behind Robinhood’s decision to halt trading in certain has been explored elsewhere and will be dealt here with dispatch. Suffice it to say that payment for order flow (PFoF) is the logical outcome of the zero-commission trading model, and the source of most of Robinhood’s revenue.

Because PFoF can imply less-than-optimal pricing on customer trades, it is not something Robinhood (or any other brokerage) will trumpet. But it is hardly a secret. The percentage breakdown of revenues taken from “market makers” like Citadel Securities on NYSE trades is set out in Robinhood’s 2019 regulatory filings:

Profitable Clearing Agreements

Figure 2. Split of PFoF received by Robinhood Securities and Robinhood Financial

Source: SEC Form 606, Robinhood 2019 4Q disclosure

Figures like the above explain the influence a market maker like Citadel Securities might have over Robinhood. Indeed, data from Bloomberg Intelligence cited in The Wall Street Journal indicates that Citadel pays out over a billion dollars a year to brokerages for order flow.² Robinhood’s decision to limit trades in Gamestop and other securities could be construed in this light to have helped out its client Citadel CEO Ken Griffin, who had just sunk $2 billion (through his Citadel Investments fund) to rescue Melvin. Griffin, however, had already bought into Melvin at a fire sale price, and would be unlikely to jeopardize his reputation (and by extension, his financial empire) to recoup a few million bucks. He was already getting a deal.

The bigger beneficiary in this case would be Point72 head Steven Cohen, who had $1 billion with Melvin (and agreed to invest an additional $750 million, bringing the bailout total to $2.75 billion), before Robinhood halted trading. Was Griffin exerting pressure on Robinhood to help his partner Cohen bail himself out? Or was it to safeguard the system that puts Citadel at the center of the trading universe?

If all this sounds confusing, know this: the details matter less to the public than the perception that Robinhood was rescuing the hedge fund managers at the expense of the little guy. The public ire transcends the particulars of the deal, that is, in that it targets the hedge fund moguls (of which Ken Griffin is one) as a class. It also takes aim at Robinhood, the self-declared avatar of industry democratization, for appearing to abet this outrage.

THE FALLOUT FOR ROBINHOOD

The Gamestop scandal represents the third bloody nose for Robinhood in nearly as many months. The suicide of a 20-year old options trader last fall was a significant but relatively short-term PR blemish. The optics of recent platform outages also seemed surmountable, particularly once incumbents went dark as well. The current kerfuffle may be different in that it undercuts Robinhood’s (literal and figurative) position as an honest broker.

The decision to restrict trading put Robinhood at odds with its stated mission of democratizing the markets, and set its business practices in the sights of regulators. A December filing from Massachusetts that accused Robinhood of trivializing investment risk through the use of gamification strategies could pave the way for more aggressive measures at the state level.⁴ That same month, Robinhood paid $65 million to settle Securities and Exchange Commission (SEC) charges that it had failed to secure best pricing for customers on trades,⁵a settlement that echoed a similar agreement with FINRA in 2019.⁶ Looking ahead, the ascension of Obama-era veteran Gary Gensler to the head of the SEC will herald an even more aggressive approach to enforcement.

For Robinhood, the most pressing matter will be keeping investors onboard. Investors may have shorter memories (and may be more forgiving) than the SEC, but Robinhood will need to grapple for their confidence. A recent capital raise⁷ will enable overdue investment in customer-service infrastructure as well as in the tools and architecture needed to compete with challenger platforms like Webull and Public.

Ultimately, efforts to resolve regulator concerns around best execution and regain public trust will be interlinked. Diversification of revenue away from PFoF (e.g., in the form of more margin lending and investment in the firm’s Robinhood Gold premium subscription offer, which provides users with Level 2 or bid-ask information on trades) will help demonstrate alignment with the interests of the retail investors. Expansion of education-focused Robinhood Learn will also help assuage critics and put Robinhood more in tune with the zeitgeist.

Robinhood Gold

Figure 3. Level 2 Market Data for $5 a Month

Source: Robinhood

Robinhood will ride out the current tempest, but securing investor loyalty over the long-term will be harder. Market conditions will shift post-COVID, and a new generation of investors will enter the scene. Today’s investors will have started families and begun to build a nest egg; in short, they will use platforms like Robinhood to construct portfolios as part of a larger financial plan. As lines between the advised and self-service businesses blur, focus will need to be less on the trader and more on meeting the credit, protection, and investments needs of the long-term investor. The future of self-directed investing, in short, may not be so self-directed after all, and firms like Robinhood will have to move quickly to stay relevant.

RECOMMENDATIONS

Help your clients to evolve. The self-directed investor should not be typecast (“young, male, and hale”) but understood in terms of a continuum. Today’s active trader may be tomorrow’s advice-seeker…or vice-versa. A “pots of money” investment framework will keep clients engaged as their needs change.

Find ways to empower the little guy. The trading frenzy around Gamestop points to rising competition between retail and institutional interests. Brokerages should support retail investor hunger for learning and self-realization by providing access to third-party data and back-testing tools like Chaikin Analytics.

Start engaging female investors. Female investors constitute a minority of investors active on self-directed platforms. Incumbents have an opportunity cross-sell them. Digital platforms like Ellevest offer a template in terms of the use of language and a prioritization of goals over investment performance.

Create an entry point via fractional shares. Fractional shares, which give smaller investors access to pricey stocks, appeal to new market entrants. They also support demand for customization by enabling the creation of a diversified portfolio for as little as a few hundred dollars.

Bring social energy in house. Incumbents can harness the social energy found on Stocktwits and Reddit by bringing elements of community onto their platforms. eToro and newcomer Public engage use trade mirroring, leaderboards and other elements of gamification to make investing a social experience. Of course, firms can make trading social and still maintain their own YouTube channel.

Embrace new types of platforms. Firms also should identify and seek out new channels. Some of the most popular new entrants evince nostalgia for older ways of communicating. Invite-only iPhone app Clubhouse calls to mind a 1970s telephone party line. Launched during the pandemic, the audio-based discussion forum has harnessed the participation of celebrities like Drake and Elon Musk to muster exclusivity and growth. Chat-based platforms like Discord and Telegram host lively discussion groups centered on investing and other topics, while offering a user experience similar to that of Slack. Incumbents have an opportunity to add their voice to these platforms, as well as others as they emerge.