Retail Trading Bonanza Is Good for Market Makers, Less So for Quants and Hedge Funds

The confluence of commission-free trading and markets’ precipitous March drop has touched off a circus of retail trading activity — a trend that’s eliciting sniggers from traders wary of a “dumb-money” bubble.

The confluence of commission-free trading and markets’ precipitous March drop has touched off a circus of retail trading activity — a trend that’s eliciting sniggers from traders wary of a “dumb-money” bubble.

But while new data suggests retail traders’ sway over markets as a whole is limited, their power to invigorate discount brokerages, buoy market makers, confound quants, and upstage hedge funds could nonetheless play a meaningful role in reshaping the sector over time.

‘Gamified Investing’

Since retail brokerages and asset managers dropped trading commissions to zero last fall, they’ve set about recruiting elusive young investors into the fold.

Robinhood, E*Trade, and SoFi Invest offer “slick user interfaces, low fees and near-instant account opening” that lower trading friction to the level of “‘gamified investing,’” according to one millennial investor who found himself making progressively riskier bets in recent weeks.

With help from the once-in-a-lifetime buying opportunity created by markets’ March implosion, such approaches have already borne fruit. In the downturn’s early days, new-account openings surged at TD Ameritrade (+150% YoY), Wealthfront (+68%), and Betterment (+25%).

Retail trading volumes have also spiked as remote-working “newbie” investors find themselves with more time on their hands. Average daily trades at TD Ameritrade leaped from 900k in October, when the platform abolished trading commissions, to 2.9M in March. Retail participation overall “‘is at levels we haven’t seen in 20 years,’” according to one industry expert.

“‘It’s like gambling,’” one writer of romance novels said of her new day-trading habit — an apropos comparison given that the suspension of casino and sports activity in recent months has likely driven bettors into investing.

‘Flight to Crap’

Dave Portnoy, founder of the weekly gambling newspaper Barstool Sports, has drawn considerable attention for his recent experimentation with day trading. He’s entertained his 1.5M Twitter followers with brash statements, calling Warren Buffet “‘washed up’” and adopting the mantra, “Stocks only go up!”

Retail activity has grown so feverish that industry pundits have cited it as a driving force behind US stock markets’ unprecedented rally from bear to bull market.

Despite the massive economic stimulus and quantitative easing measures underpinning that rally, financiers have largely derided the rally’s extreme nature — and the army of retail traders championing it — as “‘a speculative fervour.’” “Free Trading Couldn't Have Come at a Worse Time,” a Wall Street Journal headline lamented.

“‘You have heard of a flight to quality,’” Interactive Brokers chief investment strategist Steve Sosnick said. “‘How about a flight to crap?’” Billionaire investor Leon Cooperman cautioned that retail investors “‘are just doing stupid things, and in my opinion, this will end in tears.’”

Retail investors have been implicated in a number of market mishaps in recent weeks including sending Hertz’s stock price soaring 1,500% after it declared bankruptcy and pushing ADRs in Fangdd, an obscure Chinese real estate firm whose name resembles the FAANG tech stocks, up thirteenfold.

Moreover, retail investors’ public promotion of stock picks in Twitter feeds and on Reddit threads like WallStreetBets is driving much of that concerted action, prompting comparisons to the days of the dot-com bubble. Bloomberg Businessweek even suggested retail brokerages’ inability to process negative prices may have pushed oil prices negative by shutting out day traders.

Still, recent analyses have refuted the notion that retail investor activity is propping up stock markets as a whole. A Barclays report found that when more Robinhood investors move into a stock, it garners lower returns, not higher. Another study by SocGen found that “Robinhood investors’ total holdings are relatively tiny,” limiting their ability to buoy markets.

Wall Street Impacts

But while retail investors’ collective sway over markets may be overstated, they could nonetheless help shape the fortunes of Wall Street firms across the trading spectrum if their greater participation continues.

First and foremost, they could give a much-needed boost to retail brokerages now intent on hacking each other to pieces in a cutthroat zero-commission environment.

For market makers, meanwhile, payment-for-order-flow (PFOF) arrangements with retail brokerages figure to boost revenue. Market makers paid Robinhood nearly $100M for order flow in Q1, with payments more than doubling from January ($19.4M) to March ($45.4M).

On the flip side of the coin, heightened retail investor activity, should it continue, could throw a wrench in the engine for some industry participants. If trend-following algos spot and chase retail investors’ herd movements into specific stocks, they could be in for a rude awakening when stocks like Hertz come back to earth.

Worse still, if rogue bands of retail investors were to begin knowingly baiting algos into next-generation pump-and-dump schemes, the integrity of stock markets as a whole could be at risk.

Finally, retail investors’ recent participation has met with success — even if only incidentally — that could further undermine hedge funds’ raison d'être at a sensitive juncture. Goldman found that a basket of stocks favored by retail investors has exploded 61% since markets’ nadir, handily besting hedge fund and mutual fund favorites (+45%).

Those numbers undermine hedge funds’ argument that their superior ability to pick value stocks makes them investors’ best option in volatile markets.

Ironically, then, it isn’t retail investors’ ability to move markets that makes them worth keeping an eye on for Wall Street. Rather, it’s everything else.

This article was originally published in Curatia.

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