“Robinhood investors’ evident lack of skill in aggregate is consistent with commission-free investors behaving as uninformed noise traders,” reads a new academic paper by Oklahoma State University’s Gregory W. Eaton and Brian S. Roseman, and Emory’s T. Clifton Green and Yanbin Wu.
The recent debate over whether the Robinhood set, “informed” by WallStreetBets and other manifestations of “social trading,” can beat the pros or otherwise “stick it to the suits,” is absurd on multiple fronts.
As WallStreetBets discovered during the GameStop saga, unintended consequences can undermine the message, casting considerable doubt on the viability of the “movement” in the process. Distressed-debt investors made hundreds of millions during the two-week soap opera, for example. And if you’re in the “creative destruction” camp, you might ask yourself whether these unintentional bailouts are a good thing. If it’s bad for the Fed to prevent the purging of misallocated capital (by backstopping the corporate credit market), why is it good for retail investors to effectively do the same thing? Further, legions of Robinhood adherents are now acutely aware of the fact that the company’s name has always been an oxymoron, as one recent guest post reminded the retail crowd. In a sense, retail investors are not Robinhood’s “customers.” Rather, they are Robinhood’s product.
But beyond any of that, the notion that Robinhood (or Reddit or Twitter) “democratized” markets is just wrong. Market democratization is yesteryear’s phenomenon.
The proliferation of low-cost ETFs and the epochal active-to-passive shift meant that “regular” people no longer needed to pay exorbitant fees to active managers who very often underperformed benchmarks. Eventually, fees on index funds tracking broad benchmarks and simple strategies (e.g., high dividend baskets) fell to essentially zero. I’ve argued that the old adage about “too much of a good thing” applies to passive investing. But setting that debate aside, there’s no question that the low-cost, index investing revolution was one of the most beneficial developments in the history of capital markets (unless you’re an active manager, of course).
The fact is, it’s hard to beat benchmarks over very long periods of time. When you factor in high fees, it becomes even harder. Sure, some people can do it, but post-financial crisis, when the Fed and its counterparts across the developed world instituted policies that served to prop up asset prices in apparent perpetuity, the task of outperforming the simplest of simple ETFs (e.g., SPY) after fees, became Herculean for active managers and hedge funds.
In August of 2019, assets in US index-based equity mutual funds and ETFs surpassed assets in active stock funds (figure below).
That was the “democratization” of markets. Reddit, Robinhood, and the like, is just gamification. Retail investors can now “play” the market like a slot machine.
As many politicians have been keen to point out over the past two weeks, hedge funds and other whales have always treated markets like a casino, and they always will. And no matter how many congressional hearings you hold, they will never sit at the same table with, or play by the same rules as, retail investors. They will always enjoy better access and better odds.
That latter assessment is fatalistic (and somewhat depressing for this new breed of young investor), but as noted above, there is a way around it. If you’re a young investor and you really want to beat “the system,” one idea is to save up, say, $10,000 and start a Vanguard account. As much as this will irk some of my readers, most professional investors and traders didn’t beat the broader market in 2019 and 2020. How could they? Just look at the returns:
The S&P returned 31.5% in 2019 and 16.3% in 2020. And 22% in 2017. And 12% in 2016. And 13.7% in 2014. And 32.4% in 2013. And I could go on. For all the press, 2018’s decline was just 4.3%. 2015, another “bad” year by post-GFC standards, saw the S&P return 1.4% despite the earthquake caused by the yuan devaluation.
Show me a “trader” or a fund manager that claims they can consistently beat those types of numbers and I’ll show you someone who is probably lying to you. When you net out the fees you’d have to pay to retain that hypothetical person’s “services,” they are almost guaranteed to underperform over long periods.
That is, of course, a generalized assessment. At any point in time there will obviously be some “star” fund manager who grabs headlines, and there are a handful of folks who, over time, have proven adept at delivering something like consistent outperformance. But that’s the exception, not the rule. And, again, anybody who tells you different is lying to you.
Bottom line: The democratization of markets happened years ago. You can track any number of benchmarks and/or simple, safe strategies using exchange-traded products that cost basically nothing. That’s the democratization of markets. And you can reliably leverage it to outperform the “pros” over long periods, with the obligatory caveat that past performance is no guarantee of future results.
By contrast, what you’ve seen recently is just the expansion of the casino for those inclined to treat markets as an avenue for gambling. Now, the casino is open to everyone at no cost to trade, unless of course you count the value of your order flow which, if you’re a retail investor, you probably didn’t even know had any value, which is why you didn’t ask any questions when brokers started telling you that you could trade for free.
This brings me back to the academic paper cited here at the outset. The authors note that Robinhood’s “mean investor is 31 years old with average account balances between $1,000 and $5,000.” That compares to 50 years old and $47,000 in another, “heavily studied US retail brokerage sample from the 1990s.”
There is little question that a 31-year-old with $5,000 would be better off in an index fund than day-trading on Robinhood, assuming he/she intended to hold for a long period of time. But that begs the question. Because if you wanted an index fund, you probably wouldn’t be on Robinhood in the first place.
The authors also note that their “analysis of website traffic reveals that the most popular Robinhood FAQ topic is ‘What is the stock market?'” That’s reminiscent of after-the-fact searches for “What is the EU?” following the Brexit vote. Notably, the questions investors on more traditional platforms “ask” are at least a bit more nuanced. The authors note that on Charles Schwab, E*Trade, Fidelity, and TD Ameritrade, sections on “What are Stock Splits” and “What are Puts and Calls” are more likely to be viewed. The implication is that if you’re trading with, say, Fidelity, you already know what stocks are. Irrespective of whether you’re young and/or don’t have much money.
It won’t surprise you — or maybe it will, given ostensibly conflicting studies and media coverage — to learn that Robinhood ownership might not be related to future performance. Additionally, it appears that Robinhood and WallStreetBets may actually be behind the retail curve. Here’s a passage from the paper:
Recent research suggests that retail trades in aggregate positively predict future returns and earnings surprises (Kaniel et al., 2008; 2012; Kelley and Tetlock 2013; Boehmer et al., 2020; Farrell, et al., 2020). In contrast, we document that firm-level changes in Robinhood ownership are at best unrelated to future returns, consistent with uninformed trading and more similar to early studies of retail investors (e.g. Barber and Odean, 2000). Our research also adds to the literature that examines the effects of financial social media on financial markets. Several studies find evidence that certain types of social media can provide investment value (Chen, et al., 2014; Jame, et al., 2016; Farrell, et al., 2020), whereas other work suggests that social media may intensify behavioral biases and spread stale news (Heimer, 2016; Cookson, Engelberg, and Mullins, 2020). We find that the Reddit WallStreetBets forum, which is often comprised of brief posts, nevertheless strongly predicts future zero-commission retail trading, while coinciding with or lagging aggregate retail trading, which may help explain why Robinhood investors underperform relative to other retail traders. In particular, aggregate retail volume leads WallStreetBets mentions by a couple of days and therefore also leads Robinhood activity by nearly a week. The delayed pattern suggests that Robinhood investors trade after other retail traders in aggregate, which may help explain why return predictability of trades from the two groups differs.
It sounds as though WallStreetBets does, in fact, prompt trading on Robinhood, but that activity is delayed versus broader retail activity. You could draw speculative, nefarious conclusions from that, but the authors don’t, so I won’t either. Suffice to say that being too late to the trade isn’t a good thing. Being too late to a pyramid scheme is a sure way to lose money.
The section which describes the results of statistical tests run by the authors is not flattering for Robinhood. Or at least not for Robinhood’ers, if you will. Consider this:
The central result.. is that changes in Robinhood ownership do not positively predict future stock return at alternative horizons up to 20 days. The estimated coefficients on Robinhood ownership with no control variables are generally negative and none are significantly positive. Controlling for other return variables and firm characteristics does not change the inference. Thus, there is no evidence that Robinhood investors on average are informed about future returns. This result is in a dramatic contrast to the predictability of order flow from a broader set of retail investors. Across all specifications, aggregate retail order imbalances positively and significantly predict future stock returns, consistent with prior findings. In summary, although retail trades in general positively predict future returns, Robinhood investors on average appear to behave as noise traders.
It may, in fact, be fruitful to study and parse retail investor order flow when it comes to predicting future returns. But when you isolate Robinhood, the benefits of that analysis are less clear, to put it generously.
Importantly, the authors’ approach isolates effects on market quality using platform outages. To do that, they bring in WallStreetBets. Here’s how:
Analyzing the market effects of Robinhood platform outages requires a forecast of which stocks Robinhood investors would have traded in the absence of the outage. Our main proxy relies on message board activity from the Reddit WallStreetBets forum (r/wallstreetbets), which has “become synonymous with retail zeal in the pandemic age” (Kochkodin, 2021). We also consider measures of lagged Robinhood trading activity to proxy for expected trading during outages. We confirm that mentions on WallStreetBets as well as lagged ownership changes strongly predict future changes in Robinhood ownership in general, and we explore the effects of platform outages on stocks with expected Robinhood trading.
This is where the analysis gets especially interesting and, in my view, especially damning (the authors don’t put it that way — I’m expressing my own, subjective interpretation). Consider a few additional passages from the paper:
An influx of noise traders could potentially enhance or harm stock market liquidity. In canonical adverse selection microstructure models such as Glosten and Milgrom (1985) and Kyle (1985), an increase in noise trading reduces the likelihood that market makers face informed traders, which should lead to improved market liquidity. On the other hand, inventory risk models such as Ho and Stoll (1981) and Grossman and Miller (1988) emphasize that market makers are concerned about fluctuations in their inventory’s value, which may be magnified by noise trading shocks. In this setting, an increase in noise trading may result in reduced liquidity.
Taken together, the findings support the view that zero-commission traders have negative effects on stock market quality, consistent with behavioral noise trader and inventory risk models.
Our analysis indicates that during platform outages when zero-commission trading is restricted, stocks favored by Robinhood users experience reduced bid-ask spreads and price impacts as well as lower return volatility, suggesting that Robinhood investors may negatively impact market quality. These results do not appear to be due to market conditions on days with abnormal activity. In particular, pseudo-events that are assumed to occur one hour after the actual outage, are not associated with changes in market quality. Further, after removing stocks with intense event-day WallStreetBets activity, outages early in the trading day, and outages during the COVID-19 turbulence of March of 2020, we continue to find that market quality improves for Robinhood stocks when outages restrict zero-commission traders.
Zero-commission trading depends on payment for order flow arrangements between brokers and high frequency traders, where HFTs pay brokers a fee for the opportunity to act as market maker for their orders. During platform outages, we find significant evidence that HFTs pull back from stocks favored by Robinhood investors. To capture the effects of zero commission traders on financial markets that are distinct from the mediating role of HFTs, our final tests partition Robinhood-favored stocks into those with high and low HFT activity. During platform outages when Robinhood investors are restricted from trading, we find the strongest improvement in market quality for stocks that are popular among Robinhood investors but are not actively traded by HFTs. In contrast, stocks that are both popular among Robinhood investors and actively traded by HFTs see their market quality degrade. The evidence suggests that the lower market quality associated with zero-commission investors is best explained by uninformed trading rather than predatory HFTs.
All of this paints an unfavorable picture for Robinhood traders. According to the results of this study, they are less informed than other retail investors, trade a week behind other platforms (due possibly to the intermediary role of WallStreetBets), don’t have a good overall track record, and may adversely affect liquidity and market conditions more generally.
If you’re looking for quick takeaways from all of the above (and I realize it’s quite a bit to process), I’d suggest three things.
First, Robinhood and social trading didn’t democratize markets. Passive investing did. And while the passive investing revolution risks bumping up against the old “too much of a good thing” adage, it was (and is) an unequivocally positive development. The gamification of trading and the blurring of the line between gambling and investing among unsophisticated investors is an unequivocally negative development.
Second, beating hedge funds and professional traders needn’t be a “movement” or couched in confrontational, revolutionary terms. If what you want is to claim “victory” over the pros, one good way to do it is to buy an index fund from Vanguard (or a similarly revered firm), wait a decade, and then compare your performance to a cross-section of hedge fund returns after fees. Chances are, you’ll have done better than many of them. Relatedly, I can almost guarantee that your favorite “pro” didn’t outperform the cumulative return of the S&P over 2019 and 2020, especially not for a hypothetical long-term investor who bought during the ~19% pullback in Q4 of 2018.
Third, Robinhood (and, indirectly, WallStreetBets) may be deleterious to the health of markets and, more importantly, to the psychological well-being of the people who frequent those platforms.
Draw your own conclusions. As long as they’re consistent with mine. (I’m just kidding. Sort of.)