The Acceleration of Retail Participation

February 11, 2021

Diego Tremiterra

MARKETS UPDATE.

KEY TAKEAWAYS

  • Asset price performance has been quite solid across the board and the Yield Curve has continued its steepening, with rates in the long end getting closer to 2%.
  • January’s activity in the equity markets broke many records, helped by the increased participation of retail investors. But if history is of any help, retail investors tend to underperform, and we believe it’s unlikely that they’ll continue to be as active as they’re now in the medium to long term.
  • Robinhood halting trading was less about ideology and more about collateral needs, and Ark Invest AUM inflows might imply liquidity risks that investors are currently underestimating.

 

KEY PRICE PERFORMANCE TO DATE

 

INFLATION AND RATES

Since the beginning of the year, we’ve seen a continuation of the steepening of the US Yield Curve, with short-term rates (controlled by Central Banks) coming down further while longer-term rates, which moves with inflation expectations and economic growth, have been increasing towards the 2% level. While this is not surprising, we’re keeping an eye out to see if the long end of the curve tests the resolve of the Fed in implementing Yield Curve Control.

 

EQUITIES IN CONTEXT

Global equity markets increased their market cap by more than $5 trillion in 2021 alone to $108 trillion. Markets in the US are at all-time highs and current sentiment implies that investors are interested in buying every dip.

However, the current equity rally could suffer a loss of momentum in the short-term as the rebalancing that occurs in January, which tends to be the largest source of equity demand (37% of annual rebalancing efforts in 401k portfolios take place in the first month of the year), fades off in February, with inflows slowing down, on average, by 40%. This could present a liquidity issue compounded by record high margin debt registered in the last months of 2020 (up 62% since March of 2020), an indicator that has had historical success in timing recessions and corrections.

 

That being said, the outlook over the next couple of months is unlikely to revert anytime soon. Last month was the largest January in history for equity-related offerings in capital markets (+150% yoy) which, again, highlights the strong demand despite the record level amount of new equity supply. Similarly, in the last quarter, global equity markets have registered the largest quarterly inflow in history (+$255 billion), and the current run rate of the first three weeks of January implies this level of enthusiasm will continue.

While many have been made a fool trying to call an end to this madness, we’ll caveat that there’s still plenty of liquidity that can flow into equity markets (since 2008, 95% of inflows have gone to bonds with only 5% to equities) as passive flows will likely continue to be a major buyer at indiscriminate prices simply through 401k contributions.

Lastly, whilst every Central Banker understands that allowing loose financial conditions further increases the disconnect of valuations to fundamentals, none of them are incentivized to halt any of the current shenanigans, especially amidst a global pandemic. The party might pause for a while, but it’s likely just for a beer run and not your neighbors calling the police.

 

RETAIL STATS

Unless you’re like our Brand Ambassador Ryan who’s been living in the middle of the Arizona desert out of his Airstream, then it’s likely you agree that THE theme in markets so far this year has once again been the acceleration of retail participation in the US equity market. Currently, retail single-stock trades make up 20%-25% of the overall market volume, up from 15%-20% a year ago and 10% in 2019. Some interesting stats (courtesy of several analysts at Goldman Sachs):

  1. US Households own 35% of the US Equity market (they owned 90% in 1950) whilst Hedge Funds own 3%, but most of this is long-term holdings that households don’t actively trade. There is also little data on the portion of that ownership that is actively traded.
  2. Notably, Daily Average Revenue Trades (a measure that gives a proxy for retail activity) hit a record 15 million per day in 2021, and for most online brokerages the amount of trading has tripled since 2019. Whilst the increase in trades has been concentrated in a smaller portion of their customer base (less than 10% of their customers represent more than half of the trades), the dollar value of small trades by retail trading is up 85% over the past year.
  3. This means that, whilst the data isn’t super clear, it is fair to assume that retail investors are participating in the market to a wider extent than they usually do.

That being said, just by taking a look at the latest earnings reports of investment banks, one can easily understand that trading has increased across the board, not only for retail. There’s also been an increased interest in the options market given the access to leverage (hence the margin debt increases above).

  • In the US, trading volume has been hitting new records. US markets recorded the largest cash volume ever, 15% higher than the previous peak set in October 2008. The same happened for derivatives volumes, especially for calls, where 7 out of the 10 largest call options days ever registered happened in the past month.
  • The enhanced activity in the options market forces market makers to also buy the underlying asset implied in the options contracts (hedging their short gamma positioning), which has a self-perpetuating effect of driving the price of the underlying asset higher as more people buy call options on that asset. This has further accentuated the enthusiasm around the performance of the market, which increases participation from retail.

A hypothetical for you to consider; assume that retail investment is here to stay (even if we don’t think that’s the case). What are the primary implications of this paradigm shift? Tweet at us your thoughts.

 

RETAIL IMPLICATIONS

A 2009 study by UC Berkeley on the likely impact of increased retail participation in the market found that:

  • Heavily bought small-cap stocks by retail investors in one year underperform stocks that have been heavily sold by 4.4% in the following year (this increases to 13.5% for the stocks with the highest concentration of retail participation).
  • Small-cap stocks in which retail investors are net buyers in a given year tend to outperform, but the opposite happens if the stock is medium or large-sized.
  • Whilst medium and large-sized stocks tend to rise in the short term because of increased retail activity, they tend to underperform on an annual basis as “individual investors are providing liquidity to institutions who are selling overvalued stocks and buying undervalued stocks”.

Other studies summarized in ‘The Behavior of Individual Investors’ research piece conclude that:

  • “The average individual investor underperforms a market index by 1.5% per year. Active traders underperform by 6.5% annually.
  • Lower income, poorer, younger and less educated investors [#Millennials] allocate a greater proportion of their wealth to individual stocks, hold more highly concentrated portfolios, trade more often, and have worse performance.
  • High-IQ investors are more likely to hold mutual funds and larger numbers of stocks.”

The retail theme certainly matters, especially if your investment horizon is short, if you focus on small caps, if the direct-to-consumer fiscal stimulus policy continues, if no commission platforms continue to add customers, and especially if you engage in short-selling (risk models now have to contemplate the possibility of “coordinated” moves by retail investors).

That being said, the collapse of the Efficient Market Hypothesis argument is supported much more by the current monetary framework (ZIRP and QE) and the rise of passive investing, rather than what’s transpired over the last few weeks (meme stocks and short squeezes). We believe it’s important to keep this perspective amidst the gluttony of press coverage this theme has received.

Empirical data from the above studies show individual investors tend to have subpar performances on a pretty consistent basis. It would be a stretch, in our opinion, to think that, on a longer time frame, retail investors would rationally decide to (probably) continue underperforming while more potentially lucrative and stable options (index funds, ETFs, actively managed mutual funds) are available. This is a mania, one that eventually will pass (and be referred to in the years to come).

 

ONE COMMENT ON ROBINHOOD

Since we’re on this theme, the only thought we would like to add with respect to the whole Robinhood and r/WSB narrative (there has been an overload of coverage that we would like to avoid adding to…yes, while adding to it) is that trading in financial markets (especially through leverage) is highly regulated, and for the most part, that regulation has been put in place to try and ensure the well-functioning of financial markets.

Robinhood halting trading likely has little to do with trying to protect Wall Street and much more to do with following the regulatory requirements of posting collateral. They didn’t have enough collateral to back up their customer’s trades, which ended up forcing them to halt trading (as it would have required even more collateral, which they did not have) and raise more capital than the entire amount raised since inception.

 

A(RK)CTIVE MANAGEMENT

Active management has seen $1 trillion worth of outflows into passive vehicles in the past year, and those numbers triple if we take a decade-long view ($3.1 trillion out of active). Half of the equity AUM around the world is in passive vehicles, a share that has doubled in the last decade, and we’ve frequently written about the implications of it for equity valuations. Through the beginning of 2021 though, we’ve seen a reversal of this trend, with investors preferring active stock selection. And there is no other investment fund that has dominated this narrative better than ARK Invest, which manages active ETFs and has only lagged Vanguard in terms of inflow volume in 2021.

 

Ark has increased AUM fivefold in the last nine months of 2020, and has taken in more money in the last five trading days than in the first five years combined.

It’s important not to overlook this phenomenon. ARK takes high beta single stock bets, which so far, have delivered 39% average annual return since inception in October 2014, and they were among the first fund managers to own Tesla and publicly announce their bullish views on bitcoin.

The increase in AUM signals the thirst of the market for TESLA-like bets, where “disruptive innovation” is the fundamental argument, tailored then to a certain sub-industry. Whilst the increase of AUM tends to be a potential headwind for performance given the increased difficulty of getting in and out of positions without moving the price, with ARK there’s an additional uncontemplated risk: liquidity.

As reported by Jason Zweig at WSJ: “43.5% of ARK’s total equity holdings are in stocks of which the firm owns at least a tenth of all shares outstanding. At Vanguard Group, by contrast, only 9.7% of total equity positions are in such concentrated holdings”. Yes, we’re talking about funds of different size, but with ARK, investors are incurring in a significantly higher liquidity risk that might be otherwise understated given how concentrated the portfolio is. ‘Big Short’ famous Dr Michael Burry flagged on Twitter that ARK resembles the Manhattan Fund in 1966, PBHG Growth or even Janus in 1990-2000s, all of which didn’t really end up well. Pair this with the volatile nature of their holdings, and you’re in for a one helluvaride! (Albeit an EV one).

 

US STIMULUS UPDATE

The American Rescue Plan is Joe Biden’s $1.9 trillion stimulus package that the Democrats intend to bring to US citizens hopefully by the expiry of the previous employment benefits in mid-March. The proposal for the plan includes:

  • $1,400 payments to those making less than $75,000 per year
  • Extension of the $300 per week unemployment benefit (to mature in March) through September, while increasing the amount to $400 per week
  • Plans to start increasing federal minimum wage from $7.25 to $15 by 2025 (although no increase will be made during the pandemic)
  • Eviction and foreclosure moratoriums extended through September
  • $350 billion for local and state governments, $170 billion to help schools remain open, $50 billion for COVID testing and $20 billion for vaccination programs

The current US Administration doesn’t really need the support of Republicans (they only need unanimous support from fellow Democrats) in order to pass their stimulus package, but they would certainly prefer this to be a bi-partisan agreement, meaning that Biden and Harris might concede a reduction of the size of the package if it ensures more Republican’s support (at the “expense” of people earning more than $300,000 or of state and local governments).

Time is of the essence though as both the Senate and the House want to pass a relief bill in a matter of weeks. Despite there being unanimous Republican opposition to the current plan and a counter-proposal made of just over $600bn (significantly below what Biden is targeting), we’re unlikely to see a lot of back and forth on this as the Democrats basically hold all the cards. The Republicans will likely be forced to meet in the Democratic middle (i.e significantly north of $1 trillion).