Investment

Why family offices should pay more attention to Robinhood Markets than active managers

Newly published research shows an obsession with attention-grabbing data is undermining returns for traders who use a commission-free service set up by Robinhood Markets. 

But family offices will know that research-driven stock pickers are in no position to criticise, given chronic failures in their own attention span which have led to 70% of them lagging their benchmarks. 

Professional investors sneered at the Robinhood crowd when they piled into their first Meme stock – the struggling video retailer GameStop

They are steadily switching funds to passive managers, while commission-free trading is here to stay, with PayPal said to be considering a rival service.

The Robinhood critique makes it clear that clients need to choose their trades with care. 

“Heightened attention-driven buying leads to more concentrated trading by Robinhood users than other retail investors and contributes to buy-side herding events that are usually followed by negative returns. 

“For example, the top 0.5% of stocks bought by users each day experiences negative average returns of approximately 5% over the next month.” More extreme herding events are followed by negative returns of nearly 20% although the more frequent impact of herding tends to be a relatively mild -1.8%.

The study is authored by four academics, led by Brad Barber of the University of California. It is called: “Attention Induced Trading and Returns – Evidence from Robinhood Users”.  It questions whether Robinhood should promote “the fun of trading” when inexperienced investors fall victim to herding by pushing popular share prices up, only to see them fall when attention moves on.

Barber & Co say Robinhood’s trading app limits trading choices and encourages people to trade too frequently, at 40 times the rate experienced at Charles Schwab. Around 35% of Robinhood trades are concentrated on the most popular stocks, against 24% from other retail investors. 

None of this is ideal. But Robinhood will continue to attract business because it offers commission-free trading as a result of bundling up orders and selling them to market makers like Citadel, keen to use the data to inform its trading. The SEC has talked of putting limits around the practice, but few are convinced it will act. In the interim, Robinhood’s market value is a forward-looking $38 billion. 

Robinhood points out its commission-free trading has attracted millions of younger traders back to the stock market. They can be highly sophisticated, taking part in social media discussions hosted by the likes of Reddit to compare notes. They can hunt in packs, looking out for Meme stocks capable of rising fast, on receipt of an eye-catching titbit of information.

Professional investors sneered at the Robinhood crowd when they piled into their first Meme stock – the struggling video retailer GameStop – and put the squeeze on hedge funds with short positions. Subsequent performance has been volatile but GameStop, now under new management, has held onto a twelve-fold gain compared to the start of the year.  Another early Meme stock, AMC Entertainment, has risen eight-fold this year.

Research into 57 popular listed Brazilian companies by Claudia Yoshinaga and Fabio Rocco, published in 2019, confirmed the importance of attention-grabbing news in today’s markets. 

They found a rise in the number of searches on Google led to an increase in related trading activity culminating in share price falls as soon as euphoria fell away. They see a similar pattern in bitcoin, another meme situation, which often rises on the back of bullish comments from its army of fans. And soaraway Tesla was a meme stock long before the phrase was invented.

Momentum trading reflects the attention growth stocks are receiving from Robinhood traders, and others. The trend, which develops out of growth investing, becomes more frequent during the late stages of a bull run when the influence of retail investors becomes strong. 

Asset managers, who tend to be value investors, are suffering because they use fundamental research which does not support momentum trades – or memes. 

In June 2021, Willis Towers Watson, the investment consultant said no more than 30% of active managers were beating their benchmark. They have lost trillions to passive management and live in fear of losing more. As a result, they have chosen to diversify out of their core business, despite the risk this will slow down their recovery.

According to recent research by Inalytics, the data provider, professionals display skill when they know which stock to buy. But they can be bad sellers. Rushed selling decisions cuts their aggregate performance by 1% a year, when loss aversion undermines their previous conviction. Inalytics says sellers would perform better selling stocks at random.

The professionals also trade their stocks too frequently, due to indecision. They are the biggest contributor to hidden fees which can cost 0.35% a year. Behaviour issues, trading costs and client fees take frictional costs close to 2%, helping to explain why active managers find it so hard to beat the indices. 

 

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