The Market Impacts of Retail Investors
Just over the past two weeks, the share price of AMC Entertainment has gone from trading around $12 per share to over $50 per share fueled by the retail trading crowd and online investing blogs. Events such as these are nothing new and we are confident that there will be more events such as these in the future. Here at Silicon Hills Wealth, we wanted to dig into some detailed research to discover what is truly driving these price swings and the impacts it is having on markets. We also wanted to provide some answers for our clients on how they should view these events and what action, if any, they should take.
The Impact of Robinhood Investors
To understand the impacts retail traders are having on security prices, we analyzed two research papers published in the Swiss Finance Institute where the authors explain the concept of inelastic markets and their hypothesis on why a small subset of investors are having major impacts on security prices 1,2,3. Below are some of the highlights from the research:
- Despite Robinhood traders holding only 0.2% of the equity market, they accounted for 10% of the variation in stock returns during Q2 of 2020
- Robinhood traders herd into specific stocks, showing similar trading behavior across the majority of accounts on any given trading day
- Robinhood traders have a preference for trading in small cap stocks, the aggregate market capitalization of small cap stocks would have been 25% lower without Robinhood demand in the first 6 months of 2020
- Robinhood traders were a major source of liquidity for markets during the Covid-19 panic in March 2020; the Robinhood platform promotes a “contrarian” investing behavior where investors anchor on previous prices and expect prices to revert to their original level
It is clear to see that despite their small amount of capital relative to the entire US equity market, Robinhood traders and retail investors alike can generate massive pricing pressures on securities, in particular small cap stocks with high social media attention.
Elastic vs. Inelastic Investors
How can a small group of investors with limited capital have such a profound impact on markets? A new theory titled “The Inelastic Markets Hypothesis” explains how the rise of passive ownership of securities and the movement of capital from individual households to institutions has created a unique market dynamic over the recent decades. Not all investors are created equal; many large institutional money managers along with pensions, insurance companies and endowments trade infrequently in the market. Passive index funds are perfectly inelastic in theory since they do not trade based on changes in prices, passive investors accept the markets price (price takers vs price makers) and hold a market-cap weighted portfolio in perpetuity. For example, when GameStop experienced a drastic increase in price back in January the company’s weighting in the Russell 2000® index also dramatically increased relative to other positions in that index; however, index investors did not sell their shares since they hold a market-cap weighted portfolio.
Where is the Money?
Over 60% of GameStop’s shares were held by passive investors that do not actively trade in markets. The hedge funds that were holding GameStop short would not provide additional liquidity as this would add to their short exposure. The researchers show that purchasing just 10% of the outstanding shares would generate a 55% increase in the price of GameStop; a multiplier of 5.5.
On the table shown above, we see that if Robinhood investors had not engaged in buying Ford Motor Co. in the second quarter of 2020 providing liquidity to the market, the stock would have produced a –16.41% return versus the 25.88% rally it experienced.
Takeaways
The purpose of this article is not to label Robinhood in a positive or negative light; instead, we wanted to provide clarity on recent events within the markets that have investors asking questions. Platforms such as Robinhood have introduced and engaged a broader audience to the process of investing. There are both positive and negative effects that have developed in markets. Capital markets are not static, meaning they change and adapt over time through innovation, research, and technological advancement.
The rise of low-cost passive investing has provided generous benefits to investors by allowing them to access the markets returns in a low-cost tax efficient manner; however, market dynamics may also be changing with this rise in passive investing. Could too much of a good thing be bad? We will have to wait and see but the evidence supports the notion that retail traders are having a greater impact on security prices due to the inelastic nature of passive indexing. At Silicon Hills Wealth, we believe that combining the low-cost, rules-based approach of index investing with an active systematic touch can mitigate events such as GameStop and AMC and allow investors to benefit from the best of both approaches.
1 Gabaix, Xavier and Koijen, Ralph S. J., In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis (May 15, 2021). Swiss Finance Institute Research Paper No. 20-91, Available at SSRN: https://ssrn.com/abstract=3686935 or http://dx.doi.org/10.2139/ssrn.3686935
2 van der Beck, Philippe and Jaunin, Coralie, The Equity Market Implications of the Retail Investment Boom (January 30, 2021). Swiss Finance Institute Research Paper No. 21-12, Available at SSRN: https://ssrn.com/abstract=3776421 or http://dx.doi.org/10.2139/ssrn.3776421
3 Gabaix, Xavier and Koijen, Ralph S. J., In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis (May 15, 2021). Swiss Finance Institute Research Paper No. 20-91, Available at SSRN: https://ssrn.com/abstract=3686935 or http://dx.doi.org/10.2139/ssrn.3686935
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