Robinhood is back. And instead of a skilled archer robbing the rich in the Sherwood Forest, Robinhood is a mobile phone app for trading stocks created by two skilled marketers, Vlad Tenev and Baiju Bhatt. And a good argument can be made that the Robinhood app was integral to the meteoric, and unprecedented rise in the stock market after the pandemic crash, so I think its worth understanding what they do and how they have changed the financial markets.
They chose the name because Tenev’s wife would introduce him as the Robinhood of finance to her friends, when they first started working on this app in the proverbial garage in Silicon Valley. They wanted to build a phone app that was easy and fun to use, and with free trading. “Through Robinhood, millions of everyday people have the opportunity to participate in our financial markets,” Robinhood CEO and co-founder Vlad Tenev told CNBC in an email. “We’re proud to be opening up access to wealth creation for people previously left behind, and we remain committed to democratizing finance for all.”
So how are they democratizing finance? What are they doing that wasn’t available already?
Robinhood started in 2013. Prior to Robinhood setting the precedent for the whole industry dropping ticket charges for trades, the trend was already headed in that direction. Household names like Charles Schwab and later E-Trade had already pushed the industry from a commission business as depicted in the movies “Wolf of Wall Street” and “Boiler Room”, toward a fixed dollar per trade which had gotten as low as $5 before going to zero. Robinhood can take credit for pushing everyone else to offer free trading.
Tenev and Bhatt started their career as “Flash Boys” which is the title of a Michael Lewis book which investigated high frequency traders. They met as students at Stanford and eventually ended up in New York together where they built software for hedge funds which made each stock purchase or sale even faster so that they could take advantage of tiny price differences on different stock exchanges. For example, you might buy shares of Apple stock at $124 on one exchange because you know you can sell it at $124.01 on another exchange if you are quick enough. That might not seem like a lot but if done using millions of dollars, hundreds of times a day, it adds up to a lot! So, Tenev and Bhatt knew how the sausage was made because they made it! And they also knew that some financial firms and some banks would pay for the opportunity to make that $0.01. This is how Robinhood makes most of its money.
Robinhood does what the whole industry has been doing for decades. When you enter an order to buy or sell a stock, your brokerage firm sends that order to a stock exchange or a financial firm known as a market maker to match you up with a buyer or seller. Imagine your brokers like Robinhood, Schwab, E*TRADE, Morgan Stanley etc. are like “real estate agents”. If you want to buy or sell a house a real estate agent tries to find a buyer or a seller and charges you a commission. And then there are house flippers, who buy a house and then quickly it for a profit. Market makers are like house flippers, and in this comparison, they have cornered the market. They pay “real estate agents” to send them all the flippable “houses” for sale before they get listed. Since the market makers use computer algorithms to trade, they buy or sell to the customer and then buy or sell to a different customer most of the time within a split second and at a better price. Robinhood alone was paid $331 million the first quarter of this year for sending their orders to 4 or 5 different market makers. If they are willing to pay that much to execute an order, imagine how much they must be making. This payment for order flow (PFOF) is industry standard although some firms like Fidelity, Merrill Lynch and Public don’t accept payment for the order flow and some execute the orders in house. If you are interested in how much money your broker pays or earns from PFOF, then google “606 disclosure” followed by the name of your broker to get the gory details.
Why should you care? If your order were big enough then you should care because you could have, should have (in my opinion) gotten that better price that the market maker got. But if your order was small enough, the amount you don’t pay in ticket charges ($5) is probably more than the better price you could have gotten. And if democratizing finance is important to you, then you should take note, that all this trading is making a select few behind the scenes who were already very rich, even richer.
Are taking away the ticket charges that much of a draw for people to trade stocks. Considering how much people pay in credit card interest that they seem to ignore, and people are now trading crypto currencies with as much fervor as stocks, and in most cases are being charged a ticket charge – I don’t think human psychology really cares whether there is $5 ticket charge or not.
Tenev revealed in February that the value of all their customer accounts is $35 billion more than the customers had deposited. This hard to verify since Robinhood does not share the details of their assets, but especially incredible since they disclosed at one point in 2020 that their total assets under management was $20 billion (in contrast to E-trade’s $600 billion and Schwab’s $3.8 trillion). If you had invested $3500 (the average account size at Robinhood) in January 2014 in the Nasdaq 100 (40% of which is made up of Apple, Amazon, Microsoft, Facebook, and Google) your account would have been worth $13,000 when Tenev made that statement. I use the NASDAQ 100 here as a best-case scenario as if investors all bought the highflyer tech stocks and held on to them. This would be an envious return to have on one’s investments, and yet even in that best case of scenarios Tenev’s $35 billion assertion does not add up. How individuals do as stock traders is hard to measure since that data is not revealed, but we can look at how professional money managers have done and give Tenev the benefit of doubt that the average Robinhood investor does at least that well.
Warren Buffet famously won a bet with a hedge fund manager that in a 10-year period 10 selected hedge funds could not beat the performance of the S&P 500. Furthermore, over the last 20 years as you can see in the diagram below about 90% of fund managers under-performed their index. And even as time period shortens from 20 years to 5 years and less, we see that most fund managers under-perform their index. Its most likely then that most traders and even investors don’t do better than the $&P 500 in the end.
A wise investor friend, says “stock picking is nearly impossible, unless you mean investing in stocks versus trading stocks. Then you just have to have common sense and patience”. By patience I believe he does not mean waiting for the mid-day rebound, or even for quarter end earnings to be reported. He means letting a company’s intrinsic value be realized. Typically, this can take years. By common sense, as Warren Buffet says, “What could we do here that would be the dumb thing, and how do we avoid it?” The problem that most people have is we cannot resist the temptation to make more. And during times like the last year, the Robinhood era, if you will, “Throughout this rollercoaster of a pandemic-era stock market, it’s nearly impossible to tell which investors are smart, which ones are dumb, and which are just plain lucky.”
Robinhood has been front and center in the stories of amazing stock runs not seen since 1999, like Tesla and many other well know tech companies and then there are the meme trading frenzies where social media platforms like Reddit have fueled wild moves in stocks like Hertz last year, and GameStop (GME) and AMC Theatres (AMC) more recently. I sometimes think that energy created from Reddit has replaced that of the Wolf’s of Wall Street.
Some of the meme trading story is framed as a revolution against the “evil hedge funds”, with intent of hurting hedge funds. But even during the GameStop saga when the masses were pushing up the price because certain hedge funds were betting the price would go down, those funds and plenty of others were certainly joining the buying frenzy. Funds, banks and market makers were in the loop. When retail investors were buying so were they and then selling and realizing huge gains before the masses sold or as they held on to their positions in defiance. Major banks over the last year mostly reported blockbuster earnings despite record low interest rates and concerns of a recession, because of their trading profits, which have been enhanced by the volatility created by retail investors who chase trending stocks.
Robinhood has enriched the rich because they have done such a good job of marketing their product, millions of new unsuspecting investors have driven up prices of assets. Their product is simple and no different than what was already available. But its more fun to use, its colorful, and the experience and process is designed to activate and excite our neurotransmitters. I’m not sure why brokerage firms never marketed to the small account size like Robinhood has. Maybe they didn’t realize the potential of small investor order flow and certainly didn’t realize the power of the small retail investor in the driving up stock prices. And of course no-one predicted correctly the effect of the pandemic on human behavior.
I don’t think Robinhood will create more wealth for millions of everyday people, but I do hope that the stodgy old broker dealers, clearing firms and banks take note. In a short period of time Robinhood has built a new easy to use system and for those of us who have been using these old systems we have become numb to their inefficiencies which often hide under the excuse of regulatory requirements. We drown in paperwork, we accept processing times of days and weeks, and operational errors and inefficiencies in an era when buyers and sellers can be matched in a microsecond.
And for those who care we should also note that wealth creation done correctly is available to everyone, and Robinhood has shined a light on that possibility.
If I were to “democratize” finance, I would require investing and personal finance classes in all schools, each year starting in high school. Additionally the federal government should deposit $6,750 for each newborn into an investment account, and this account would be invested in the S&P 500. Once that person starts working instead of taking money out their paycheck for Social Security that money would get deposited into this account. In the meantime, everyone else should have an account opened and all Social Security withholding deposited into an S&P500 investment going forward. Currently Social Security invests in bonds, and in the interest rate hey day they were making upward of 9%, but that hasn’t been the case since the early 90’s… today they struggling to return 2% on that massive pile of American’s retirement money.
Robinhood is expected to become a publicly traded company soon. They filed for IPO confidentially, which you have to assume is because they are not ready for full transparency. But they have to make that information public 2 weeks before their stock is available to purchase on the open market. When and if that happens, Tenev and Bhatt will each likely own over a billion dollars’ worth Robinhood stock according to current predictions. And the question remains, how wealthy will their stock make their clients and stockholders?