Fixing Retail Investing, Part I: Why Investment Tools are Failing the Individual Investor, And How They Can Be Fixed

NOTE: We’re hard at work on some big items coming down the pipeline, but I wanted to pop in and put down some thoughts that have slowly been crystallizing in the back of my brain. Big news coming in mid-June/July, so stay tuned!

One of the more-common colloquialisms that I tend to (over-) use when speaking with clients, peers, and/or network-expanding connections is that I am the “son and grandson of carpenters." It’s a bit of a stretch: while my grandfather was a carpenter for many decades in the Tarpon Springs area (and literally built the first house and neighborhood I lived in), my father spent most of his working years behind a desk minus half-a-decade-ish building military vessels at the Newport News Shipyard. That doesn’t stop him from always having a project to work on, planning it out from his portable drafting table all the way to its execution and completion. Even five years into his retirement he is always plugging away at some project in one way or another.

This carpenter/project-based adherence meant that one of the biggest lessons drilled into my brother and I from a young age was the dual need of proper preparation and proper tools to allow for the correct completion of the task the first time (“Measure twice, cut once” rings out in my head even for something as simple as hanging a picture on the wall). Great craftspeople understand the dichotomy of 1) having good tools and the knowledge regarding the optimal application(s) of every one of them, but 2) also recognizing that the tool in of itself is merely a means to achieve an end goal. Frankly, if you’re installing an entire wall, no one gives a damn how shiny or expensive your hammer is, they just want it to drive those nails in and keep that drywall up and secure for as long as possible. At the same time, you do want to use a hammer for this task: sure, there could be debate as to which type of hammer you’d use (there are so many types of hammers!), but you’re going to be using a hammer of some sort for driving in those nails rather than, say, a chainsaw.

So, why do I bring this up? The increase in retail investing over the past year has laid bare just how stacked the market is against the individual investor. Whenever an individual loses money on investments, it’s because they “don’t understand the markets” or they “allocated too much to risky assets”, but when the individual investor outperforms the market they “were lucky” (while ignoring that pretty much all performance by professional asset managers is due to luck rather than skill) or when individual investors collectively call bullshit on overextended short sellers and buy up shares of a company they’re “manipulating the market”, despite making up less than 1% of ownership of the equity available. Part of this is driven by narrative, but much more of it is driven by what is available for your typical retail investor to invest in. Based on what I mentioned earlier, we’re dealing with two major issues regarding the tools available to retail investors: 1) the investment industry as-a-whole drives retail investors toward high-turnover, speculative investing in order to benefit itself, which leads to 2) the assets readily available to retail investors being inadequate either by design or by the limitations of the medium itself.

Why has retail investing increased so much recently? Part of this is cabin fever: a year of lockdowns, stimulus checks, and a reduced variety of activities to spend them on has led to a day trading boom that is starting to reach mid-nineties levels of retail interest. This has led to an overall reduction in the quote-unquote “sophistication” of market participants, with return chasing rampant and the owning of investment vehicles because of a want to be part of the “in thing”. How else can you explain the rush into a wide variety of cryptocurrencies that far outpaces investor understanding of the products? What percentage of investors into ETH understand the long-term plans for ERC20 or Layer 2 or Proof of Stake? I’d imagine that it is much lower than the percentage of investors who are well-versed in the financials of a non-glamor product like Caterpillar.

Speculation and shininess are moving the market right now, and the market sloshes around from the product du jour as the narrative shifts, forever chasing returns ex post. Unfortunately, there is a gravity to this movement that can pull in disciplined buy-and-hold, long-term investors; a fear of missing out on return or that their long-term strategy is wrong because it isn’t capturing this new thing. You gotta be on Robinhood! You gotta get DOGE! You gotta get this REIT, or this ETF, or etc etc etc. They are on a road trip, but their gaze is being pulled away from the road to an attention-grabbing billboard. The tool is becoming the focus, not the end product. Even worse, the tool is more ceremonial than anything, designed to look good for a few thwacks but unable to hold up under extended use.

Most of this isn’t the fault of the retail investor: the ever-increasing gamification of investing coupled with historically low transaction fees and a wealth of investment options is pushing investors increasingly toward riding the wave of popular opinion versus standing pat with a researched and sensible strategy (we’ve written about this here and here). The nudges that the investment world typically gives are vicious rather than virtuous: platforms aggressively market new products that drive more trades so they can collect more fees and accumulate more order flow data to package and sell to massive hedge funds and investment companies (we’ve written about this as well!). Unfortunately, this positioning to drive users toward speculation and high-turnover positions leads to lower returns for the retail investor versus a long-term buy-and-hold strategy, a point that’s been made again and again and again.

(and again.)

(and again.)

(and again.)

(and again.)

Let’s take Bitcoin for instance. Yes yes yes, there is a massive depth in the debate of BTC’s pros and cons and where it’ll fit into the future of assets and wealth and blah blah blah that’s not important for this. If you wanted to go out and purchase 1 BTC, you could most-certainly do so on a variety of online exchanges, for a price close to what’s currently listed plus some transactional costs. That is something you can do right now, barring any restrictions by your local or national government. You could own BTC if you so choose to do so. Neat! However, as spelled out much more eloquently by Ben Hunt in his recent “In Praise of Bitcoin“ article over at Epsilon Theory, there is a movement happening right now by the stalwart institutions within the investing world to push Bitcoin…but not the core Bitcoin as it currently is, but a twisted, toyetic version of Bitcoin (dubbed Bitcoin!(TM) within the article) served up as a product in order for those institutions to maintain their moats and make their vig on each transaction of what should be a decentralized asset. They’re attempting to sell you a shiny, double-plated sledgehammer but it hits with all the sound and fury of a squeaky toy.

This is a common occurrence when it comes to products offered to individual investors. The Bitcoin!(TM) product gives the appearance of owning BTC, but you don’t really own BTC on top of the haircut of fees you’re losing to the middlemen for upkeep and management. That gold ETF? It’s probably a smattering of gold-related public companies or, at best, a product that attempts to track the price of gold minus the fees for all of that hard work that goes into maintaining that “close enough” facsimile to having actual gold in your clutch. Even ETFs designed specifically to go after something more abstract like industry exposure fall short: getting full exposure to, say, the Biotech or Green Energy industries using just public companies bundled in an ETF is going to miss out on all of the private startups that won’t IPO until well after they 10/20/50x for their VC/PE backers. Even ETFs specifically tracking popular indexes come up short: SPY or VOO or other S&P 500 ETFs get close, but fees are still assessed even on buy-and-hold positions, meaning a 20-year hold on SPY will still fall short of the S&P 500’s actual return over that period despite absolutely no activity on your part.

I know I’ve been harping on ETFs a lot in the above paragraph, which makes it seem like I dislike them as an asset class. I don’t! ETFs are great! They’re the most-recent innovation to move investing more toward democratization! (The jury is still out on commission-free trades: for every Vanguard acting virtuously, there’s a Robinhood acting viciously.) They are the biggest leap forward in index investing since Bogle and make mutual funds absolutely irrelevant! They allow for a wider distribution of investment strategies than ever before! But…they’re not perfect. Launching an ETF can cost upwards of six figures, require a minimum AUM to be feasible, and require an annual upkeep in the mid-five figure range. That’s much lower than most other types of funds, but still well out of reach of a majority of strategists.

Furthermore, there is an upper limitation to what an ETF can track due to it needing to own tangible assets for its positioning. This is why SPY and VOO and others take on fees: they can’t just move their price in-line with the S&P 500, they have to own a portfolio of the stocks in the S&P 500 to mimic its performance. This is why there is no ETF that truly follows the VIX: the VIX is a reflection of market uncertainty and doesn’t actually hold any assets or positions. This is why VIX-based ETFs such as VXX and UVXY are constructed from VIX derivatives rather than the VIX itself, and why the correlation of these ETFs to VIX isn’t all that close to 1. ETFs have to own underlying positions in their strategies because it is the way they are constructed: in order to prove performance of an ETF, you must hold positions that reflect your fund’s strategy. It is the proof of trust between the fund creator, the exchange hosting the fund, and the investor that what is being bought and sold is reflective of the asset itself. That’s how its been, that’s how it is. But what if another innovation comes along that removes the need for that mediator of trust, thus reducing holding fees even more and allowing for a complete alteration of what can and can’t be made into an investable asset?

…I think you’re seeing where I’m going with this.

Decentralized Finance (DeFi) has been pulling on this thread for years, but we’re starting to see some really nifty applications of asset creation in an environment where a fee-collecting middleman is no longer needed for verification. I’ve already spoken about AMPL in our previous post, but let’s do a quick recap. AMPL is a stablecoin, i.e. a cryptocurrency that tethers its value to the fiat currency of a nation. For instance, USDC is a cryptocoin tethered to USD. Stablecoins like USDC are useful for a couple of reasons, such as allowing an investor to keep a “cash” position in crypto without having to withdraw from a crypto exchange or for being a stable base pair in a liquidity pool (watch here if liquidity pools are outside your scope of knowledge). AMPL is a little different from a typical stablecoin like USDC for two reasons. One is with its structure as an elastic, non-dilutive currency: it adjusts the amount of AMPL you own in order to keep your underlying wealth consistent, something that (dilutive) fiat currencies can’t do or that (inelastic) BTC isn’t built to do. The second, and in my mind the more gamechanging innovation, is that AMPL doesn’t track USD or any other currency: it tracks the US Consumer Price Index (CPI). This makes AMPL inflation-adjusted; it’s akin to Treasury Inflation-Protected Securities (TIPS), but much easier to get into and out of. Inflation-adjusted stablecoins could be a huge combatant against hyperinflation (or even the portent of higher inflation in the current-to-near future), as they’ll preserve the purchasing power of individuals who have tethered their holdings to a localized inflation-hedged stablecoin.

While I’ve sung the praises of AMPL for two posts in a row now, it’s not the only innovation DeFi has made in the realm of “like a current asset, but better”. Volatility Protocol has created synthetic BTC and ETH volatility indexes that are calculated in the same way as VIX. Essentially, we now have VIX-derived volatility indexes for the two largest cryptocurrencies. However, they have also partnered with the Universal Market Access (UMA) Project to create synthetic tokens of their ETH volatility index for both long (volETH) and short (ivolETH) positions. What’s a synthetic asset? Check out UMA’s documentation for the details, but the short version is that they can create trustless synthetic tokens that track a publicly-available index without the need of holding the underlying position(s). It’s a financial derivative, not in the traditional sense of a “financial derivative” like futures or options, but in the mathematical sense that the price of the token is quite literally derived from a consensus based on readily-available data. These concepts are coded into various guardrails within the token itself in the forms of smart contracts and oracle systems and other structures…basically a lot of developer-level technical knowhow that I’m still wrapping my head around. Suffice to say that these synthetics can act just like an ETF, just without the cost sink of a middleman. Better even: with a little adjustment to their focus, Volatility Protocol and UMA could take the structure of volETH, swap in the S&P 500, and boom: a VIX synthetic token that can get closer to mimicking VIX than any ETF or current investable product. Or swap in any major stock exchange in the world, and get the equivalent of a VIX index for that exchange/country.

Take it one step further: why stop at synthetics of current indexes? Why not create brand new investable indexes via synth tokens? Meet uSTONKS, a collaboration between YAM Finance and UMA. The concept is straightforward: take the top 10 most-mentioned stocks on the WallStreetBets subreddit, equally weight each stock in an index, then track the price of those ten stocks over the life of the token. When the token expires, the new worth of the token will be the sum of prices of the ten stocks, adjusted for the original equal weighting. In simple terms, that’s pretty much it. There’s no weird folds or hidden gotchas in the token. The parameters are defined, the initial prices are set, the token is created, and it runs until completion, upon which the final price of the token is determined and settled with all parties. It is unmistakably DeFi in creation, but looks very traditional once built. Normal, even. Synthetics like uSTONKS and others have the capacity to act as a bridge to bring receptive old-hat investors into this new world; the gears and levers in the box might be new and confusing, but the outer cover is wholly familiar.

That’s not to say that everything is the same as traditional assets. No, there’s an additional aspect that really makes DeFI synths shine. Remember liquidity pools from earlier? Well, think of them as essentially a crowd-sourced market maker. Rather than having centralized institutions controlling the price at which markets are set, DeFi allows anyone to become a minter of tokens and/or a liquidity provider, moving markets based on a combination of market transactions and the pricing data from a defined and publicly-available source of truth. The more popular a synthetic, the more coins minted and the more liquidity in the pool, shifting the center of the markets from a privileged few to a meritocratic wisdom of the crowds. Popular tokens are popular due to their performance or their strategy, not due to hype or marketing. Sure, there will still be speculation, and that’s fine in measured amounts: I’m fairly risk-adverse in a casino, but I’ll pony up a few bills at a craps table from time-to-time for the excitement or to invest in the devil’s luck my brother never seems to run out of at that damn game. But the point is that the individual investor can obtain positions that are truer to the roots than ever before, where they can create the market, be in the market, or be the lubrication keeping the market moving. These sets of tools will finally be as advertised.

However, a new class of funds isn’t much use without the proper platform to support them. I’ve got ideas about that, too. Stay tuned...