Fixing Retail Investing, Part II: Platform-Based Nudges Toward Long-Term Investing
NOTE: We’ve been promising some big news to drop around this time…unfortunately it seems that our ambition, research, and propositions might be outpacing the technology currently available. Depending on the results of some discussions in the coming weeks, we might either be seeing a delay of the aforementioned news announcement or a future part of this series that goes into what we’re working on, what we’re aiming for, and the persistent gap preventing the connection between the two sides.
…That’s pretty nebulous, isn’t it. Uhhhhh…just hold tight, things are still in process!
Welcome back everyone! If you have yet to read Part I, please click on over to that post in order to get your bearings straight before diving into this one. Good? Good.
In Part I, we wrote at-length about the many aspects of the investment industry that are set up to penalize retail investors. This is done in a variety of ways:
The industry pushes retail investors toward high-risk, high-turnover investments/strategies. These will work well during a speculative bubble, but the fallout when the bubble pops is catastrophic.
Many ETFs, derivatives, and other structured products are facsimiles of the underlying concept. An S&P 500 ETF is close to the returns of SPX, minus the assessment of fees and any shortcomings in the product’s management…and that’s one of the easiest to manage. VIX ETFs and industry ETFs where a majority of companies are privately-held are atrocious in their correlation with their namesakes. These products can hold together during the good times, but when there’s a downturn the products that have a low correlation with their core concept will fall apart.
Investing platforms aren’t structured toward long-term, buy-and-hold investing due to a misalignment of incentives between the platform and its users. The true drivers of profit for these platforms are transaction fees and packaging order flow data to sell to the large actively-managed funds (like hedge funds).
There is a multitude of research out there on how a long-term, buy-and-hold strategy has a significantly higher return over time than an active strategy. This means that platforms that nudge users toward actively trading are actively harming the wealth of their user base in order to drive higher profits.
Much of the product side was discussed in Part I, and although we touched on a few of the platform issues, we didn’t really go down that pathway last time. Unfortunately, a lot of the root issues with products are also the root issues with platforms. Fortunately, this makes for a great jumping-off point.
Much like products, the platforms aimed toward individual investors attempt to monetize the flow through their offering as much as possible. In products, this takes the form of a variety of fees: management fees, custody fees, acquisition fees, etc. Some fee assessment makes sense: managers should get some return on the work they’re putting in to keeping the strategy adhering to the core concept as much as possible. One then might expect that products with higher fees such as mutual funds and the “2-and-20” hedge funds would produce higher returns than their streamlined ETF counterparts. However, there is actually a negative correlation between the fee size and return performance. If that’s the case, why wouldn’t you go with a low-fee, average-to-good return ETF for a long-term buy-and-hold? Well, those higher-fee fund providers tend to turn some of that money right around into marketing, which brings in more investors and their capital, which provides a larger marketing budget, and so on. For an industry where returns are laid pretty bare and universally comparable, there sure are a lot of customers who still fall for razzle-dazzle instead of results.
This obfuscation and toll-collecting middle-manning occurs in platforms as well, just in a different way. This doesn’t necessarily come in the form of fees a la products; in fact, the “zero-commission” movement has swept throughout the industry. That’s a bit of a misnomer, though: there are no fees when buying stocks/ETNs/etc., but there are still fees upon selling your investments, which isn’t the worst thing in the world but is a misleading way of promoting your services. Of course, the reason that these platforms can even offer “zero-commission” trading is because they’re making their profit off of other aspects of your portfolio. As mentioned before, these platforms package and sell order flow data to large asset managers/hedge funds, making it very clear that those that invest on these platforms are merely users and not customers. In addition, these platforms will lend out their users’ investments in a process called securities lending. In this process, the lender temporarily transfers their securities to a short-seller, who pays a borrowing fee then sells the securities to create their short position. When the short-seller repurchases the securities, they are transferred back to the lender, and the short-seller keeps their (hopefully successful) return. You’d expect that the investor who has purchased the securities to be the one to obtain the full or even a partial borrowing fee, right? Unfortunately, that’s not the case with a lot of the popular platforms: they will keep the fees for themselves with the users not even knowing that their securities have been loaned out. So much for alignment of interests between the platform and its users.
And why should there be? As long as you’re on their platform they’re profiting off of you without cutting you in. Instead of focusing on making a real connection to investors and supporting what’s best for each one of them, they load up their UX with flashy graphics, gamification, and virtual confetti in order to keep you hooked. They bombard you with updates on a daily basis to keep you trading and that order flow data churning. They need you to buy into the popular securities of the day so they can turn around and lend them out to hedge fund short-sellers to skim off those borrowing fees for their own pockets. You’re not a customer, you’re not in this together, you are a source of revenue and the platform will be damned if they loosen their grip for any reason whatsoever.
Clearly, there is a vital need for an investment platform that looks out for the individual investor. The best way to do that is by aligning incentives between the platform and users/customers: the platform should succeed if their clientele succeed at investment goals (that are within reason). One of the simplest ways to do this is via a platform that emphasizes buy-and-hold investing versus the speculative positioning churn that infects many of today’s platforms. We propose doing this via three main nudges:
Lock-up periods on investments. Yes, this seems a little counter-intuitive at first. Why would you want to relinquish active control over your portfolio? How does this lead toward a platform/user alignment instead of moving it further away? As we’ve mentioned many times, a long-term, buy-and-hold strategy is one of the best methods of ensuring strong long-term investment return performance. Unfortunately, we are emotional creatures who feel losses twice as strongly as successes. When you have full access to your portfolio, there is a real emotional urge to stop the bleeding when in a downturn, even though that is one of the worst times to change your positioning. This is one of the reasons that IRAs and target date funds do so well (before fees and taxes): they prevent an emotional over-correction of the portfolio. We’ve been hiding this link in a couple of the previous posts, but this is essentially the main thesis of the proposed “Coffee Can” portfolio: create a portfolio, set rebalancing and recurring deposit periods, and then bury it in the backyard and forget about it until needed for retirement, etc. Unlike target date funds and IRAs, a platform can also set up some sort of annuity return on the portfolio: a percentage of periodic returns that’s low enough to prevent major reductions in return compounding, but enough to provide some “walking around” capital for projects, vacations, etc. This is all well and good, but assuring investors that giving up active liquidity and control of their capital in order to create better investment returns is a tough sell. What else can to we do to provide mutual alignment between user success and the platform?
A sliding fee scale. Right now fees for products are the same, no matter how long they are held for. A high-frequency trader pays the same fee as a buy-and-hold investor (in theory, at least). However, people love deals. Offering lower fees for longer lock-up periods can feed that oxytocin need and nudge users toward longer-term options. A 10-year lock-up, for instance, could see fees that rival some of the lowest in the current ETF landscape. Conversely, users that are actively trading will see their fees approach the dreaded “2 and 20” levels mandated by hedge funds, dissuading all but the most-successful active strategies from even attempting to execute on the platform. This sliding fee scale is a fairly simple concept, but one with a lot of power. Think about it: if you’re choosing between a mutual fund that charges 2-3% per annum in fees and a platform that has a similarly-structured fund but has fees at a tenth of that rate, is there really a choice at that point? Mutual funds and target date funds have been outpaced by ETFs and roboadvisors for years, but a sliding fee scale could be the final nail in the coffin for an expense vestige of the past.
Only offer vetted securities. Many of today’s platforms focus on the quantity of securities they offer; the more buttons available, the more profit to be obtained after all. However, we propose a platform that focuses on the quality of the securities being offered. In addition to the usual spread of stocks, there would be a focus on securities that offer a long-term, buy-and-hold investment thesis. This could be ETFs, index funds, or even synthetic tokens; anything that fits the thesis and has been fully vetted. Of course, this offers up an interesting question: would anyone invest in an ETF via this platform, since you’d have fees from the lock-up as well as fees from the ETF provider? There are two possibilities to get around that: either create generic versions of the popular funds on-platform and eschew fees, or lend out the securities and use the borrowing fees to cover the product management fees. The latter is the ideal option, as it provides a complete alignment of incentives between the investor, platform, and the product providers.
These nudges may sound great and all, but as someone who is a firm believe in words being useless without actions that back them up, I would be hesitant to trust in these proposals without proof that the platform is truly seeking a unified alignment in incentives. Even a company with the best intentions to start can see its morality erode over time: remember, Google used to have “don’t be evil” in the preface of their code of conduct. How can you assure current and potential users that you have their best interests at-heart and provide concrete actions to reinforce that position?
Simple: make the company a non-profit.
This is definitely a rarity for the FinTech industry, but there are instances of non-profit corporations popping up in atypical industries. I would remiss to not mention Ex Novo Brewing as the initial inspiration for this idea. Despite a fairly minimal overlap between FinTech and craft beer, the root concept is quite applicable to a wide array of industries. In this case, any excess profit generated by the platform would be redirected to local betterment organizations. This does a few things. First and foremost, it removes an incentive by the platform to seek out aggressive profit-seeking activities, removing any impetus to, say, package user data for third parties. Secondly, it gives users transparency into where the fees collected by lock-ups and securities lending are being allocated. Finally, it builds a community around the platform through the collective action of users deciding which organizations will receive donations.
What do we mean by this? Let’s say that, in the past year, Person A’s portfolio generates $100 in excess fees from lock-up and securities lending, and Person B’s portfolio generates $1k. Person A and Person B each want to allocate their excess fees to three local betterment organizations, chosen either off of a list of suggested organizations by the community or by adding their own choices. Typically, this means that Person B has 10x the power of Person A in terms of funding allocation, and bigger and more well-known organizations ending up with a majority of the allocations. However, implementing something like quadratic funding allows for a democratization of allocation based on the number of funders, not the size of their individual allocation. In other words, a few mega portfolios don’t dominate the allocation choices, allowing for every community member to have their voice heard.
As mentioned earlier, words are nothing without actions. As much as I feel these are the foundation for a truly unique and beneficial step forward for individual investors, there are merely the opinion of one person. So, I want to end this post a little differently than usual: I want to make your thoughts and opinions on the above heard. I have created a Discord channel for Novatero in the hopes that a community starts to form around creating a better step forward for individual investors. Let’s get a discussion going. I’m looking forward to it.