Dangers Of Democratisation In Investing
Iman Olya
23rd December 2020
Updated with a note on 1st February 2021
I. Intro
Democratisation (British and correct spelling) is such an overused and exaggerated term, that I hesitate to use it.
My degree in Politics provided me with a deterministic view of the British export of democracy. Probably explains part of my hesitation, particularly given my Iranian heritage (Churchillian expansionism and the like…). But I digress.
For the purposes of this memo, the term democratisation refers to the fair(er) and widespread access to something new. That something new is investing.
Historically, institutions were the main investors across all asset classes. They still are. But things are moving in the direction of the Average Joe. And this could be dangerous; let’s explore why.
II. Institutional Investors
Institutional investors are just entities that pool individual and business cash to invest in assets like stocks or real estate. Examples of these institutional investors include banks, pension funds, hedge funds, mutual funds, insurance companies and credit unions.
Take pension funds for example. The money you and your employer put into your pension, goes into a pool of cash. That massive pool of capital is managed by a pension fund, who invest that hard moolah into low-risk low-return assets. Now consider that pension funds hold ~$32 TRILLION in assets. The US alone accounts for ~$19tn or 58% of this. Imagine a 1% return on assets per year: that’s $320bn profit per year! But 1% is actually low; typically these funds look for 2.5%+ returns.
However, what’s a measly 2.5% when I have literally hundreds of people saying to me they’re trading stocks on Robinhood, e-toro and Trading212 and making 20%+ returns on speculative assets?
Well, firstly the bigger the fund, the more risk averse it’s likely to be. If you’re a fund manager you’re not going to risk billions of (other peoples’) dollars on a speculative asset; if you lose that money, you’ve basically fucked up millions of peoples’ savings. Secondly, these are long-term funds, so they’re not aiming to return large amounts in a few years. Their investment horizons are 20-30 years, as most people will start saving at around 31 years of age, and enter retirement in their 60s.
III. The Average Joe
I remember in November 2017, the crypto vessel was suddenly starting to skyrocket. A number of people trading Bitcoin and Altcoins were entrenched in their rhetoric of the use-case justifying the price rise. In fact, many Cryptonians argued that Bitcoin was still heavily discounted. Of course, their predictions were not accurate, and unlike Superman, the upward rally paused as it was reaching orbit. The reasoning at the time was attributed to democratised investing. The supposed logic I heard over and over was “if your Uber driver is investing, then a crash is coming”. The reality was the 80% value drop was due to whale sell-offs: large holders of Bitcoin quickly selling and suddenly increasing supply, causing a drop in price.
Early scouts of the Bitcoin bubble felt vindicated attributing the crash to the Uber drivers (pun intended). However, apart from just being a gross and offensive generalisation of taxi driver intelligence, it was outright wrong. Uber drivers themselves are quite diverse. In California, for example, only 9% of Uber drivers spend at least 40 hours per week on Uber. This isn’t their full time gig. Bucketing these folk into the type that would buy without fair diligence or sound reasoning is unfair.
But this does not mean the sentiment was wrong.
Below, I outline five modes of investing that are being democratised and show the dangers of each.
IV. Modes of Democratised Investing
1. Crowdfunding
Look, when crowdfunding works, it’s amazing. But more often than not, you’re betting, and in gambling the house always wins.
Successes are few and far between, but they include companies like Eight Sleep. See our interview with CEO and Co-Founder Matteo Franceschetti here, where he discusses how they blew through their pre-order targets on Indiegogo (4-5k of orders). This brought with it operational challenges for actually building their high-tech beds. But aside from that it was a great platform for them to catapult up from. You can see more examples of successful crowdfunding campaigns here - but kudos if you actually recognise any of the names. A lot of these examples are tech products or derivatives of tech (e.g. video games) that (1) people are not likely to be experts on and (2) are by definition not commercially viable (hence the need for funding). So you really are betting on the pitch or product. This is not at all different from Angel or VC funding. Occasionally, and in the case of Eight Sleep, great businesses can be overlooked by VCs. However, you are probably going after the bottom of the barrel - companies that VCs and seasoned Angels have passed on as they invest heavily across thousands of businesses.
There are other problems too, namely:
Your investment is illiquid - you cannot pull out of the business for a long time - often several years. You may also not get dividends as these businesses typically reinvest profits to facilitate further growth
Your holdings are diluted - later investment rounds mean your initial investment is worth less than the original equity
You’re at risk of being scammed. The SEC can’t even get a clear picture of fraud in the space for the below reasons:
A long period of time for equity issuers’ liquidity events
The absence of initial public offerings
A dearth of secondary trading markets
Not much data on the repayment of debt securities
The typical latency of fraudulent activity
So basically if I were to have my rational hat on, I would not bet on equity crowdfunding campaigns unless I am an expert in the sub-sector and I see a product that blows my socks off.
2. Stock Market Retail Investing
The ‘Average Joe’ has long been seen as a side note in the investing world. This is ironic given the involvement of retail investors in the Great Depression. But it historically made sense not to care about retail investors. They were small investors by value of ticket size and crucially, companies they could invest in did not have the rocket-growth capability of tech startups. So the downside impact of retail investor bets on specific companies were low.
Today this is changing. Retail investors make up to 25% of market trade volumes at peak. Robinhood, a trading platform for retail traders has already amassed 13m+ users, with an average age of 31 (make of the age what you will). The most popular stock on the platform is Virgin Galactic at the time of writing: a speculative stock by all accounts. Retail investors can also get involved in capital raises now, like IPOs, through products provided by Primary Bid. We talked in detail about Primary Bid with a VC fund who has backed them, in episode 8 of our podcast.
More importantly though, regardless of channel into the public markets, the companies we are bullish on are defying traditional metrics and methods of investing models. Tech companies, like Tesla and Snowflake, are rallying massive valuations and huge trade volumes with relatively poor fundamentals.
What’s more concerning is institutions are seemingly following retail sentiment.
Tesla, by all rational accounts, is overpriced. And it is a bubble, by definition. According to Research Affiliates, there are two considerations that determine a bubble in real-time (not post-hoc, which is easier):
Using a lindy approach to valuations, e.g. DCF, the business needs implausible (note, not impossible) growth assumptions to justify the current price
The marginal buyer does not care about valuations - they just want in (sound familiar?)
With Tesla, this means they’d need to grow at 50% per annum for 10 years, and increase profit margins above any car manufacturer today, in order for today’s price to be justified. This is implausible. Their cost base is very high (cos batteries are expensive, bruh) and they have not scaled to the major manufacturing levels of Toyota or VW to have economies of scale.
However, I do believe classing Tesla only as an auto manufacturer is short-sighted. In my opinion, they are (or aim to be) a data company; on the B2C side leveraging EVs and the Powerwall as the loss-leaders for entering the home. On the B2B side, entering the data play by grid balancing and DSR through large-scale battery deployment. So it’s not a straight comparison to car companies.
Nonetheless, bubble fever is part of the reason that Baillie Gifford divested 24 million shares, alongside Fidelity, JP Morgan and Credit Suisse. They see Tesla as a risk. (NB: any further positions would have also pushed BG past their concentration thresholds)
But the thing about bubbles is that they can deflate slowly or even never pop. Amazon is a great example - they were a bubble in 1999/2000. In the bear market of 2000-2002 Amazon stock plummeted by 90%. But it came back implausibly, through horizontal moves, moving away from just being a book retailer. So short sellers have so far been seriously in the red by going against Tesla, as the stock continues to skyrocket.
This explains why Goldman and Coatue have actually bought into the stock. Goldman upped its rating on Tesla, noting its faster than expected market share capture in the EV space. They cite improving profitability, falling battery costs and a proliferation of models available from many EV makers that will help supercharge EV adoption.
Source: CNN Business
But this is dangerous, because as Matt Maley explains, these banks need to ride the short-term wave, to see short-term gains. I question whether these institutions would have invested in Tesla had retail investors not been so bullish on the stock to overbuy it. I also question whether institutional investors see this as an opportunity for a long-term strategy vs an opportunity for short-term gain to capture value through the volatility of the stock. The latter is very dangerous for retail investors, as a dump (or similar to Bitcoin, a whale sell off) could bring the price crashing down. We recently heard of SoftBank’s whale activity in the tech markets - and of course Tesla was one of the investments.
In addition, the low or no-cost trading platforms used by most retail investors actually engage in data sharing, or “payment for order flow” (PFOF). Platforms like Robinhood, TD Ameritrade, Schwab, and ETrade have been selling their customers’ orders to market makers like Virtu, Two Sigma, and Citadel for years. In 2020 H1, Robinhood brought in an estimated $270m from this revenue stream! This is nuts when you think about it - they’re literally showing hedge funds where to bet, and double down on retail sentiment, further exacerbating any bubble phenomenon.
Whatever you believe about Tesla though, at least there is a value proposition behind it that many are bullish on, regardless of the fundamentals. More interestingly however, is the notion of a wider bubble beyond tech companies. That is the bubble of index funds.
If you’ve ever watched The Big Short, you’ll know that Christian Bale plays a crazy character. A neurosurgeon in his residency, who quit because he got bored. Atypical of any Wall Street Exec, and exceptionally intelligent. Well the character is Michael Burry - the man who predicted, and shorted, the 2008 financial crisis. This guy came out in 2019 to state that index funds were a bubble.
More recently, Mike Green, Chief Strategist at Logica Funds and ex Manager of Peter Thiel’s fund, also came out on the Odd Lots podcast to explain his reasoning as to why index funds are a bubble. Jim Chanos, the President of Kynikos Associates, adds to this prolific list - he’s the guy who shorted the Enron collapse.
These ex A-list investors are essentially saying that today’s excessive valuations are being driven by the ‘Fed put’ (over-reliance on the Federal Reserve to save the markets by pumping liquidity) and retail investor speculation. This has been amplified by the pandemic with unprecedented stimulus and no sports betting (which explains Portnoy and his fanbase too). This is dangerous as we are now too reliant on Government and Central Banks to keep conditions right (low rates to stimulate spending). Green argues that the past 30 years have seen index funds grow massively. Index fund inflows are the “single largest transactors in the market by far”. Therefore, by definition, these aren’t passive investments and they must be influencing the market. And the Average Joe investing large portions of cash, and their pensions, passively through index fund baskets are artificially inflating the markets. So if we take the S&P 500 index, you would invest in all 500 biggest stocks in the US. What happens to stock 501? With inflated valuations of the top 500, stock 501 lags behind. This is called the index inclusion phenomenon. It’s what Burry also goes by, but he looks at it the other way round; he sees it as an opportunity to buy stocks outside of the bubble, i.e. stock 501 is available at a discount.
Burry also calls out the lack of price discovery, given high valuations and index money pumping into the markets. Fundamentals don't reflect valuations, and so price discovery has not occurred effectively. He sees a snap back to reality when fundamentals come to the fore. We’ll see what happens, but if he’s right, you can bet your bottom dollar the Real Slim Burry will stand up.
It is important to note that Burry, Green and Chanos are short sellers; or in other words, contrarians. They win by betting against the status quo. And they may lose a lot (like Jim’s painful short position on Tesla) but when they win, they win HUGE. So take their words with a pinch of salt, but don’t ignore them. Passive investing and the democratisation of stock market investing could be causing a bubble.
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Note: Update since the Reddit frenzy (1st February 2021)
This article was written a month before the GameStop short squeeze. But the fundamental argument has come up again - democratisation is great, but risky. Especially if it impacts the big boy market makers, at which point the beneficiaries of PFOF money will step in and all hell will break loose. (NB: Robinhood’s PFOF revenue was almost $1bn for 2020, up from $270m in H1…)
I won’t pick up on the specifics of this historic market event as much has been written by far more competent people. But I will draw two conclusions that further substantiate my belief in the dangers of democratisation:
1) Power
The power of asymmetric information and market-making volume is slowly reducing for institutions. This is good. We need more competition and less opacity. But when that asymmetric play was based on leveraging retail market data, it just shows that institutional money really may be following retail sentiment and putting the Average Joe in danger.
2) Politicisation
There is no such thing as a free lunch. Robinhood has tarnished its (literal) name and hedge funds are hated even more now. This adds fuel to the fire of polarisation, particularly in the States. Individuals are now waging war and the inherent risks are large if politicisation continues (make no mistake, r/wallstreetbets is a political movement). Bubbles and incoherent investments will come quick if this movement is hijacked (as we saw pretty unanimously from politicians across the spectrum…).
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3. Angel Investing
Angels are ‘holier than thou’ as they are being praised for their risk taking. Typically businesses that Angels invest in are running out of money or don’t have a line of credit from banks or VCs.
Angels typically invest ticket sizes between $5k to $150k. Not massive investments. But Angels are also prolific betters. They will spread-bet across a number of startups in order to increase their chances of winning on one startup. The nature of early stage investing will always come down to this, whether you are the biggest Venture Capitalist or the smallest Angel investor; it’s all a game.
The size of the ticket is not important however. Angels are looking for the next winner. They want to be along for that sweet ride. Crucially, Angels don’t want control, or majority interest in startups. Founders must own majority shares to incentivise them to grow their own business. As such, you won’t see Angels taking on more than 20-25% in return for cash.
Source: Harbott
Angels, however holy, do have their issues though.
As they scale, they are making use of democratising tools such as Twitter, Substack and podcasts to build their pipeline and brand. But these methods of further outreach are just compounding consolidation.
Alex Danco argues that Angel investing is how investors stay relevant in Silicon Valley. It’s a game of social signalling. If investors were purely rational, they would pass on early startups and founders would not accept low valuations. The premium Angels end up paying for startups is basically the “social subsidy” to get access to follow-on deal-flow and compounded returns in the long-run. Jason Calacanis plays this card really well, where being a contrarian pays literal dividends. It’s a constant comparison on tech Twitter of who got into which hypergrowth company earlier. And this is more so the case in Silicon Valley than anywhere else, as the geographic network effects of social investing are not as strong elsewhere.
So although democratising tools are helping Angel investors increase their reach, the same investors are increasing their power and this only serves to create Super Angels. Democratisation is having the opposite effect.
4. Micro VCs & Rolling Funds
Micro VCs or Rolling Funds are essentially funds built around individuals. They’re sort of like Super Angels but with other people’s money; mini-GPs if you will.
If you want to start a fund, and you have a following, you can sign up on AngelList. People that believe in you and / or trust you, will give you money to use your pipeline or technical expertise to invest in early stage startups.
The benefits here are three fold. I summarise below (or you can listen to episode 5 of our podcast, which was actually liked by Naval, Founder of AngelList!):
Democratisation: makes sourcing deals and sourcing founders far more accessible
Diversification: as an investor, you can invest in one fund that will invest small amounts across 30 or so other companies; but you can also invest in as many funds as you want as ticket sizes are so small
Diversity: more money from smaller / micro LPs enables money to be spread across more GPs (especially if those LPs are diverse themselves). Plus more diverse GPs mean more diverse founders being funded and and more diverse societal issues being solved
So democratisation of VC in the form of Rolling Funds has its benefits. But it's also problematic. The same criteria that impact mechanisms of self-fulfillment and compounding consolidation with Angels also work here. First mover advantage is already a thing in Rolling Fund land, with GPs like Sahil Lavignia being oversubscribed. And the power law applies; big names attract the majority of LP cash. But equally, everyone and their mum are seemingly starting these funds, as long as they have a little clout. The market is rife for bad actors, especially given a lack of hard regulation in the space.
I’m bullish on Rolling Funds, but I note that if early stage investing typically works at 7-10 year IRRs, are the people that are investing (on the side) in these funds really going in with the long-term mindset? It remains to be seen…
5. Special Purpose Acquisition Companies (SPACs)
SPACs, along with Rolling Funds, are the new craze in investing. SPACs, or Special Purpose Acquisition Companies are just shell corporations that merge with private companies to take them public. They’re typically led by big sponsors with clout, e.g. Chamath or Bill Ackman. The reason is, when these shell companies list themselves, investors are buying into the capabilities of the sponsor and their teams. There is no operational business to buy into. Investors are betting on a Chamath or a Bill to get a strong operational business, like an Opendoor, to merge and IPO. And in doing so, investors get rewarded with warrant shares - an option (the right, but not the obligation) to buy more stock post-merger at a predetermined price, even if the value of the stock goes up (hence these warrant shares can become very valuable).
I’m nowhere near as bullish on SPACs as I am Rolling Funds. The major benefit for retail investors is that SPACs give access to initial listings, whereas traditional IPOs don’t. But companies like Primary Bid are starting to do this anyway. Investors also get to redeem their shares for the original buy-in price (net of IPO fees) if they don’t like the look of the business the sponsors bring to the table. But investors pay a heavy price for this.
Firstly, most of the SPAC listing costs (albeit smaller than IPOing an operational business) are born by the investors. Even if shares are redeemed (for example if investors don’t like the sponsor’s choice of company or if the 2 year life of the SPAC ends), investors still only get back shares net of listing fees.
Secondly, sponsors get founders shares or ‘promote shares’ at nominal prices. This is usually 20% of the value of the SPAC. This dilutes investor shares significantly. A paper by Harvard Law, called ‘A Sober Look at SPACs’, finds that the median dilution is 33%; i.e. for every $10 share, by the point of merger the cash is only worth $6.67.
Thirdly, you are again entering a bet. If all this democratisation stuff isn’t making you think that Vegas has entered the chat, maybe the next Bugsy Siegel will lead a SPAC and we’ll see it unfold in real time. But anyway, in this case, not only does the dealer take 20%, but almost 60% of the time, you’re likely to lose. See below for a graph of total SPACs that have failed (all those below buy-in price of $10 a share).
Source: FT
You’re also betting on a person. By buying shares in a blank cheque company, investors are literally just throwing cash at someone they supposedly trust. In most cases, they don’t know that sponsor personally. They are betting on one sponsor and their team. As can be seen above, most of these bets fail.
Finally, this supposed democratisation has led to a slew of shitty companies getting to IPO. One of which is Nikola. You can read more about Cyrus’ thoughts on the “car” company here. But the point is, these types of deals, even if they have well-intentioned and intelligent investors or sponsors, end up attracting cash-strapped and unstable businesses in need of rapid injections of capital. This reeks of risk. Downside risk.
V. Conclusion
Investing for the masses always needed to happen.
Tech is spearheading the proliferation of investment for all. But all paths toward democratisation are turbulent. The friction we’re currently experiencing could lead us down a dangerous route, unless we regulate better to stop bad actors from taking advantage.
But it’s also about education. More Average Joes are inevitably becoming financially literate and able to make more informed decisions with their money. YouTube, Twitter and social media in general are helping drive this. So I’m bullish on improved decision making by retail investors too.
The systemic risks associated with our investment decisions are also inevitable, and beyond the control of the layman. The dangers of money printers brrrring their way through an unprecedented crisis will rear their ugly heads down the line, but that doesn’t mean we can’t address these things today and mitigate eventual ruin.
For now it appears these assets are only returning more to the investor, but the writing is on the wall. With the cooperation of those who build these tools and better regulation from the powers that be, a proactive approach to disincentivising bad actors will emerge; and I genuinely believe the democratisation of investing emerges as a powerful force for good. Let’s hope no totalitarian Churchillians or fraudulent Siegels end up stealing the shine in the meantime.
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