Why Wall Street is Not Rigged

The rise of GameStop and others has been as an anti-Wall Street protest. But while the organisers are annoying, the game is not crooked, says Morningstar columnist John Rekenthaler

John Rekenthaler 5 February, 2021 | 10:08AM
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Wall Street

Underlying GameStop’s (GME) rally, as well as those of other fashionable purchases, including Tesla (TSLA), Bitcoin, and Peloton (PTON), is the belief that Wall Street is rigged against common investors. For various reasons, these assets are viewed as being outside the system. They appeal to those who wish to tear down the house.

Funds Are Fine

For those of us who have spent our careers following mutual funds, the sentiment is difficult to understand. Mutual funds and their younger siblings, exchange-traded funds (ETFs), are thoroughly populist investments. Their performances are comparably calculated; their portfolios publicly posted; and their costs uniformly assessed. All investors within a given share class receive the same treatment.

As a result, fund shareholders typically receive what they expect: a portfolio that reliably tracks an investment marketplace. This statement obviously describes index funds; for example, Vanguard 500 Index (VFINX) gained 13.72% annualised for the decade ended Decemeber, 31, 2020, as opposed to 13.88% for the benchmark itself. But it also holds for most actively managed funds, especially the larger ones, which tend not to stray far from the index’s performance.

Matching the overall marketplace, by definition, is not losing a rigged game. Nor is lacking the opportunity to own hedge funds. The 10-year return for Eurekahedge Hedge Fund Index, through Decemeber 31, 2020, was 5.2% annualised. That performance not only sharply trails that of Vanguard 500 Index, but it also lags the result for each of the company’s target-date funds.

Quite literally, an employee who doesn’t even realise he has a pension - that is, one who was defaulted into a Vanguard target-date fund upon joining the company and who never checked the paperwork to realise contributions were coming out of his salary each month - would have earned higher profits over the past decade than the typical hedge fund investor. How is that drawing the short end of the investment stick?

Equities, Too

Those who invest in stocks directly also fare well. Thirty years ago, retail brokerage commissions were well above those paid by institutional investors. Today, those commissions either are often explicitly free, as with Robinhood, or almost free. The barrier that commissions once placed between retail and institutional investors has been removed.

What’s more, everyday investors often pay lower spreads on their stock trades than do the institutions. This occurs because market makers would rather conduct many small trades, which tend to cancel each other out, than a few big trades, which might skew in one direction. Besides, large bettors might know something that market makers do not. For these reasons, market makers will frequently reduce their prices for retail transactions, to entice brokers to send those orders.

(The same logic applies to bookmakers who accept sports bets. Better to receive 1 million wagers of £10 than 10 wagers of £1 million each.)

Finally, information for retail stock investors has never been more freely available, thanks to advancements in technology and communications. Nor has trading ever been so accessible. No longer must retail investors await stale copies of printed research reports that circulated through Wall Street days ago, or telephone their requests for stock trades. Review an electronic feed here, open a page there, click, and be done. As the professionals do.

In short (so to speak), it is not true that Wall Streeters receive the cream of the investment crop while others are stuck with the remains. Anybody with £1,000 to spare could have turned a 260% profit over the past decade by buying a US stock index mutual fund. Such a profit would have exceeded that earned by most Wall Street professionals. The investment party truly is for everybody.

Bad Behaviour

However, there’s no question that Wall Street’s business practices are often distasteful. The unholy arrangement between the investment bankers who repackaged leaky mortgages before the global financial crisis and the ratings agencies who obediently certified those securities as being investment-grade cannot be justified. (Note: Morningstar has since become a Nationally Recognised Statistical Ratings Organization itself after those events.) Nor can one defend revenue-sharing agreements between funds and brokerage platforms.

The animus toward hedge funds is also understandable. By design, hedge funds operate in near secrecy and do not accept ordinary investors. Employees who refuse to talk their peers, while also excluding them from their social circles, are likely to be roundly detested by their coworkers. It is therefore no surprise that hedge funds are deeply unpopular with the public. 

A recently cited example of bad behaviour was when several discount brokers, including Robinhood, halted trading in GameStop. Some suggested that this widely unpopular action was done to appease the demands of hedge fund managers. The preliminary evidence suggests otherwise; the decision appears to have been triggered by regulatory requirements.

However, there is a difference between disliking Wall Street--or at least, disapproving of the favours it receives--and criticising the integrity of the investment process. The former is certainly acceptable. The latter, though, is a step too far. What’s more, such claims harm those who have not yet invested, by dissuading them from doing so. The vitriol punishes the less fortunate.

 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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John Rekenthaler

John Rekenthaler  John Rekenthaler is vice president of research for Morningstar.