We live in a golden age of retail trading. Technology-driven innovation has spawned mobile-first trading apps with no commission and no minimum investment. Fueled by the pandemic zeitgeist, retail traders surged from 10.1% of U.S. equity volume in 2010 to more than 25% in 2020. As a group, retail traders are second only to high-frequency market makers, but are now ahead of quantitative investors (15.9%), hedge funds (9%) or bank-affiliated traders (5.8%).
A profound shift in investor composition is bound to have a far-reaching impact on markets. In a new paper with Charles Martineau, we investigate the impact of the retail trading surge on the flow of information in financial markets.
The data: Retail volume drives analyst coverage, but less so in 2020
We find that, between 2014 and 2019, analyst coverage is strongly correlated with retail trading volumes — even after controlling for factors such as market capitalization, investor attention, industry, institutional ownership. Analyst coverage is particularly clustered in stocks with large retail volumes: There is a coverage gap of two analyst reports between the average high-retail (Q5) and the average low-retail (Q1) stock — a large effect, considering that the median U.S. stocks only receives two analyst reports on average in a given quarter.
The pattern changes suddenly in 2020. Analyst coverage becomes more evenly distributed in the cross-section of stocks. The driving force of the effect is that stocks with relatively low retail volumes (Q1) attract significantly more coverage in 2020 relative to previous years.
A model: Retail flow allows institutions to reduce price impact
How to explain the result, particularly since analyst reports are targeted toward institutional, rather than retail investors? To make sense of a data, we build a model of the market, complete with analysts, institutional investors, and retail investors.
A useful intuition is that, in regular times, retail order flow is a scarce resource. Analyst reports are relatively more valuable in high-retail rather than low-retail stocks, since institutional investors can “camouflage” their orders and trade more aggressively on signals without incurring significant price impact. Therefore, funds and banks are willing to pay more for reports in stocks with large retail following, and analysts simply respond to the demand.
Coverage clustering emerges when analyst incentives to “chase” retail volume are stronger than competitive forces. That is, analysts find it optimal to cover the same retail-heavy stocks as their peers and capture a fraction of the order flow, rather than covering the low-retail stock and establishing a monopoly over its institutional volume. The rationale is that institutional volume in the low-retail stock is likely to be low despite better coverage, since information cannot be traded on without significant price impact.
What happens when retail trading surges across the market? Well, if the supply of a scarce resource increases, its price drops: retail volumes become less valuable. Since retail order flow is abundant, institutional traders are able to trade more aggressively on their signals everywhere. Therefore, the demand for information in retail-heavy stocks become weaker, and analysts can differentiate their coverage choices without sacrificing institutional order flow. In the data, that would amount to a surge in coverage for previously neglected stocks — exactly what we observe.
The bigger picture
Why do we think a more “balanced” coverage across stocks is better for markets? The impact of a skewed information supply is not always benign: greater analyst coverage is often associated with a lower financing cost which can lead to a re-allocation of capital in the economy. In other words, large companies can grow faster — which is not very good for innovation in the economy. A more uniform information supply allows smaller, previously neglected companies to raise capital cheaper and have a stronger voice in the economy — a very valuable side effect of improving market access for retail traders.
Full research paper is available [here]