University of Arkansas, Fayetteville ScholarWorks@UARK Finance Undergraduate Honors Theses Finance 5-2021 The Evolution of Investing Bradyn Papke Follow this and additional works at: https://scholarworks.uark.edu/finnuht Part of the Finance and Financial Management Commons Citation Papke, B. (2021). The Evolution of Investing. Finance Undergraduate Honors Theses Retrieved from https://scholarworks.uark.edu/finnuht/62 This Thesis is brought to you for free and open access by the Finance at ScholarWorks@UARK. It has been accepted for inclusion in Finance Undergraduate Honors Theses by an authorized administrator of ScholarWorks@UARK. For more information, please contact [email protected]. The Evolution of Investing by Bradyn David Papke Advisor: Dr. Thomas Hayes An Honors Thesis in partial fulfillment of the requirements for the degree Bachelor of Science in Business Administration in Finance Sam M. Walton College of Business University of Arkansas Fayetteville, Arkansas May 7, 2021 1 Introduction We live in a world that is constantly changing. The world of business is no different. The name of the game is innovation. How can companies innovate to stay relevant in the minds of their consumers while also remaining profitable? The investment industry has seen one of the biggest evolutions this century. If someone were asked what the investment industry looked like 15-20 years ago, their response would most likely depict a trading floor, lots of yelling and screaming, money-hungry brokers, and complicated numbers and symbols on a bunch of screens that they do not even want to try to understand. Technology and the idea of Corporate Social Responsibility has vastly changed that view. Today, nearly every company that is involved with financial markets has completely re- wired the way they do business. Advancements in financial technology, or “FinTech”, along with a general movement into online business and interaction, have made finance and investing more palatable for the general public. An example of a company that has taken this industry by storm is Robinhood. The creators of this multi-million-dollar company desperately wanted to simplify stock trading and make it for everyone. Even in their mission it says, “we’re on a mission to democratize finance for all.” For the longest time, the finance industry was only for those who could understand the complicated terminology and intricate trading algorithms. Companies like Robinhood have made investing simple, interesting, and profitable for people of all ages, no matter their income level or financial background. With the emergence of companies like Robinhood, the big banks have created their own versions of simplified trading to accommodate their customers and to keep up with the competition. One example that will be looked at in-depth is Bank of America’s Merrill Edge trading platform. Big banks have realized that they can no longer simply sit back and trust that their traditional investing strategies will generate the same level of customer satisfaction. With the creation of the Merrill Edge trading platform, Bank of America Merrill Lynch (BoAML) can extend their reach as a company into new target markets including lower income households and beginner traders. The concept of free trading, once thought to be new age thinking, has turned into an expectation in stock trading and has now transformed even the most traditional of financial organizations into believers. Accompanying the dramatic shift to FinTech and online banking, impact investing, or ESG investing, has become very prominent with financial advisors and their clients. ESG investing stands for Environmental, Social, Governance. Simply put, this is a move in the investment industry to companies that promote both financial returns as well as overall impact on the world. More so than ever before, people seem to value social responsibility. Whether that be reducing their carbon footprint, standing up against injustice, or giving philanthropically, individuals desperately want to make this world a better place to live. That belief has now translated into investing. The world looks at the companies they make their purchases from and demand more. Companies cannot get away with just appealing to a certain target market. They now have to focus on the bigger picture and stand for something bigger than themselves in order to stay relevant with their consumers. Businesses are now expected to be the leaders in driving change environmentally, socially, and in our governments. All in all, investing has gone through a massive transformation in the past 20 years. The world is innovating and changing at a rate that has never been seen before. Shifts to online banking and investing, big banks changing traditional business models, and investors caring more about global impact, have led to the democratization of financial markets. In this paper, we will look into how the everyday investor has changed because of the emergence of these online 2 trading platforms and apps, the business models of these companies, and the ESG or impact investing strategies that so many financial advisors are implementing with their clients, all in an attempt to reveal the evolution taking place in the investment industry. Robinhood Background and Business Model Robinhood is one of the pioneers of the trading app industry. Companies like E-Trade, TD Ameritrade, and Schwab have had online trading platforms dating back to the 1990s, so this industry has been around for some time. However, the stigma surrounding these companies was, in my own words, “it takes money to make money.” Therefore, the younger generations, the lower income individuals, and beginner traders were left out of the early stages of online trading and investing. Insert Robinhood. The idea of Robinhood came to two Stanford grads, Vlad Tenev and Baiju Bhatt, who were great friends and roommates in Palo Alto. The two moved to New York upon graduation and started two finance companies, selling trading software to hedge funds. Throughout the course of business with these hedge funds, Vlad and Baiju realized that these big trading companies pay effectively zero to trade, while regular Americans must pay commission on every trade they make. Rather than building software to add wealth to the wealthy, the two friends left New York to go back to California to begin “building products that would provide everyone with access to the financial markets” (Robinhood, 2021). Their mission became one of the now coined phrases in the FinTech industry, “to democratize finance for all.” Figure 1 below simply shows the massive amount of growth that has taken place in all companies with online trading in the past year. As you can see, Robinhood’s growth is nearly double the amount of the next closest competitor. Figure 1 As far as revenue goes, Robinhood makes money on their trading platform through various ways. Zero commissions on trading is a great way to attract people to your platform, but money still must be made to operate. So how do they do it? The majority of Robinhood’s revenue comes from the following: Rebates, Robinhood Gold, Stock loans, income generated cash, and Cash Management. First, let us dive into their largest source of revenue, rebates. 3 From the start, Robinhood placed the majority of their revenue burden on rebates, or payment for order flow (PFOF). In Q1 of 2020, Robinhood raked in 70% of their revenue from PFOF. Essentially, instead of taking a commission at the point of sale from the customer, Robinhood sells their trades to market-makers and charges them a percentage of the spread on every trade. These market-makers then execute the best possible trade with their sophisticated algorithmic models and try to shave a little off the bid or ask price to make a profit themselves. To simplify, these “market makers” pay Robinhood to be able to execute customer trades. This practice is considered very controversial because of its lack of transparency. Some other ways this tech giant makes money are Robinhood Gold, stock loans, and income generated cash. Robinhood Gold is their premium app subscription model, offering “a suite of powerful investing tools” not offered to regular users. The added benefits include, Morningstar research reports, NASDAQ market data, bigger instant deposits, and margin investing. The stock loan option is like a bank except with securities. An individual can borrow money from Robinhood Securities to purchase stocks on margin. They then will have to repay Robinhood with added interest until they can pay off the loan. Lastly, also like a bank, Robinhood makes money off the cash deposited by customers. Instead of letting that money sit there on their platform, Robinhood places a large majority of outstanding cash in interest-bearing bank accounts to earn some form of compensation for holding your money. The final major source of Robinhood’s income is their Cash Management debit card. This card earns .30% APY, gives customers the benefit of no fees at over 75,000 ATMs, and offers direct deposit and virtual usage of the card anywhere Mastercard is accepted worldwide. As with any credit card company, Robinhood earns money from interchange fees. These fees are paid to the card company for processing funds from the customer’s bank to the merchant’s bank. For credit cards, this fee is around 1.81%, but for debit cards it is only around 0.3% per transaction. Figure 2 below shows a percentage breakdown of Robinhood’s larger revenue sources. As you can see, PFOF carries a large portion of the weight for revenue streams. Figure 2 Robinhood has paved the way for zero commission trading platforms. When asked about their business model, Vlad and Baiju say they cater their tech-savvy platform to the younger generation. From personal experience with the app, it is simple, free, and addicting. Stories of young millionaires’ day-trading penny stocks on Robinhood fuel many Millennial and Gen Z- er’s dream of getting rich quick.