The pandemic turbocharged the financial trading industry

We continue building out of theme baskets and the next one will be on semiconductors and rare earth minerals as the semiconductor shortage will stay with the world for another couple of years according to a recent interview with Intel CEO Gelsinger. Besides the current supply bottlenecks, the semiconductor theme is a great long-term investment theme for investors as it plays into the digitalization of the world economy and eventually the IoT (Internet-of-things) theme putting the physical world on the Internet.

The main question is whether the good times can continue. With people returning to their offices as economies reopen, and volatility comes down it is difficult to see the industry continuing at the same high growth. The last year’s momentum will also most likely not continue and that in itself will make it more difficult for many retail investors and thus reduce growth.

The key events to follow for this theme basket are the upcoming IPOs of Robinhood Markets and eToro which are two giants in the retail brokerage industry, and then of course rising inflation as it could cause significant trading activity in bonds increasing profitability of institutional brokerage firms.

Can market makers offer long volatility exposure?

In our 100-year portfolio, which is designed to weather many different economic and financial seasons, we allocate 5% of the portfolio to long volatility components as this exposure is only type that can mitigate highly correlated market sell-offs. The typically way of adding long volatility components is through either long out-of-the-money puts on the equity markets or long VIX futures (around mid on the forward curve), but both implementations come with negative carry.

One way to mitigate this, is buying looking at market-makers such as Virtu Financial and Flow Traders. Bid-offer spreads widen dramatically during steep selloffs, as we observed during the pandemic led sell-off in 2020, which increases the profitability of market-making operations. Flow Traders increased its net income 9x in 2020 from the year before. As the regression of Virtu Financial and S&P 500 below shows, the raw beta (sensitivity to the equity market) is 0.07 on weekly observations the past five years. It is also notably that Virtu’s share price goes up during the market selloffs in early 2018, and then again in late 2018 during the Fed’s policy mistake, and then again during the pandemic selloff in 2020.

Key risks

Investing in the financial trading industry is not without small risks. The industry is known for experiencing dramatic tail-risk events with some recent ones being the Great Financial Crisis, euro area crisis, the recent blow-up of Archegos Capital Management, Knight Capital Group, and the Swiss unpeg hitting many retail brokerage firms. These events can cause large sudden declines in financial trading firms and something investors should consider. Financial trading companies are also trading at high valuations driven by the strong recent demand and that could lower future returns for shareholders. Trading is driven by volatility in financial markets and in 2021 there are already many signs that volatility is coming back to its low levels prior to the pandemic. This could suppress trading activity. The biggest risk to the industry is another major 50% drawdown in equities like that post the dot-com bubble and the Great Financial Crisis, as it pushes investors and traders out of the industry for a long time lowering future growth in volume and profits.

Previous notes on equity themes:

The commodity sector and the reflation trade in 2021

Bubble stocks go into ‘hyperdrive’ mode

Introducing Next Generation Medicine basket

Updating our Green Transformation theme basket

Launching Saxo’s E-commerce theme basket as more growth lies ahead

Be careful of bubble stocks and updating bubble methodology

Gaming is a long-term winning industry

Black energy takes the lead as green transformation stocks turn negative

Is the market getting too excited about travel stocks?

India has tremendous upside in the 21st century

It takes $300bn to join the mega cap club

Green transformation will drive high growth in batteries

China's future sits in the consumer and technology sectors

Has crypto industry crossed the Rubicon? Launching crypto theme basket