Quants Scrape Reddit to Help Hedge Funds Dodge More Retail Pain

(Bloomberg) -- A list of the hottest stocks on Reddit and Robinhood may seem like a recipe for riches just now, but at Wolfe Research it’s quite the opposite: A list of shares to avoid.

After scraping Reddit boards and Robinhood data, Wolfe’s team of quants is telling institutional clients to avoid fighting this band of newbie day traders altogether. They say the retail army really is emerging as a disruptive show of force that makes both betting on and against their favored stocks a dangerous game for Wall Street players.

By using so-called natural language processing tools, the systematic shop mapped out the investing preferences of day traders who inflicted a historic hedge-fund short squeeze last week.

“It is probably wise not to short their favorite stocks,” researchers led by Yin Luo wrote in a note. “Given the highly speculative nature of the Reddit buzz signal and retail investor behavior in general, we recommend using retail participation as a risk factor instead of an alpha signal.”

That may prove timely advice for anyone considering a bet against GameStop Corp., the video game retailer at the center of the action last week whose shares were sliding on Monday.

At the same time, the smart money will find it hard to profit from the message-board crowd since there’s little systematic method in the speculative madness, the Wolfe team concludes.

With data from Reddit, Robinhood and an unnamed broker, it built a portfolio of retail favorites that has returned 84% over roughly the past year, beating an equally-weighted version of the Russell 3000 at 54%. Yet that stellar performance came with a gut-wrenching 38% drawdown and a one-way weekly turnover at 26% -- a kind of volatility that would put off most professionals.

Overall, day traders appear to love companies with low profitability in high-profile industries such as communication services and consumer discretionary.

But there are key differences between the Reddit and the Robinhood crew. For example, the former has a higher propensity to bet against hedge-fund favorites and to trade on momentum, which follows up-and-down price trends.

The Reddit portfolio has been increasingly driven by bets on specific stocks and sectors -- suggesting an idiosyncratic investing style that will make it hard for money managers to predict where the retail cash goes next.

“We expect continued and heightened volatility for these stocks,” the researchers wrote, referring to those heavily traded by individuals. “Unless managers have strong convictions, these stocks probably should be carefully watched on both long and short sides.”

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