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From WSJDN
The New Pied Pipers of Wall Street
When Ralph Risch assembled his investment team, he did everything by the book. He studied the strategies of each candidate, took a close look at their track records, and tried to find just the right mix of safe and aggressive stock pickers.
It took a while, but he finally found some hotshots to run a chunk of his money: One owns a catering company, another runs a web-casting firm, and a third is an Air Force officer stationed in Germany who uses a strategy that seeks to “eliminate emotion from the equation.” What they had in common were solid stock- picking records—just as impressive to Mr. Risch as those of the pros, if not more so. In fact, Mr. Risch was so confident in his team that he opened a brokerage account that automatically copies their trades.
The result so far? The team isn’t exactly hitting home runs yet: He was recently up about 4% since opening the account in October and dropped the military officer to cut his risk. But he’s sticking with it. “You can learn a lot by watching what other people are doing,” says the 43-year-old father of three from Portland, Ore.
Who needs a stock broker or mutual fund when you can take on the big shots at their own game? A growing number of investors are casting their lot not with Wall Street’s giants but with the small-time stock pickers on Main Street.
Covestor.com, the site that Mr. Risch uses, has grown from a handful of registered users to more than 27,000 since it launched in 2007. Another upstart, kaChing.com, says it has attracted more than $6 million from clients who follow its “geniuses”—seasoned pros plus a handful of individual investors who have racked up exceptional records verified by the site. Those individuals include a former chemist, a health-care industry worker and a college student who caught the investing bug after watching the Oliver Stone movie Wall Street (and who is up more than threefold in the past year).
Internet brokers such as Zecco and TradeKing have also joined the party, hosting online communities where thousands of account holders post their portfolios, banter about stocks and follow each other’s picks. “It’s really catching fire,” says TradeKing CEO Don Montanaro.
Of course, it’s one thing to play Xbox games online with a college kid across the country; investing with strangers is another matter. Mr. Risch, for one, has never met the folks who trade on his behalf. While he reads their blogs and strategies, he has no idea when they might, say, take a flier on a high-risk stock. And he isn’t sure how his portfolio will perform if the markets take a dive. Though many of the managers have disclosed their track records going back at least a year, what they’ll buy or sell next is anyone’s guess. “It’s an experiment,” Mr. Risch concedes.
And it’s not always a cheap one. Fees for most managers on Covestor average $98 a year for each $10,000 invested, but managers charge up to 2.3% for the more actively traded portfolios. That doesn’t include trading commissions that clients pay separately. KaChing’s fees average 1.25% before commissions, and it has some managers who charge more than 2%. That compares with the fund industry’s average expenses of 1.4% for actively managed domestic stock funds. KaChing CEO Andy Rachleff says the fees aren’t high when you factor in other expenses, such as marketing fees and sales charges that can jack up the costs of mutual funds. Covestor CEO Perry Blacher adds, “There are no hidden fees, no middlemen, no Wall Street conflicts of interest.”
Folks have traded stock tips over cocktails since the days when an old-fashioned was invented, in the late 19th century, and investment clubs have been around in the U.S. at least since then. Today about 7,000 clubs meet to discuss stock ideas, pool their resources and try to beat the market. With the new tools of social networking, though, much of the activity is moving online, opening up the experience to anyone with an Internet connection.
Companies are increasingly trying to profit off the trend. Covestor and kaChing get a cut of the management fees that clients pay to have automatic trading in their accounts (though on both sites you can also follow other investors for free and make the trades yourself). Online brokers such as TradeKing say their virtual communities help them save money on customer service because investors often answer one another’s questions. Plus, clients active in the forums may be more inclined to trade—and pay commissions. Zecco CEO Michael Raneri says he can’t prove that the social features boost trading revenue but says people have “better ideas” for trades and may then act on them.
The social-finance sites are also attracting some pros aiming to expand their investment-advisory business. Most advisers work locally and often don’t accept clients with less than $250,000, putting them out of reach for many. On Covestor and kaChing, some managers are using the sites to attract and sign up clients around the country. The minimum investment is just $3,000 for kaChing and $10,000 for Covestor. KaChing, initially open to amateurs and small-time pros, is now focusing on professional managers. “If you have a fantastic record, you’re likely to attract new assets,” says kaChing CEO Rachleff.
Of course, even a dart thrower aiming at a stock table can crush the market for a year or two. Few of the managers on Covestor can point to track records of five or 10 years, with brokerage statements to back up their returns. Investors on kaChing have acquired genius status in the past with as little as 12 months of returns trading a virtual portfolio, though the firm now requires those who aren’t already registered advisers to pass a regulatory exam. And it’s practically impossible to determine whether such short-term gains are a result of luck or skill, says Dartmouth finance professor Kenneth French, an expert on stock and fund performance. “If you’re doing it for entertainment, that’s fine,” he says. “But the idea that you could identify skill in two years of performance is simply absurd.”
Another potential pitfall: stock manipulation. The “model managers” whose trades can be automatically followed by other investors on Covestor must disclose their other brokerage accounts and agree to audits of their trading activity. But the amateur managers aren’t regulated by the Securities and Exchange Commission or the Financial Industry Regulatory Authority. Instead, they’re considered publishers of financial data, and they can buy or sell whatever stocks they like, within the site’s liquidity and market-cap guidelines. There are also other investors who post trades and comment on stocks, and they could talk up a small, thinly traded stock and then sell it after other investors have piled in. Covestor CEO Blacher says his site monitors comments to make sure no one is blatantly shilling for a stock and adds that investors have been kicked off for infractions such as “inappropriate commentary.”
To help guard against unscrupulous traders out to make a quick buck, both sites restrict the types of stocks their managers can hold. KaChing doesn’t allow penny stocks and limits a manager (and his followers) to trading 10% or less of a stock’s average daily volume. To guard against stock manipulation, Covestor allows only stocks that trade at least 10,000 shares a day and have a market capitalization of more than $50 million. Still, even those restrictions could leave the door open for thinly traded stocks whose prices could still be influenced. And while registered advisers are required by law to act in their clients’ best interests, there are no such restrictions on amateurs posting their trades and making money from other folks who follow their models.
Online brokers are finding ways to tap the social-finance craze. E-Trade owns a virtual-trading site called ClearStation.com, which has around 50,000 “ClearHeads” who post virtual portfolios, rate one another’s performance and swap stock ideas.TD Ameritrade has taken the idea a step further, with a trading platform called MyTrade, part of its purchase of brokerage firm ThinkorSwim. Account owners trade tips, track one another’s real trades, dish on strategies in chat rooms and send private messages. And TD Ameritrade plans to integrate the features into its own trading site. “We’ll be playing on a much bigger dance floor,” predicts Tom Preston, a cofounder of ThinkorSwim.
The sites are also luring investors seeking alternatives to traditional mutual funds and asset managers. Nathan Brown, an investor in Allen, Texas, put $300,000 in a brokerage account that auto-trades with Covestor managers. He says his portfolio has gained 18% since October, ahead of the overall market. Mr. Brown, 33, says he likes the “trader feeling” he gets through following his Covestor managers. He likes seeing their rationale for trades, and he can drop a manager or switch to one taking more or less risk with a few mouse clicks.
One stock picker he’s following is Timothy Sykes, who is among the most popular on Covestor. Mr. Sykes is a high-energy New Yorker who says that, as a college student, he turned his $12,415 in bar mitzvah money into a $1.64 million fortune in four years. He’s also an entrepreneurial machine who wrote a book, runs a Web site, makes instructional DVDs (deluxe set: $697) and offers personal coaching ($3,297 a pop) on his trading techniques. Mr. Sykes frequently shows up at the top of the Covestor rankings and has more than 6,000 followers. But the number that stood out recently was this: a 369,255% total return since he started on Covestor in November 2007.
Yet Mr. Sykes says this figure isn’t realistic. Covestor doesn’t factor in cash that may be held in an account: If Mr. Sykes puts 20% of his portfolio in a stock, Covestor calculates the returns as if he went “all in,” skewing the data. Including cash, Mr. Sykes was recently up 194%, still handily beating the market. But his strategy doesn’t translate well to automatic trading because Mr. Sykes says he often buys and sells stocks that don’t meet the liquidity and market-cap requirements for Covestor accounts; many of his trades get filtered out or can’t be replicated. Covestor CEO Blacher acknowledges that the posted number is not the return that Mr. Sykes himself achieved. The result is returns for his automatic-trading portfolio aren’t nearly as impressive: It was recently up 30% since he started it in April 2009, slightly behind the S&P 500. “I’m not an investment manager,” he says. “I do this for entertainment and informational purposes only.”
From the May issue of SmartMoney magazine.
