| 09 March 2010

If there’s a consistent refrain among new start-ups in the financial space it’s that they are going to “change the rules of investing.” We suppose that when an industry is as insular and broken as, say, the mutual fund industry, challengers are bound to line up.

We’ve watched “game-changing” firms pop up over the years – perhaps going all the way back to Financial Engines, which is now all grown up and planning its own IPO. We’ve seen firms like Marketocracy and Cake Financial (which was recently shut down) all trying to reinvent either the process by which we choose mutual funds in our retirement accounts or reinventing the mutual fund itself.

Editors Note: This is the first in a series of six articles we are publishing on the topic.

Game-changing concepts always sound great in theory. But rarely do things pan out for these firms – at least not the way they expected.

Financial Engines is a success because they stopped selling individual subscriptions to their “black box” advice tool and instead focused on selling services to 401(k) providers.

The MetaMarkets fund, which billed itself as a web-centric investment manager and online investment discussion community, solicited trades from the “herd,” as it were, and shared the detail behind each trading decision. While the fund shot up 44% during its first few months, it subsequently fell 70% and closed in 2001.

Editor's Note: We originally mistook the MetaMarkets fund for the Marketocracy Master's 100 fund. In terms of performance, The Marketocracy Masters 100 fund has been rated 5 stars by Morningstar twice in the last eight years and in two different categories and is ahead of the S&P 500 since inception. See comments below.

While the Marketocracy fund has performed well in certain years, it has struggled to maintain assets. The Marketocracy Master 100 fund buys and sells stocks based on the best-performing trades of a pool of 20,000 members. The idea was to tap into the wisdom of the crowds directly and benefit from their collective expertise. It worked well at the outset, gaining 42% in 2003 and amassing upwards of $44 million in assets under management by 2007.

But then things leveled off and the fund eventually took a big 45% hit in 2008. Over the last three years the fund has performed worse than 90% of its peers, losing 12% over the course of those three years, according to Morningstar (MORN). The fund’s assets under management have dropped to $18.3 million.

Now, however, there are two new “game-changing” challengers we’re watching with intense curiosity: kaChing and Covestor. Though their paths are quite different, both firms made a splash in the space with various claims of transparency, low costs and improved performance. And they are both claiming that their efforts will, you guessed it, change the rules of investing.

KaChing was introduced as “a radically new way for individuals to invest in the stock market,” and a “compelling alternative to mutual funds,” in various company releases. “Covestor Plans Internet Revolution,” insists a Financial Times headline. “Covestor Investment Management Threatens the $16 Trillion Mutual Fund Industry,” claims the company in its own press release.

This is a story about kaChing and Covestor and their attempts to change the way we invest. But it’s also a story about the problems we face in the financial services industry in general. Whether these firms succeed or fail, they have already established that they alone have the gumption to stand up to an undoubtedly broken and troubled system.

So we were delighted to have the chance to interview the co-founder of kaChing, Dan Carroll, and the Co-Founder of Covestor, Simon Veingard. We also had a chance to ask Jeff Borack a few questions. Jeff is not only a certified kaChing “genius” but also one of the (very) few to rise up out of the general populace to prove himself as a successful stock picker.

What follows is our take on the matter – which we have chosen to publish as a series of articles. But to be clear this is not a review of either product. We like both companies (honest!) and we think each has something terrific to offer. We do think, however, that their very existence – as well as their successes, changes and troubles – raises very interesting questions about the state of financial services today.

It’s those questions that really interest us.


Part 1: Make a Case

As is often the case with stories like this, we start with someone wondering if there’s a better way. Andy Rachleff, co-founder of the hallmark venture capital firm Benchmark Capital, had such a moment. “As a member of the University of Pennsylvania endowment investment committee and a frequent investor in Hedge Funds,” said Rachleff, “I was convinced that individual investors were not offered the best opportunities to invest their money.”

Dan Carroll, an active investor in his own right, wanted to challenge other investors to publish their performance. Perhaps, he thought, there might be an active community of investors willing to share their approach – and an equally active community willing to follow their advice. And so Rachleff and Carroll joined forces to become co-founders of kaChing. Rachleff and famed Internet pioneer Mark Andreessen were among the firm’s first angel investors.

The kaChing experiment – and after all, it is an experiment – got its start as a Facebook application in 2007. There, happy Facebook users could create virtual portfolios with real stock picks that kaChing would execute.

Such “paper trading” applications are not new. Brokerages like optionsXpress (OXPS) have used these virtual trading applications to encourage account holders to practice more sophisticated trading techniques. They’ve also been used by brokers as a way to generate leads for new accounts, and trading simulators serve as the backbone for stock market games, such as CNBC’s Million Dollar Portfolio Challenge.

What kaChing had going for it was that this was the first such application born in a Web 2.0 social environment. The application had interactivity in its DNA and encouraged it as part of the investing process; and it generated quite a following. (Facebook currently shows just over 26,000 monthly active users on the app page. I’m sure kaChing would claim many more.)

"It makes total sense to apply the open source approach to a business other than software,” said Marc Andreessen, who also serves as an advisor to kaChing. “Finance is a perfect example – kaChing will surface all kinds of financial market information and insight that you'd normally never get to see."

Market efficiency experts would probably disagree with that statement. Or at least, they would argue, whatever insight kaChing may surface, well, they’re likely already built into a stock’s price.

But if Andreessen is not a student of efficient theory, he is arguably the master of social networks. As such, his voice counts. “When I was approached by Dan,” Andreessen continues, “I knew that he had the right idea to use a social networking platform and that by combining it with an ‘Open Source’ business and technology approach, we would create the first open and transparent investment environment where everyone has the opportunity to earn superior investment returns.”

While it’s great to think that everyone will have the opportunity to earn superior investment returns, as we will soon see, the reality is that few actually enjoy them. But first, let’s introduce our second platform.

Covestor took a slightly different approach to the problem of reengineering investing. The company was started in 2005 following a similar “better way” moment from Simon Veingard. “We didn’t believe that investment talent was necessarily all on Wall Street,” he told us.

Rather than sharing virtual portfolios, the team at Covestor wanted to see if individuals would be willing to share their actual portfolios with the world – flipping the switch, as it were, on their otherwise private performance. Once signed up for the service you can hide your real name and you can fudge the total dollars invested, but all of your actual trades are there for the world to see. (In fact, in most cases trades are simply automatically imported from your broker.)

The firm was launched with backing from Union Square Ventures, Spark Capital and Amadeus Capital Partners. After a series of behind-the-scenes tests and experimental portfolios they were ready to launch Covestor.com in 2007 without knowing, really, if anyone would be willing to publish their portfolios.

“If you wanted to participate,” said Mr. Veingard, “you really had to open the kimono and show us your brokerage account.” And open they did. Mr. Veingard said they were all surprised at the willingness of these investors to share their information.

With the idea officially born, it was time to execute. To see how each company launched their products and quickly evolved, read part two.