| 10 March 2010

In didn’t take long for both firms, in their own way, to congregate the requisite critical mass of participants. Through its efforts on Facebook, MySpace and eventually on their own Web site, kaChing had gathered a massive 350,000 virtual portfolio managers. That number would climb to 400,000 by the end of last year. Now it was time to see what sort of business they could create.

In December of 2008 the kaChing team revealed a bit more of their playbook to the public. The company announced it had registered with the Securities and Exchange Commission and was prepared to start aggregating assets under management. Though it would be a year before they actually collected any assets and started trading portfolios, the clock was ticking and notice had been given.

Covestor, meanwhile, had organized a just-as-impressive group of 20,000 investors willing to share their actual trades with the public. In July of 2009 Covestor had an announcement of their own: the launch of Covestor Investment Management. The firm was the first to flip the asset management switch and at launch they had ten active managers that users could follow with real money.

Editors Note: This is the 2nd in a series of 6 articles we are publishing on the topic. Part one is located here.

Several months later, in October of 2009, kaChing announced it had gone live with its automated money management service; and the race was on. Through a series of orchestrated PR and marketing efforts kaChing was quickly able to aggregate upwards of $3 million in assets under management with half a dozen “genius” managers.

Here’s how it works – and it’s roughly the same for both organizations. Managers are qualified based on a criteria set by the company. That criterion usually includes some measure of risk, performance, and consistency that is more “investable” than lucky one-hit wonders. (We’ll talk more about the criteria they choose later.) These managers are then able to collect assets under management and charge a fee for their management services.

But to be clear, the assets are not gathered by the managers. Instead, they’re collected by kaChing and Covestor who serve as the fiduciary captains of the ship. It is kaChing and Covestor that handle all operational, customer service, suitability and account management issues. The funds are deposited with brokerage firms like Interactive Brokers, in the customer’s name, and then auto-traded by kaChing and Covestor, as a result of the managers’ trading decisions.

So the managers and “geniuses” in this sense are more like stock jockeys. Their job is simple: make trades. If they do well they are more likely to grow assets; and they collect a fee of anywhere from 1-3% of assets for those services, of which the firms, Covestor and kaChing, usually retain 75 basis points.

But if a young start-up wants to claim they’re changing the rules of investing then they have to establish which rules they’re referring to. In other words, who, in our story, is the enemy? In this case both kaChing and Covestor have chosen the same dragon to slay: actively managed mutual funds.

Mutual funds – not all, but especially actively managed mutual funds – are expensive. Not only that they have poor performance, Mr. Veingard told us, and it’s an industry that hasn’t yet been disintermediated; meaning there was plenty of opportunity to improve on the whole process.

If Mr. Veingard’s swordplay was subtle, kaChing’s Carroll was much more direct: “We’re going after the $7 trillion in equity mutual funds with an annual turnover of $800 billion,” he told us.

Okay, we get it. Mutual funds are a big target and of course any good business plan shows massive market opportunity. But what is it, specifically, about actively managed mutual funds that make them the right target?

In our conversations with leaders at kaChing and Covestor, there were three things that were consistently brought up to us as big problems with mutual funds: costs, transparency and performance.

Now that the stage is set, next we dive deep into costs and find out whether kaChing and Covestor are able to innovate on the cost problem. To see part three click here.

Editor’s note: this is the second in a series of six articles. The first article is available here.