| 11 March 2010

It was clear to us in our conversations with the founders of kaChing and Covestor that they saw a huge opportunity to improve on many aspects of financial services. But there were three specific things they all consistently identified as big problems, ready for innovation: costs, transparency and performance. Today we take on costs.

Editor's note: we received a response to this article from kaChing's CEO, Andy Rachleff. It is located at the bottom of this post.

KaChing in particular hangs a big hat on the cost and fees issues. (Covestor makes a point, but keeps it subtle.) KaChing has a page devoted to explaining to you just how much your mutual fund is charging you compared with the average fee you might expect from a kaChing relationship. In this effort kaChing offers one of the better, more helpful discussions of some of the exorbitant fees that we’ve seen. We applaud the group for outlining fees which are either completely hidden or, at best, are difficult to understand. Marketing fees, load commissions and even trading costs are often overlooked marauders that create a large suck on even the best funds.

However, we must point out that kaChing is not the only dragon slayer on a campaign to attack fund fees head-on. While some funds stick to old models (particularly those actively managed funds and target-date funds often used in 401k plans), other fund families have been relying on that very same low-fee argument to drive assets for years.

Editor's Note: This is the third in a series of six installments. Part one is located here. Part two is located here.

Vanguard, for example, is so committed to low fees that its founder, a gentleman you may have heard of named John Bogle, testified to congress in 2003 (PDF) on this very issue, urging representatives to consider fee reform.

Vanguard funds, we should point out, typically run in the 0.15% range for fees, all-in. The big difference is active versus passive management. But study after study shows that indexed funds generally outperform the more expensive actively managed funds. (Yeah, we thought you’d ask, so here’s one.) (PDF)

In another example, Charles Schwab (SCHW) charges exceedingly low fees on some of its new Schwab-branded Exchange-Trade Funds. We’re talking fees as low as eight basis points all-in. Schwab’s large-cap ETF (SCHX), for example, charges a management fee of eight basis points with no loads, no 12b-1 fees and not even a commission to trade for Schwab clients. (They do charge a premium of around 0.04% for new buyers – which brings them about even with the Vanguard’s of the world.)

So what is it that’s getting reinvented here, anyway? When we surveyed kaChing’s site, fees varied from 0.975% on the low end to 3.00% on the high end, though most geniuses seem to be settling in on a 1% fee on average. This fee doesn’t include trading commissions, which run $0.02 per share traded if you use Interactive Brokers (IBKR). KaChing says this pushes their average to 1.42%. Similarly, Covestor charges management fees of 0.05% to 1.5%, not including trade commissions.

But the discussion does not end there. KaChing, sensing the challenge from naysayers, funded a study by Lipper to look into the cost issue a bit further. Lipper found that investors in actively managed mutual funds paid an average of 3.27% in fees. This is highway robbery, no doubt. But the claim ignores a lot of extenuating circumstances. For example, most of the more expensive actively managed funds are sold in highly restrictive 401(k) accounts. In other words, they’re offered to people who don’t have a choice. That is definitely a dragon we’d like to slay, but we would argue it’s an entirely different problem solved in an entirely different manner. (As we write this, neither firm allows you to mirror trades in your retirement account.)

While it’s true that there are plenty of way-too-expensive mutual funds available to an unsuspecting or uneducated public for purchase at any time, it’s also true that there are plenty really low-cost funds – especially both actively managed and indexed exchange-traded funds – that go completely ignored in kaChing and Covestor’s argument.

What We Don’t Like: More Unexplained and Misunderstood Fee Facts

What’s ignored in their mutual harangue against mutual funds are some of the cost problems that kaChing and Covestor, themselves, face. And there are many. If mutual funds have problems with embedded tax liability*, marketing fees and loads, then kaChing and Covestor have problems with balance, slippage and turnover. Let us explain.

Because in the kaChing and Covestor world you own the stock rather than owning a fund of pooled money that then purchases the stock, this creates several problems, the first of which is an execution problem known as “slippage.” When a manager enters a trade, the same trade is automatically executed on your behalf in your account. But there is no guarantee on the execution. (Here we would like to applaud Covestor for carefully outlining these potential issues for their clients.)  

We like that both companies have done a good job of requiring their managers to refrain from front-running, which could otherwise be a serious concern. (A PDF copy of kaChing’s “consulting agreement” which clearly outlines the front-running prohibition is located here.)

Front-running occurs when an advisor tells their clients to buy a security that they have already purchased. The demand, caused by all the new buyers, could inflate the cost of the security which creates a profit for the advisor. Front-running is as nefarious as it sounds because it’s a calculated decision made by a manager to benefit from the follow-up trades, and this is why it’s illegal.

But while both firms may be able to control front-running, what they can’t control is “slippage,” which is essentially the same phenomenon except that it’s a cause-and-effect rather than a calculated decision. If a great manager has 500 accounts and they try to execute a trade on, say, E*TRADE Financial (ETFC) at the same time for all clients, it is possible that the price will move as each trade is executed. That means that account holders further up the queue could be getting a better price.

The counter-argument is that trades on actively traded shares with high daily average volumes won’t see much of a difference in price. We’re simply suggesting you can’t ignore slippage. Even if that difference is a few pennies, those pennies add up to significant differences over time.

Editor's Note: in follow-up converstions with kaChing they informed us that they avoid slippage by combining all buy or sell orders into one all-or-none block orders. A complete response from the CEO is copied at the end of this post.

Here are a few more things you can’t ignore that could affect performance, or costs, depending how you look at it. Cost basis: when you open an account and fund it with, say, $10,000, you have to be brought up to speed on the holdings; therefore, your cost basis on the holdings will never be the same as the manager’s. Suitability: your trade may not be executed at all if it’s deemed not suitable for your account. This also affects the accounts overall balance, or diversification. Rounding: your orders will be rounded, so it’s not necessarily the same purchase amount as the manager. Each of these could affect your return positively or negatively as compared with the manager’s return.

Then there’s the tax problem. Alas, capital gains tax is a universal joy. While there are plenty of tax burdens to be had with mutual funds, it’s not as if funds managed through kaChing and Covestor trade tax-free. A quick look at the kaChing geniuses shows Dan Carroll with a 264% turnover rate, Jeff Borack with a 160% turnover rate and the current #1, Min Thang, with a 171% turnover rate. Each manager is averaging anywhere from 15-20 trades per month, probably half of which (we would hope) result in some tax liability (at both short and long-term rates) in addition to the commissions generated for each round trip.

Both firms claim to take into account turnover and commissions in their stated performance. But given their focus on costs, we would like to see a clearer explanation of the costs that impact a mirrored portfolio, just as they’ve done with their mutual fund cost explanations. In other words, any fee comparison chart ought to include fee or pricing exposure one would have in a mirrored account that they don’t have with a mutual fund.

What We Like: The Attention

If there is one undeniable benefit these groups bring to the table it’s this: they help bring attention to some real problems in the financial services industry. When we talk about these services here in the office our conversation always seems to land on costs. It’s the most visible – and debatable – point on which everyone wants to compete, and yet is least understood by the consumer. We think it’s great that these firms are fighting against fees and raising consumer awareness, much like John Bogle has done. It makes us wish that costs were more tightly controlled and regulated, as Bogle suggests.

But kaChing hammers on costs so much – and focuses their efforts on only the largest, most bloated funds that we dare say it almost seems unfair, strange as that may sound. The thing is, these firms are doing such a good job of focusing consumers on costs that it won’t be long before they become the subject of a cost discussion. And it might not be pretty.  

The lesson? Hammer on costs at your own peril. If changing the rules of investing means you don’t charge 12b-1 fees but you do create slippage, if it means you don’t charge loads but you do generate turnover, then we would argue that it’s not necessarily to the benefit of the investor. The rules may have changed, but the game is the same.  

For our next article, we take a look at transparency and performance.

Editor's Note: This is the third in a series of six articles we're writing on the topic. Part one is located here. Part two is located here.


Response from kaChing's CEO, Andy Rachleff:

Thank you very much for your informative series. Unfortunately I think you misunderstood a few issues WRT how kaChing works:

1. kaChing only compares its expenses with those of the relevant competitor, actively managed mutual funds. We purposely do not compare our cost with that of Index funds (like Vanguard) because kaChing only offers an actively managed product. Index funds are extremely cost effective if you are looking for a passively managed product.
   
   
2. Our managers charge a range of fees, but so do actively managed mutual funds. That's why kaChing compares averages to averages to make the most fair comparison.
   
   
3. There is no "slippage" on the kaChing platform. Trades in customers' accounts are executed within 1 second of the trade made in our portfolio managers' model accounts. Should a difference occur in that short amount of time then we adjust the portfolio manager's portfolio to reflect the price paid by our customers. That way we insure the customers get EXACTLY the same performance of the manager subject to rounding. We also limit our portfolio managers to only invest in stocks and ETFs that have a significant float (ie no penny stocks) and even then limit the amount they can invest to 10% of the 3 month average daily trading volume per day. The last thing we wanted was to have our customers subject to "slippage."
   
   
4. It is true that our customers’ performance may vary slightly from that of our portfolio managers due to small account sizes. We disclose the amount of the difference before the customer pulls the trigger on a new account. We could have addressed this problem by increasing our minimums, but we thought the opportunity to invest behind a kaChing portfolio manager who outside of kaChing has a $1 million minimum account size with as little as $3,000 more than made up for the slight differences due to rounding.
   
   
5. True your cost basis will only be the same as that of your portfolio manager if the manager initiated the position after you chose to have your money managed by him, but that is irrelevant. You will have exactly the same PERFORMANCE as your manager from the day you initiate your account. If the manager didn't think a particular position was worth continuing to hold then he would sell it. Remember, a hold is equivalent to a buy at the current price.
   
   
6. Customers are not at a tax disadvantage as a result of investing on kaChing as compared to an actively managed mutual fund. We disclose a portfolio manager's turnover precisely so our customers can decide if they want to incur a lot or a little short term capital gains. We even provide "kayak like" tools to filter on turnover among other parameters. Our managers offer a wide variety of turnovers. Some of our managers have turnovers of as little as 20% which means their average holding is 5 years. We think this is a decision best made by our customer and go out of our way to disclose as much information as possible so our customers can make informed decisions. Mutual funds just started disclosing turnover last year and they really fought having to do it. Unfortunately most investors are not aware of the likely tax efficiency of their mutual funds because it is so hard to find. Of course index funds are extremely tax efficient.
   
   
7. Our focus is not on cost. It is the third item in our three pronged value proposition: 1. Unparalleled transparency 2. Screened talent 3. Simple low fees

Thank you for the opportunity to clear up these misunderstandings.

Best
Andy Rachleff
CEO, kaChing






* This is the problem created when you buy into a mutual fund with gains not yet realized. Even though you may not have enjoyed those gains, you’ll pay the tax on them. As Rachleff explained in a blog post, “Imagine buying a house and having to pay the capital gains owed by the seller?  I can just picture your real estate agent saying: ‘Joe, before you move in, please pay the government your portion of the $700k profit the seller made on the house.’”