| 12 March 2010

When pushed on cost and fees, Covestor’s co-founder admits they are not necessarily innovating on price. There are more expensive options out there, and there are less expensive options out there. “Look,” said Mr. Veingard, “the old model just doesn’t work. Investors are clamoring for transparency. We’re going to showcase managers and you’ll see their accounts and how they trade in real time.”

This was, after all, how Covestor got its start. Get investors to “open the kimono” and show everyone what you’ve got. Seems about as transparent as you can get, right.

But “there is nothing out there that is transparent as kaChing,” Mr. Carroll told us. Okay, probably true. On both counts. In both cases kaChing and Covestor show all the trades their managers are making and even liven up the space with research, insights and commentary from the manager. And we think that’s great.

Editor's Note: This is the fourth in a series of six articles on the topic. Click here to view articles one, two and three.

Transparency is important whether you’re the type of investor that wants to see every decision in minute detail or just wants to know that the information is there if ever you’re curious. There is great comfort in the notion of transparency and to some extent a sense that you are still in control.

But, interestingly, most investors we talk to haven’t actually clamored for transparency. While we agree that more transparency is needed we also recognize that what’s really needed is an effort to educate investors why a transparent approach is helpful and important.  

While Covestor and kaChing may be approaching transparency from a new angle – treating it as an opportunity rather than a burden – transparency itself is not unique. Charles Schwab (SCHW), for example, recently launched a series of Schwab-branded ETFs. The company updates the holdings in those ETFs on a daily basis. Invesco’s (IVZ) PowerShares now publishes all of their holdings for all of their products, and they update those holdings on a daily basis. (In fact, transparency has become a cornerstone of the Powershares marketing campaigns.)

While some have argued that the information ETFs provide is not true transparency, we suggest the point is simpler than that. Funds and mangers can adjust quickly, and they have. If transparency is what the people want, they will get it eventually. And let’s not forget that it has been standard practice for these firms to publish research, fund objectives, and performance on a regular basis as well (though, admittedly, this can be really hard to find).  

But there’s more. Pick a fund, any fund, and we can find information about who is managing the funds and what other funds they’ve managed and their track record on those funds. We know how much money is coming into or out of the fund. We know what kind of turnover they expect and what they’ve achieved. We know how the funds have performed both pre- and after-tax and taking into account all expenses. Some of this is required by FINRA and the SEC, some of it is not but is offered anyway or is tracked by firms such as Morningstar and Lipper.

Many funds are anything but transparent and we agree it’s a problem. Some have succeeded in correcting the problem. Transparency, we believe, is an easy gap to close; and some funds have already decided that it’s a competitive advantage to close that gap. If kaChing and Covestor can improve on transparency -- perhaps innovating through online tools -- if they can help investors understand what it all means, and perhaps push other brokers and advisers to do the same thing, then kudos for their efforts.

Show Me The Money

Perhaps even more important than transparency and costs is bottom-line performance. This is an issue that kaChing did a good job explaining to investors in a recent blog post from one of its geniuses, Andy Mathieson of Fairview Capital. Mr. Mathieson uses the same Dalbar statistics John Bogle quoted to congress – though updated. The point, us mutual fund investors, by and large, perform very poorly. If you compare the performance of the funds in general and add to that our own individual investing decisions to switch into and out of funds, we always lag well behind index averages.

It’s too early to tell whether kaChing and Covestor will be able to improve on this trend. They just don’t have the track record to go up against funds in an apples-to-apples comparison. To be clear, their managers do have track records. And yes, they look great! But we’ve just capped out one of the greatest bull runs in our market’s history. The question remains, what will happen next?

Take kaChing genius Min Thang for example. His current 267% return (as we write this) reflects a whopping six-week run-up in April and May that, when it passes by in April next year will suddenly drop to about even with the S&P. Yet, interestingly, his portfolio is being marketed daily as a portfolio that returns 267%, which is only true if you mirrored his trades during that period.

As for Covestor, one of their more popular managers is Timothy Sykes. There the problem is different. His performance is good, but essentially matches the S&P 500's performance over the last year. But his risk score is a 5, which means that those mirroring his trades are taking a huge risk to essentally match a return that could otherwise be attained with a benchmark index fund.

Thier current top-performing manager, Douglas Estadt, a self-professed day-trader, was actually down 16% by February, but is currently up a whopping 250%! Also a big-risk manager, Covestor would likely only approve certain accounts to mirror his trade that can handle that sort of risk. (I was able to pass that criteria by answering a few short questions here.) 

Transparency is most important when it comes to bottom-line performance. Most funds, whether actively or passively managed, can be viewed through the lens of very helpful, if basic statistics on performance. These usually include some form of performance over the last year, three years and lifetime of a product, taking into account costs and taxes. KaChing and Covestor do this as well. But what we have found even more helpful is the data that shows the "best three months" and the "worst three months" of a fund's performance over the last year and the number of up vs. down years. This gives investors a better sense for the fund's volatility and possible gain or loss. (See, for example.) 

Min Thang, Timothy Sykes, and Douglas Estadt, they all have great performance. But their performance also raises some tough questions: for example, when Mr. Thang rolls into 2011, will he drop out of genius status? And if he does, how is this different than survivorship bias? (Survivorship Bias: when mutual fund companies close down poor performing funds and only market the hot performing funds.) Perhaps this already happened with Mr. Sykes, who is still listed as the most popular manager, but who dropped down in the rankings in terms of his return. 

If geniuses and managers drop out of genius status or lose popularity, we are all but certain other geniuses and managers will take their place. Someone, somewhere will be posting good numbers. And this is exactly the problem we face today with the mutual fund industry, which is always as good as its current best-performing fund.

Speaking of performance, it turns out 0.001% of kaChing members were able to achieve Genius status after the first year of operation.  This caused the management team to take a left turn and reinvent the company. That’s the topic for the next post.

Editors Note: This is the fourth in a series of six articles on the topic. Click here to view articles one, two and three.