| 15 March 2010

In part four we wrote that, it turns out, only 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, in a sense, reinvent the company. Such shifts are not only common in the world of start-ups, they’re almost expected; especially when a firm is trying to change such deeply ensconced rules and habits.

In a blog post on December 9th, kaChing co-founder Andy Rachleff gently announced the firm’s shift in strategy. They decided to focus kaChing.com on the asset management business and trade mirroring, Rachleff told kaChing users, while shifting the virtual portfolio action over to Facebook (renaming it the “InvestingIQ App”). They were doing this, Rachleff said, because “some were confused to see the majority of their navigation bar dedicated to managing a virtual portfolio.”

What followed was a maelstrom. Loyal kaChing users posted 70-plus comments, not one of which (as far as we could tell) was in favor of the change. They labeled the move a “disaster,” “offensive,” and, well, “very bad!”

Editor's Note: This is part five in a six-part series. To view the first article, go here.

Rachleff responded to the barrage the next day with, shall we say, a more “precise” and pointed take on the move. We have nothing but respect for Rachleff and his comments – which basically amount to, “hey, it ain’t personal. It’s just business.” He emphasized the inability of the 400,000 early participants to generate consistently good, “genius-like” returns. He was very clear about the shift to support RIAs.

“Adding RIAs will significantly enhance our customers’ choice,” said Rachleff, “and therefore improve the attractiveness of our trade mirroring service.”
But this move to focus on hitching with RIAs rather than managing an open marketplace for investors raises some interesting questions. Because as we see it, kaChing’s shift could perhaps make the company more like the very funds and services they fought to change.

“We have learned that very few amateurs are capable of earning ‘Genius’ status by virtue of generating an investing IQ > 140,” said Mr. Rachleff. “As a matter of fact, only 4 out of more than 400,000 amateurs have done so in the past year and a half.”

Wait – wasn’t the whole idea behind this thing to suss out good amateur investors? Now they’re saying that, clearly amateurs can’t invest their way out of a hole and this idea that we could do any sussing out of investing talent was foolhardy, right?  

Not necessarily. Let’s not forget that the whole idea of “genius” status is not some generic achievement accepted by academics and statisticians but rather is a specific measure created by kaChing staffers. We’re not saying it’s wrong, we’re just saying it’s their view. “So how do the pros pick investment managers?” asks kaChing’s Rachleff in a blog post. “To answer that question, we turned to the best, the managers of the Ivy League endowment funds.  Between them, these managers oversee more than $100 Billion, so they’d better pick right.”

Mr. Rachleff goes on to suggest that Ivy League endowment managers are so good because, 1) they have great risk-adjusted returns, 2) they have a compelling investment rationale, and 3) they stick to a stated investment style and preference. This served as the basis for their kaChing “genius” criteria.
We think it’s fair to ask a very simple question: are these are really the right metrics by which to measure every investor’s performance? Unfortunately, the answer is a very un-simple: “maybe.”

Consider, for example, what would happen if we applied these same criteria to the current pool of actively managed mutual fund advisors? I’m sure kaChing staffers would argue that many of them would fail the test. And on this we agree.

But how many? Probably not 399,996 out of 400,000, but a good number of them would. And why would they fail? Because their rationale wasn’t “compelling” enough? It’s just not clear.

What is clear is that most fund managers can’t even beat market indexes. According to a study performed in November 2009 by the Center for Investment Management at the University of Albany, there are currently 1,749 actively managed mutual funds in the U.S. that fall within one of nine distinct Morningstar categories, such as “value,” “mid-cap” and “small cap.”

Those funds manage a collective $1.2 trillion in assets. And here’s the rub: less than 50% of those funds performed better than the corresponding Vanguard index fund. For example, only 29% of the available actively managed small cap growth mutual funds outperformed the VISGX, the Vanguard small cap growth index fund.
When you include fees, only one group (Value Index) averaged a better return than the corresponding Vanguard index fund. All other groups performed worse than their corresponding Vanguard Index fund.

Here’s another interesting suggestion: instead of applying the genius criteria to actively managed fund advisers, why not really put it to the test by applying it to those Ivy League endowment managers? Would they pass muster or be brushed aside like the 399,996 other virtual portfolio managers who missed the cut at kaChing?

The fact is, even the Ivy Leagues fell victim to the markets and to some of the same mistakes a lot of managers and individual investors made during the bull run-up: they strayed from their stated strategy way too much and cost their endowments dearly (see, for example, “Ivy League Endowments Finally ‘Dumb’”). We know that of this, perhaps even Mr. Rachleff would agree.

So does this mean the “genius” criterion is faulty? Not necessarily. But if the criterion is exactly right, that’s a little scary because the truth is only 0.001% of investors can actually meet it. Perhaps this says more about the markets and our ability to produce results than it does about kaChing’s choice of criterion.
The fact is, whether you’re a mutual fund or an RIA, whether you perform better than or worse than market averages, the game is assets under management. We wouldn’t be surprised, for example, to see kaChing change its criteria over time – or do away with it altogether – in order to enable a broader offering to potential clients.

Covestor, for its part, appears to be the lone holdout; they seem willing to let the whole “amateur” portfolio manager marketplace thing run and see what happens.
If kaChing didn’t completely throw in the towel on “amateur” investors, it made clear its strategic direction and where it expects to find bankable investing talent going forward. “In the future,” said Rachleff, “we expect the vast majority of our new Geniuses to be outstanding Registered Investment Advisors (RIAs) whose verified track records we import. More than 40 RIAs approached us since the launch of our service in late October to join our platform.”

Next, we conclude our story with a look at RIAs and the opportunities that exist, or don’t, for companies like kaChing and Covestor to support a new type of RIA network that can compete with companies like Charles Schwab (SCHW) and TD Ameritrade (AMTD).

Editor's Note: This is part five in a six part series. To view the first article, go here.