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Monday, October 19, 2009 Looks Like ATerrible Way to Pick a Money Manager: More Likely a Case of "Fooled By Randomness" than a Good Way to Find "Genius" Managers

NYT today has an article on a new investment website named kaching that purports to offer a better way to invest with a money manager by following the trades of an investing "genius." Needless to say I am EXTREMELY skeptical. IMO it is virtually guaranteed to send investors to chasing performance and jumping from strategy. In addition frankly I'm not sure at all how it would actually work in practice. And I certainly have problems with their methodology for determining who is a genius.

my bolds and italics

from the nyt
october 19, 2009
Site Lets Investors See and Copy Experts’ Trades

SAN FRANCISCO — The trouble with mutual funds is that investors can feel as though they have put their money in a black box. The 90 million Americans with money in funds know little about fees, what securities their money is invested in and who is in charge.

As you will see imo this website trades one type of opacity for another.

....On Monday, KaChing is to add a new twist. Customers can set up brokerage accounts that automatically mirror the trades of a money manager, some of them professionals.

“The idea of an asset manager showing all his research, his holdings — it’s unheard-of,” said Mr. Carroll, now 27 and the vice president for business development at KaChing. “In the financial industry, the idea is that information is currency; they protect it with their lives.”

Individuals are desperate for advice and transparency from people who help them manage their money, and mutual funds do not provide enough, said Andy Rachleff, KaChing’s chief executive and a longtime venture capitalist who co-founded Benchmark Capital.

“The mutual fund industry is a $10 trillion industry that has seen no innovation for 25 years. The Internet has had no impact,” Mr. Rachleff said.

Boy is that off the mark ! there are now index funds for global and domestic indices that never existed 25 years ago not to mention exchange traded funds which though not mutual funds are certainly a low cost and transparent investment vehicle available to the individual investor with virtually any size investment account....

KaChing has attracted a roster of prominent early investors from Silicon Valley who have financed the company with $3 million. ....
The angel investors have also been investing their own money through KaChing during the pilot period. “The concept is great — the ability to tap into not just the wisdom of the crowd, but to be able to identify and invest with the particular geniuses in the crowd that stand out,” said Mr. Andreessen, who has invested $100,000 using the site.

By various reports Andreessen's net worth in the hundreds of millions making a $100,000 investment account with kaching little more than a marketing expense (and it worked: look how they use it in their pr)

Customers will be able to open a brokerage account with Interactive Brokers and link their account with their choice of investors on KaChing. KaChing charges customers a single management fee of 0.25 percent to 3 percent, set by each investor. KaChing keeps a quarter of the fee, and the investors get the rest.

Each time the investors make a trade, KaChing will automatically make the same trades for the customer. Customers can log on whenever they want to check their portfolio’s performance. They can send the investor private messages and receive alerts if the investor does something unusual. With the click of a mouse, customers can stop mirroring an investor.

A few operational questions ?

A quick glance at the "genius " portfolios shows investment portfolios with 20 or more stocks and long and short positions. How could an investor with $50,000 or less invest with this strategy ? will he hold positions as small as 5 shares or less ? I assume clients must have margin accounts to implement the shorts, yet margin accounts under the "know your customer rules" should only be approved for sophisticated investors are all new account applicants screened for that ? How are any margin calls executed ? What is the mechanism for block trading. The investor certainly has transparency, but how comfortable will he be when large numbers of short position show up in the account particularly when the stocks or the overall market become very volatile ?

and how scary is this ?

Only a dozen people have qualified as genius investors so far. They include a retired lawyer in Omaha, a student at Chapman University and the founder of a Bay Area investment firm.

For investors, KaChing is a way to make some money on the side or expand their existing business. Andrew F. Mathieson, founder of the investment firm Fairview Capital in Greenbrae, Calif., said he hoped to use KaChing to cater to people who did not meet the firm’s million-dollar minimum.

And a Few ?s on how they screen for managers

here's how they explain their methodology on their website

kaChing operates an investing talent marketplace where you can "invest like a Genius" in your real brokerage account. On kaChing, a Genius is an investor who, not surprisingly, earned an Investing IQ greater than 140, built a track record over more than a year and agreed to live by the same personal trading restrictions as a classic mutual fund manager. Investing IQ is the first objective metric to evaluate whether an investor is lucky or good. It's based on the same 3 factors used by the Ivy League Endowment managers, the world's premier evaluators of investing talent, to rate their prospective investment managers:

1. Risk adjusted returns – based on an investor's information ratio
2. Sticks to Strategy – based on an analysis of how an investor made returns
3. Quality of rationale – based on a kaChing behavioral algorithm that measures community response to an investor's research

To call the above the methodology of "ivy league management" is inaccurate if not outright deceptive. Let me count some of the ways:

1. No responsible endowment investment manager would base his choice of money.
manager based on performance of as little as one year.
2. I assume the kaching folk are referring to the Yale model. As documented in David Swensen's book Pioneering Portfolio Management. Yale uses an intensive screening process including interviews and visits to the prospective manager's offices before selecting a manager.
3. The key determinant of the strong long term performance (and recent setbacks) of the Ivy league funds was the large allocations to alternative investments such as direct investments in commodities and real estate,venture capital,and private equity. This is nothing like the kaching portfolios which are composed solely of traded equities.
4. While the kaching folk purport to be totally transparent they don't make clear their methodology for determining geniuses in any detailed manner. They also don't give their criteria for taking a manager off the "genius" list. Sorry but criteria descriptions listed above don't cut it for me. While the holdings may be transparent real time the methodology for choosing geniuses certainly is not.
5. Many of the portfolios are concentrated by industry or otherwise. Yet the kaching site gives no guidance that such a portfolio should represent only a small part of one's investment holdings.

Most important the kaching strategy has the potential for giving an investor a lighted match next to a stack of open gasoline barrels particularly given the known behavioral tendencies of investors to chase performance. I saw no guidelines on the kaching site for building a portfolio: riskiness of concentrated and long/short portfolios, importance of balancing an overall portfolio with lower risk fixed income and broad index funds, the advantages of globally diversification. There was also no mention of the potentially high tax bill from latching on to a strategy that incorporates lots of short term trading.

The potential for kaching clients to jump from hot hand "genius investor" with eye popping short term returns (a quick glance at the list of "geniuses" shows investors with one year returns from 80-179% you guess where investors will put their money. And knowing investment behavior they will dump the genius when he invetiably drops down the list of high returning geniuses and move on to the next one.

I was asked if something like kaching might "put me out of business". Since I put together low cost (some kaching managers charge 1.25% or more), globally diversified portfolios, managed to minimize taxes and tailored to my clients personal situation and tax status....I'm not too worried.

But best of luck to the kaching investors. As my readers know I don't think there is such a thing as an "investment gehius". Once again check Taleeb's Fooled By Randomness.

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