Mirror, Mirror On the Wall Street: Does It Pay to Be a Copycat Investor?

Mirror Investing: The Risks and Rewards of Being a Copycat Investor
Mirror Investing: The Risks and Rewards of Being a Copycat Investor

When your mother scolded you, "Monkey see, monkey do," it usually meant you were foolishly following your friends without a second thought about consequences. Well, some investors think that old-fashioned advice isn't applicable in today's digital world.

Social media plus investing equals mirror investing. The twist is that while social media is about sharing information, mirror investing means you're not sharing the data, but the results. You link your account to another investor, and when they execute a trade in their account, the same trade gets executed in yours at virtually the same time, says Ornella Grosz author of Moneylicious: A Financial Clue For Generation Y.

You can choose to mirror a friend, relative, or someone from a list at one of the firms offering mirror trading -- in other words, a stranger.

In 2006, Perry Blacher, CEO and co-founder of Covestor, launched one of the first mirrored investing firms. Since then, over $150 million of mirroring trades have been put through the Covestor system. Covestor allows both professional money managers and non-pros a way to offer their investment strategies to others. "You have access to a range of expertise and someone who has skin in the game because they are also investing their money, as opposed to offline where the person gets paid regardless of how their investments perform," says Blacher.

Others offering the service include Ditto Trade, TD Ameritrade's Autotrade and Wealthfront, which launched 18 months ago, and now has $200 million invested on its platform, according to founder Daniel Carroll.

The Upside of Mirroring

The number one advantage is transparency, says Barry Randall, who has had investors following him on Wealthfront since April of 2010. "An investor can see everything I own in real-time, can see my past trades, can see performance measurements that are up-to-date. Mutual funds don't offer this kind of data and if they do, it's several months old," he adds.

Randall's followers have more than $630,000 with him, and his portfolio's one-year return is 34.8%. He earned an MBA at the University of Texas at Austin, worked as a sell-side analyst covering technology and for a decade worked on the buy-side as a mutual fund analyst and portfolio manager, before starting his own firm, Crabtree Asset Management, a registered investment adviser.

Mirror investing can make sense for some people, says Daniel Wesley, CEO of creditloan.com. "If you don't quite have the time to dabble in the market but want to get it done, someone else does the job for you," he says. "If you find it hard to make decisions on your own, now someone else is on the reins of the job. If they have better skills than you, then it may prove to help your account in the long run. And you can always stop it whenever you like."

Risky Business

Such explanations haven't silenced all the skeptics.

"Would anyone think seriously about doing mirror doctor visits?" asks Donald J. Moulton, a certified financial planner and co-founder of Retirement and Tax Planning Specialists. "'You go to the doctor and let me know what he prescribed and then I'll take the same thing.' Of course not. It would be ridiculous. But for some reason, following a friend's account -- or worse a stranger's account -- somehow is supposed to make sense despite the fact that (s)he has different goals, different income, different assets, different time horizons, different risk tolerances, a different family dynamic, different expenses."

"If I'm a retiree, am I choosing a Master Trader who is actually a 19 year-old who bought options on Apple (AAPL) because they liked the iPod? Is this really what I want in my account?" he asks.

The Cost of Being a Copycat

Another cause for criticism is cost: Some of these mirror accounts charge from 0.5% to just over 2% of assets per year. "This is more than most advisers, who give a customized portfolio, as well as more than most mutual funds," says Moulton. The average annual report net expense ratio for all open-end mutual funds is 1.21%, according to research firm Morningstar (MORN).

"Ultimately, fees are fair if you get value for them; that is, doing better with the help than you would on your own," says Adam Bold, founder of The Mutual Fund Store, which provides fee-only investment advice. "But with some mirrored investing accounts charging upwards of 2% of the portfolio, that's too high. For that price, you could get individual, fee-only advice from a professional,"

Fees substantially higher than 1% could offset the potential investment gains in the account, according to Patrick Fisher, a chartered financial analyst with Schneider Downs Wealth Management Advisers.

Not Quite the Wild West

Then too, the person you follow doesn't have to have any sort of license, any experience, and they could have any motivation, legal or not, for allowing people to mirror them, explains Moulton.

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"Let's say a Master Trader was less than concerned about legalities," he postulates. "They could set up a big account with most of their money and a smaller account to use as the MT. Now in the bigger account they buy an investment with little volume. Next they buy it in the MT account, triggering additional buys in all the followers, and pushing up the stock price. They then sell in the large account for big profits and later sell in the small MT account for a small loss. Since they are not licensed or regulated, what's to stop this activity?"

But the mirror investing world is not exactly the Wild West -- there are some investor protections. For example, Wealthfront has a white paper on its site that details their manager selection criteria. Investors fill out a questionnaire which makes it easier to find money managers who match their long-term investment goals. You receive money manager recommendations based on your appetite for risk and return and your sensitivity to paying taxes. You can browse or filter from Wealthfront's complete list of managers. You can review money manager details such as strategy, assets managed, current holdings, relative and absolute returns and risk profile before you invest. And, you can compare up to three managers side-by-side to see differences in their approaches and results.

Wealthfront says it notifies customers promptly if their money manager materially changes his investing behavior, including an increase in trading frequency, an increase in portfolio risk or a deviation in investment strategy.

With Covestor, to manage a model account, you must be at least 18, a year's audited performance history, and trade the strategy with your own money in a new brokerage account. Model managers are asked to trade within a limited set of rules, based on the risk scores of their models. Covestor applies filters to models to ensure that non-qualifying trades are not mirrored.

Amateur Hour on Wall Street

"Granting trading authority over your portfolio to a complete stranger, who may not even be an investment professional, is imprudent at best, and may be downright dangerous," says Joe Jennings, investment director for PNC Wealth Management.

There are no advantages to the retail investor if they are mirroring a day trader or hobbyist. "That isn't responsible investing in our view. But if mirrored investing allows retail investors to invest with screened professional money managers who the everyday Joe might not have access to, it is a way of leveling the playing field," says Carroll.

Bold raises his eyebrows at the whole concept. "How about an accurate track record, and exact expertise? How well documented is this person's history?" he asks. "Bill Gross, for example, has made hundreds of millions of dollars in his career. It's because he's one of the best bond fund managers out there. I doubt there are any Bill Gross-types allowing someone to mirror their trades."

Then too, says Fisher, there is a possibility of severe under-performance. If the trader does not have a long-term track record that is verifiable, you may be taking quite a leap of faith. "Even if the trader does present a strong long-term track record, there is nothing to guarantee that they will stick with the investment style, or trading strategy that helped to compile that track-record. Particularly, if the trader undergoes a period of under-performance, he may increase the level of risk in the account in an effort to make up the losses in a short period of time. This increased level of risk could subject the account to even greater under-performance," warns Fisher.

Lower Standards, Higher Risk

Quite simply, adds Moulton, "This is one of the worst ideas I've seen in some time. This is worse than following hot stock tips randomly emailed to you because at least then you have control over when you buy and sell the garbage being pedaled. No one should invest this way, even if it is mirroring someone they know. Investors should be aware that they are turning their life savings over to a stranger and asking to be defrauded," he adds.

Ken Kamen, president of Mercadien Asset Management cautions, "We've seen in this country what happens when standards are lowered -- like when we made it easier for people to buy houses. Well, with mirror investing the thinking is that more people will have access to money managers. I see a parallel in people buying homes they couldn't afford and people investing and not doing homework. The housing situation blew up and people lost their homes. You have to ask yourself if it's really in your best interest to have a potential cowboy running your portfolio?"

As far as track records go though, Sam Lloyd, 65, began investing with Covestor in March of 2010. His experience so far, "It's the best idea in investing I can remember," says Lloyd, who was doing most of his own investing. "This takes the burden of trading off my back," he adds.

Lloyd estimates that his investment is up 15%, though he admits he got off on a rocky start. "When I first started, Covestor did not show the average investor's return on their website. Going just on the returns of the manager, I invested my money with a day trader who made money while I was losing it." How does that happen if you're trading the same securities? "Because the market moves too fast and is sometimes too thin to get the same prices that the day trading manager gets," says Lloyd. "It's mostly with small and micro cap stocks that you get a lot of slippage," he adds.

What inspired him to give Covestor a try? "The ability to diversify among different strategies and asset classes, rather than being required to put a million dollars with one manager outside of Covestor and the quality of managers," he says. You can get into mirror investing with as little as $10,000.

Follow the Leader to Better Returns

The key to success was thinking things through from the outset. "Have a concept in mind of what you are looking for. For instance, I wanted to invest in MLPs [Master Limited Partnerships], so I had Dan Plettner manage them for me when Covestor first made his MLP program available. Having a concept in mind, I could ignore the little ups and downs along the way because I could rely on my judgment that MLPs made sense," he adds.

Mirror investing is also available for currency investors. In October 2010, Currensee launched the Currensee Trade Leaders Investment Program, giving investors of all types the ability to invest in the currency market. They seem to be off to a good start: Trade Leaders have a return of more than 40% over the last six months, says CEO Dave Lemont.

Mirror investing isn't likely to lose its luster any time soon, and its fan base continues grow. Says Carroll, "After the initial sign up, over 50% of all investors that have been with Wealthfront for more than a year have upgraded and added more money with the service, so I think that is a sign that they are pretty happy with Wealthfront. In addition, a composite of our money managers available to retail investors has outperformed the S&P Total Return by over 400 basis points."

So, monkey see, monkey do? Maybe.

Cautions Kamen: "Buyer beware."

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