Can You “Beat The Market” With Trade Mirroring?

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Have you ever wanted to invest like the wealthy and keep your money with a professional asset manager? Tell your friends at the bar that your wealth is safely in the coffers of a swanky wealth management firm? Have access to the double-digit rich-get-richer returns that only guys with yachts have?

Thanks to a new technology called trade mirroring, you can. Whether that’ll be a wise investment choice for you is another question. Here’s how trade mirroring works; you decide if it makes sense for you:

Trade mirroring means hooking your brokerage account up to that of a professional money manager. The manager doesn’t know you and you never get to sit down in his wood-paneled office, but you get full access to his stock trades, which are executed in your account automatically within seconds.

Instead of the six-figure minimum these guys usually require, you can get in for a mere $10,000. You pay the manager a percentage of assets (generally 1% to 2% annually) plus a small fee for each trade. Covestor, a leading trade mirroring firm with over $100 million in trades per month, estimates that its typical $15,000 account will pay $40/month in total fees, or 3.2% per year, while a $90,000 account will pay closer to 1%. (Covestor’s average account size is $50,000.) These fees–at least at the low end–are in line with the industry average for separately managed accounts — but much higher than ETFs or index mutual funds.

Besides Covestor, the other big name in trade mirroring is Wealthfront (formerly kaChing). Initial press about trade mirroring lumped it with social investing sites and focused on the idea of mirroring the trades of everyday hotshot investors rather than registered investment advisors.

Covestor still offers the opportunity to invest alongside average Warrens and Jims, along with professional money managers; Wealthfront offers only professionals. “We’re not social at all,” says Wealthfront founder Dan Carroll proudly. Since Wealthfront launched in late 2009, it has drawn over $100 million in assets under management, with the average account holding about $75,000.

Carroll says their managers are vetted using the same process employed by successful Ivy League university endowments. You can go to Wealthfront’s site right now and look at their managers’ portfolios and performance: most of their managers are handily beating the market.

What is “the market,” anyway?

Wealthfront and Covestor both compare their managers’ returns to the S&P 500, stripped of dividends, which understates overall stock market performance by several percentage points. “If they’re using the S&P 500 index, they’re only looking at part of the return of part of the market,” says Allan Roth, author of How a Second-Grader Beats Wall Street. “If they’re investing in stocks that aren’t just the 500 largest, they’re comparing apples to parts of oranges.”

Put another way, literally anyone can consistently beat the S&P 500. Just buy a low-cost S&P 500 index fund (such as SPY) and reinvest dividends. You’ll get all the returns of the S&P minus a tiny fee, plus the dividends.

Wealthfront, to its credit, does provide more appropriate benchmarks on individual manager pages. But most of its marketing materials still compare apples to dividend-free oranges. Carroll says the benchmark is irrelevant: “Either way you cut it, our managers are significantly higher than the particular benchmark.”

Beating the market: every bit as easy as dating a supermodel

Have you ever dated a Victoria’s Secret and/or Abercrombie and Fitch model?

So it goes with beating the stock market. Some people actually do it, which makes the rest of us think we might have a chance, too. And we do, just like we have a chance of dating a supermodel: a microscopic chance that requires us to hang out near photo shoots — or put our money at unnecessary risk (in both cases).

Carroll says this view is too negative. “We believe it is consistently possible to outperform the market,” he says, “and we believe it is possible to objectively identify who will outperform the market.”

Larry Swedroe, an investment manager and author of the Wise Investing Made Simple series, is unconvinced. “You could say, well, I don’t just pick the average fund, I’m going to pick the great money managers, the ones that are vetted, right?” says Swedroe. “Well, all the evidence from every study ever done shows that there’s no persistence of performance beyond the randomly expected.”

Roth also cautions against performance chasing. “We typically go into something after it has outperformed,” he says. He is especially skeptical of any company offering managers that have been vetted by looking at their past returns, even over a long period. “All that means is, we’ll get you in after they’ve been hot and you’ll be there when they’re not.”

Carroll says Wealthfront offers new tools to determine which managers will continue to produce alpha, returns above the appropriate benchmark. “It hasn’t been possible before Wealthfront to do the analysis to determine who is lucky and who is skilled,” says Carroll. “We know there are many heretics out there that say alpha is dead, but we fundamentally disagree. We think we are off to a great start and can do a good job at finding managers that can outperform going forward, net of fees.”

Perry Blacher, founder of Covestor, is more circumspect. “If people make the argument that sort of says, hey, listen, active management doesn’t really work over the long term, statistically, if you don’t think so, we’re not for you,” he says. “I’m not saying it’s better than ETFs.” He’s saying that for those who want to try to beat the market, a trade mirroring service is a good and transparent way to do so, since with these services, more so than with mutual funds, you know exactly what you’re buying: every manager’s actual trade history is completely visible before you put down a dime.

In the case of Covestor, this is an instructive way to spend your time, since you can peruse its 131 portfolios and see that hardly any of them are outperforming on a risk-adjusted basis.

“And that’s sort of all we do,” Blacher adds. “The value is in openness. We’re like an open-source hedge fund, if you like.”