Not too long ago we discussed some developments in the world of investment management that are serving to make new investment strategies available to individual investors.  The investment management industry has always been modular.  Investors could pick and choose from a variety of funds and managers.  However today’s “modular” investment accounts provide investors access to managers and strategies not currently available from mainstream providers.  This new wave of services harnesses the social aspect of the Internet to bubble up talent from non-traditional providers.

In today’s investment world an individual investor can create a globally diversified portfolio of ETFs with an expense ratio well below 20 bps. This puts the onus on active managers to make the case for their services.  While we are in general skeptical of actively managed ETFs, there is little doubt that they are perceived to be the future of the ETF industry.  With the low-hanging fruit of the major asset classes already taken this is the one of the few ways the industry can continue to grow.  Since most money managers missed the ETF boom they will try to shoehorn into the industry on the active side.

Maija Palmer at FT recently covered the world social investing by focusing on Covestor Investment Management and its competitors.  One area that the providers are making is in the realm of safety and transparency.  Palmer writes:

Mr Blacher, however, maintains that Covestor Investment Management can offer a safer alternative to traditional fund management. He says investors are in control of their money because the shares always remain in their name, they can close the account at any time, and there are no exit fees. And every trade is completely transparent.

There is no shortage of competition in this space.  For instance we have seen ads on the Internet for Formula Investing.  This firm is associated with money manager Joel Greenblatt of Magic Formula Investing fame and provides investment management services in that same vein.  From a business perspective the question is whether it makes sense to have a single strategy warehoused separatel where are benefits to scale in investment management.

There really are few limits on how far one could take this approach.  For instance one could see how the “timing model” popularized by Mebane Faber of World Beta blog fame could fit into this sort of environment.  Another popular model, that of piggyback investing, popularized by AlphaClone could also provide ready-made portfolios for individuals.  In both these cases the challenge lies not in identifying a strategy, but rather in implementation.  To profit an individual needs to follow the model, and not emotions prevent one from following through.  A modular investment management model could make the returns from these strategies a reality for investors.

The bottom line is that all of these services, as we said, close the loop.  They ensure that in your account you are following each and every trade from a particular manager.  One could envision a future where investors own a variety of strategies, including their own trading, in different forms:  open-end mutual funds, ETFs and these modular investment accounts.   In all cases they provide both liquidity and some level of transparency.

The challenges are many but let’s focus on two.  The first is cost.  As we mentioned earlier investors can create a globally diversified portfolio with management fees for some 15 bp.  For example, Covestor Investment Management is currently charging 1.50% for most of its accounts.  Actively managed ETFs are certain to charge higher fees that their passive ETF cousins.  For instance one need only look at the new Dent Tactical ETF (DENT) fund at 1.50% to see where active ETF fees are headed.  These fees are a hurdle any investor need overcome.

The second is the fact that these strategies are by definition active.  That is, they try to outperform the market or some given benchmark.  One need only look at the world of mutual funds to see that active management, especially after fees, is at best a 50-50 proposition.  While it may be the case that these products turn out to have better performance than the mutual fund world, it remains to be seen.

There is one other benefit to this approach worth mentioning:  performance measurement.  Many investors (and traders) are unable to accurately calculate their investment performance.  These accounts will at the very least make performance (and the effect of fees) clear to the end user.

The challenges of active management are many and investors will inevitably face some performance disappointments.  That is why investors should demand safety, transparency and liquidity before investing in any of these “modular” investment management programs.

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