Alternatives to mutual funds continue to flood the marketplace.  ETFs have grown into an industry unto itself with some $700 billion in assets under management.  Now on a more micro-scale, services that intersect between the worlds of social media and the investment industry are bidding to take more market share from the mutual fund industry.

You can now include kaChing in that bid to take market share.  (Covestor Investment Management had earlier launched a similar offering.)  At the kaChing blog it is clear that the mutual fund industry is the target:

Compare the kaChing service to its closest alternative, Mutual Funds.  Mutual Funds provide no transparency into their behavior, so the only basis on which you can choose a fund is its past returns.  But we all know that past returns are not indicative of future returns.  You’ll see that disclaimer on the bottom of every investment site webpage (including ours).  Why then do people rely on Morningstar ratings (which are almost solely based on past returns) to choose their mutual fund?  Because there is no alternative!  That is until now.

A great deal of attention being heaped upon kaChing including the New York Times, GigaOM, Technologizer and the New Rules of Investing. This service provides investors with some beneifts including performance measurement, transparency and disclosure.  The question is whether these benefits will accrue to investors and will they have better luck with these modular investment accounts than they have had with open-end mutual funds?

The problem lies not with the incumbent investment management industry, but rather with investors themselves.  None of this should be read as a defense of the mutual fund or ETF industries.  There are plenty of problems there.  However, investors as a whole have shown themselves to be their own worst enemy when it comes to fund investing.

Steve Hsu at the Information Processing blog has an interesting anecdote from a discussion with noted investment author William Bernstein.  In which Bernstein outlines the abilities a successful investor needs to have.  After some admittedly rough math they came to the conclusion that only 1 in 1000 people have the requisite skill set to be competent investors.

The evidence is pretty clear that investors have the tendency to chase the hot hand in investment performance to the detriment of portfolio returns.  In a research paper Friesen and Sapp* estimate that investors experienced dollar-weighted returns some 1.50% lower than time-weighted returns in open-end mutual funds.  In short, the (poor) timing decisions of investors have cost them real money  mutual funds.

The story isn’t any better with ETFs.  John Bogle writing at IndexUniverse shows that in the vast majority of ETF categories investor returns have lagged fund returns.  Over the five year period covered ETF investors traded themselves out of some 4.5% returns per year.  Bogle writes:

So we have evidence—strong evidence—that exchange-traded funds, because of the timing that goes on in them, are not acting in the best interest of investors. Or, that investors are not acting in their own best interests, which may be a better way to put it.

Jared Woodard at Condor Options recently had a piece up expressing his frustrations with investors who to their own detriment flit from one hot strategy to another.  An extended excerpt:

Investors are notorious for chasing performance. If a mutual fund or advisor or trading strategy has done well recently, chances are much greater that traders will commit money to that strategy or product, often independently of the long term performance, general suitability, or distinguishing features of the strategy or product.  I’ve seen the same behavior among the audience for our paid newsletters: after a winning month, new subscribers are more likely to rush in, and if we have a flat or down month, interest from new readers drops. This is exactly the kind of backwards thinking that dooms most investors to underperform even basic market benchmarks: most investors would literally be better off allocating every cent to a plain vanilla index fund, rather than jumping around from one strategy to the next like insects in the lighting section of a hardware store.

This evidence, both quantitative and anecdotal, should give one pause before embarking on any new active investment program.  The Covestor and kaChing investment programs are interesting especially in their ability to harvest new talent using the power of social media.  However as a whole we are skeptical whether investors as a whole will truly benefit.

Investors will likely flock to those managers who have experienced outsized returns.  The subsequent returns, for any number of reasons, will likely mean-revert.  It is therefore unlikely that the any of that any alpha these managers might deliver will actually accrue to the vast majority of investors.

Is this a problem with these new investment accounts?  No, it is simply a function of human nature.  Now if they could somehow fix that problem, then we would really have something.  For now, it is business as usual.  Some managers and investors will do well for themselves.  However for the majority of investors the song remains the same.

*Friesen, Geoffrey C. and Sapp, Travis, “Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability.” Journal of Banking and Finance, Vol. 31, pp. 2796-2816, 2007. Available at SSRN: