SEC Gives Social Investing Site kaChing Green Light To Take On Mutual Funds

Every social investing site wants to turn the insights of its trading members into financial products that people can actually link to their brokerage accounts. Finding the few brilliant stock pickers in the crowd and then letting everyone else follow their portfolios while taking a cut of the management fees is the business model. KaChing, which is the most popular investing application on Facebook (previously called FSX), just took a major step in that direction by becoming a registered investment adviser with the SEC. Sometime in the second half of next year, it will allow its members to link their brokerage accounts to the portfolios of the elite managers on the site and automatically follow their trades.

The company has raised an angel round from some heavy hitters in Silicon Valley, including Marc Andreessen, OpenTable CEO Jeff Jordan, Benchmark Capital partner Andy Rachleff, and Kleiner Perkins partner Kevin Compton. Bruce Dunlevie of Benchmark, Doug Mackenzie of Kleiner, and former Opsware CEO Ben Horowitz are also investors. (All the VCs invested individually). The size of the round was not disclosed.

Competing social investing sites such as Cake Financial (which launched at TechCrunch 40), Covestor, and PersonalRIA (which launched at TechCrunch 50) all have the same plan. All of these sites want to disrupt the current mutual fund industry by broadening the spectrum of potential money managers. PersonalRIA sticks with professional investment advisers, whereas Cake, Covestor, and kaChing each provide a platform for talented individual investors to attract a following.

In some respects, kaChing is the most extreme example of pure social investing. Cake and Covestor both track real trades in real portfolios, whereas anyone can create a fantasy portfolio on kaChing. There are absolutely no barriers to entry. CEO Dan Carroll argues this is a good thing because you could be a brilliant investor but not have the money to actually trade. KaChing levels the playing field.

The counter-argument is that following people who are investing real money is less risky because at least they have something at stake. It’s not just play money. The recent returns of most professional money managers, however, doesn’t necessarily bear that out.

Carroll says that risk is taken away by forcing everybody to be open about their investment strategies and showing their entire holdings and each trade as it happens. In other words, the data doesn’t lie. Carroll says:

A lot of the problem is there is no transparency. We are offering complete transparency.

Well, not complete transparency. He won’t say how much he raised from his angel investors, after all. But he does demand transparency from the investors who use his site. I guess that is what he meant. Carroll himself, by the way, has a pretty impressive stock-picking record. His portfolio is up 25 percent in the past six months, during a time when the S&P dropped 36 percent.

Some other members on the site have done even better. Richard Jones has an eye-popping 372 percent six-month return, while Nick Kwok has a 97.8 percent six-month return.

Who are these people? I have no idea. Richard Jones appears to be from the UK and uses a dog picture as his avatar. On the Internet everyone’s a dog, but would you invest your money with someone who actually presents himself as a dog? Carroll thinks it doesn’t matter. You can see his holdings and you can see his risk-adjusted returns. And the site gives you tools to evaluate whether or not Jones is good or just lucky.

Carroll has some ex-Google engineers (who doesn’t these days?) cranking out algorithms like the SuperCruncher, which comes up with a skill score for each investor by comparing the source of their returns with their stated investment strategy. If your strategy is to invest in large cap value stocks, but all of your returns are in small cap growth stocks, you might just be lucky. As it turns out Richard Jones’ skill score is 0%. Maybe he lets his dog pick his stocks.

Nick Kwok, in contrast, has a skill score of 100%. So at least he is accomplishing what he has set out to do, which is to make money by investing in financials and large caps. But his research score is low. (Each investor is encouraged to write out the reasons for each trade, and the research score is determined by how many other members indicting that they agree, disagree or think it is worthless).

Of the 350,000 portfolios on kaChing, 20,000 (1,500 of which are diversified portfolios) have actually generated positive returns over the past seven months, which is no mean feat. The idea that a tiny percentage of kaChing’s members can beat the market is really appealing, and I hope that Carroll is right. But we need more data. How many of those 20,000 can stay in positive territory, or even just beat the market?

It is quite possible the leaders will keep switching out, making it very difficult to invest in a winner over the long run. The iron law of investing is that, over time, everyone’s performance returns to the mean, or worse. Why should a bunch of investors on Facebook prove any different?