kaChing: There Goes Your Money, Here Come the Lawsuits (If the SEC Doesn’t Shut Them Down First)
I don’t know what it is with social investing websites but if you thought Cake Financial, whose Cakedex index of the holdings of its “top” investors lost another 13.86% last month, was bad, kaChing, another social investing website that offers a popular Facebook investing game application, is even worse.
Unlike Cake Financial, which tracks real trades, kaChing is a game. When you sign up, you receive $10 million in virtual money to invest and kaChing tracks what would have happened if you had really invested that money.
Earlier this month, kaChing announced that it has received approval to become a Registered Investment Advisor. What does this mean?
It means that kaChing is going to enable its users to link their brokerage accounts to the kaChing service and automatically enter trades based on the virtual trades of other users they want to “follow.” And it will give amateur users who have actually never traded a single real share of stock in their life to become their own “fund manager.”
This is a disaster waiting to happen.
When I first discussed the stupidity of social investing websites, Perry Blacher, co-founder of Covestor, dropped by and left a comment. Covestor is going to be offering a similar service but unlike kaChing, Covestor only tracks real trades.
Even then, I posted a comment in response to Blacher, noting that there are significant flaws with its model. kaChing suffers from the same flaws and creates new ones that are even more problematic.
Because kaChing’s users are not trading with real money and you really have no idea who they are and what qualifications they have, mirroring trades that are made on kaChing is akin to gambling.
As someone who trades the markets on a daily basis and helps manage a fund, I can tell you this: when you have no skin in the game, you make decisions differently. The performance realized while paper trading $10 million that you don’t have is in no way indicative of the performance that will be realized while trading real money – even a paltry $5,000.
According to TechCrunch’s article on kaChing, in response to such criticisms, “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.”
This is pure bullshit. By definition, you cannot be a brilliant investor if you aren’t actually trading.
But Carroll doesn’t seem to be the brightest of the bunch.
From the company’s post on the subject:
What does it mean that you are a Registered Investment Advisor with the SEC now? It means the best managers on kaChing can now make some serious “bling”, REAL MONEY managing a virtual portfolio on kaChing. How? By earning high risk-adjusted returns and attracting a large following, we will soon (second half of ’09) allow your followers to link their brokerage account to your behavior. You will be paid a convenience fee (our term for mgmt fee) and a percentage of the commissions generated by your follower’s broker. Just as Ebay powersellers have bustling businesses on Ebay, you can have your own investment business on kaChing. To give you an example of how much money a successful manager on kaChing can make: Let’s say you have the following:
2,000 followers
Your followers have an average account size of $10,000
Assume 1% convenience fee (our term for mgmt fee)
Assuming you make a few trades a month (you earn a percentage of commissions)
Total = $350,000 revenue split between YOU and kaChing (not sure of percentage yet). Not too shabby, eh?Does this mean I have to pay to follow a kaChing manager? Hell no! You will only pay for the convenience to hook up your real brokerage account to the manager’s behavior.
Does this mean the application won’t be free anymore? Hell no! You won’t ever have to pay to use kaChing
Is kaChing going to become all corporate and serious now? Absolutely not. In fact, we are going to make a conscious effort to make the site more fun.
Given the stupidity of this whole setup and the unrealistic nature in which it is described, I doubt that individuals will link to their accounts on kaChing (they can just give it to managers like Bernie Madoff).
But what interests me about the setup is that I question whether kaChing’s Registered Investment Adviser status even permits it in the first place.
First, based on my understanding of the Investment Advisers Act of 1940, I do not believe that kaChing’s status as a Registered Investment Adviser extends to individuals who are not its employees or investment adviser representatives (for obvious reasons). In other words, unless kaChing hires all of its users, the fact that the company itself is a Registered Investment Adviser is meaningless.
Second, to become a Registered Investment Adviser, certain information must be disclosed and certain representations must be made to the SEC. For instance, the applicant must represent that it and its advisory affiliates (officers, directors, partners, and employees except those performing duties such as clerical work) have not been charged with or convicted of a felony, have not been charged with or convicted of certain misdemeanors, have not been found by the SEC and other regulatory agencies to have made false statements, etc. Applicants are also required to disclose if any of its related persons, including advisory affiliates, are lawyers, real estate brokers, etc. Obviously it is impossible for kaChing to accurately make these representations and disclosures because it does not really know who its users are and doesn’t employ them.
Third, if kaChing is going to claim that its users are investment adviser representatives, it seems woefully unaware that certain states it may be operating in require investment adviser representatives to meet certain qualifications, such as having passed the Series 65 exam.
Fourth, Registered Investment Advisers have a fiduciary duty to their clients and I fail to see how kaChing can reasonably meet them. Given that Registered Investment Advisers are legally responsible for the advice that they give to clients and are held to a high standard, it boggles the mind that the company would want to take on the possible legal exposure the “advice” of users who may have no experience and knowledge provide to its clients.
But this all gets worse – it appears that kaChing failed to accurately describe itself to the SEC in its application to become a Registered Investment Adviser. In fact, it appears that the company made a number of blatant misrepresentations and omissions.
- The company’s application states that it has 6-10 employees and that only 1-5 of these employees will be providing investment advisory functions. I don’t see how this is the case if kaChing will be enabling any user to become a so-called fund manager. In fact, it appears that kaChing and its employees really aren’t providing any investment advisory functions themselves – the users are.
- The company’s application states that it is compensated by “ADVERTISING.” Yet Carroll’s blog post refers specifically to a management fee based on the total amount of money in the accounts being serviced. The box for “A percentage of assets under your management” is not checked in kaChing’s application with the SEC. It would appear that it absolutely should have been.
- When it came time to answer the question, “What type(s) of advisory services do you provide?”, kaChing responded: “PUBLISH VIRTUAL PORTFOLIO INFORMATION.” It did not check that it was providing “portfolio management for individuals and/or small businesses” or “market timing services” which it clearly is by allowing individuals to mirror trades made by its users.
- In its application, kaChing responds “No” to the question, “Do you or any related person have discretionary authority to determine the..securities to be bought or sold for a client’s account?” This, again, appears to be an blatant misrepresentation – if kaChing is going to “allow your followers to link their brokerage account to your behavior,” it absolutely has the authority to determine the securities that will be bought or sold in a client’s account.
I’ll leave it to the lawyers and SEC to figure this all out but I really hope that this joke of a service doesn’t gain any traction in the first place because people will lose money if it does.
And if they do, they should go after the management and shareholders of kaChing, who are conveniently listed in the SEC application. Radar Partners, which has invested over $30 million in Automattic and is founded by former Kleiner Perkins Caufield & Byers VCs, has invested money in kaChing through its Radar Partners II Fund. It sure looks like they have a lot of money to “play” with. I wonder why they invested in kaChing. Seems like they’d do far better to give all their money to Nick Kwok.
I think the biggest revelation in your post is that you are “someone who trades the markets on a daily basis and helps manage a fund.” Of course you’re cynical about social investing websites. They will introduce a lot more competition into your profession.
If simulation is worthless, then why does NASA do it? And every military organization and schoolchild?
Albert: you make an obvious point but unfortunately it’s inaccurate.
The market kaChing and Covestor are targeting (retail investors) is different from the one that professional fund managers and real investment advisers target (high net worth individuals, institutions, foundations, etc.).
Realistically, this latter group would never be inclined to use a service like kaChing or Covestor. They have no need to and in the case of institutions and foundations, most would be unable to because of their fiduciary duties.
Services like kaChing are ill-equipped to serve these types of clients, especially when you consider how limited kaChing and Covestor are. As far as I can tell, kaChing and Covestor don’t support the tracking of options trades, futures trades or commodities trades. If you have $20 million to invest, chances are you’re not going to find a long/short equities strategy implemented by some random person on kaChing to be sufficient or appealing.
Since I’m involved with a small fund belonging to a high net worth individual and a foundation, kaChing isn’t going to create any competition for people like me.
The people who will be fooled into using services like kaChing are retail investors who manage their own investments and unfortunately, they’re the most vulnerable. Many of them don’t have the type of knowledge required to evaluate investment strategies and risks or to even ask the right questions.
And unfortunately, many people only pay attention to returns, not understanding how to decipher them.
Simulation is useful. Backtesting and paper trading are used by professionals. But when you’re measuring the real performance of any investment system, simulations don’t work.
Not only do individuals behave much differently when they are trading with real money, there are flaws inherent with a simulation model like kaChing’s.
When kaChing’s users make a virtual trade, it’s logical that kaChing takes the current price of the traded stock at the moment the virtual trade is entered.
But what happens if you’re buying 50,000 shares of a stock that has daily average volume of 60,000 shares? What happens if you’re buying 20,000 shares of a stock that doesn’t trade more than 10,000 shares a day? There’s no way for kaChing to predict the impact its virtual trades would have on supply and demand in the real market.
This is especially problematic when you have a system that is mirroring virtual trades in real markets.
Let’s assume for a minute that kaChing takes off. A popular user has 10 investors mirroring his virtual trades in the real markets. He buys a penny stock trading at 10 cents/share that has daily volume of less than 5,000 shares. Depending on how many shares those 10 real investors are trading, he could cause a dramatic and rapid increase in price that is unsustainable.
The investors will inevitably lose but if this user is unethical, he could have purchased shares prior to executing the trade on kaChing and benefitted personally.
There are a whole host of problems with kaChing’s model and I suspect that if services like this do gain any traction whatsoever, eventually the SEC will receive complaints. In fact, based on the information I posted above, I think it’s inevitable that they will.
Whether or not they have the resources or will to do anything about it is another matter altogether. Right now they’re busy explaining how they didn’t catch a $50 billion ponzi scheme.
You are so right on! Because of their headline, I posted this on TechCrunch:
The SEC Gives Green Light headline here is totally misleading and dangerous (Erick, whats up?). I cant understand how kaChing and CoVestor can dupe both reporters and investors, at least any who have heard of the term due diligence.
The fact is that no legitimate broker dealer in the world will risk its license or the inevitable litigation which will arise from unhappy investors just so kaChing or CoVestor can pay Joe-The-Plumber types a few bucks for a hot hand (no matter what they call the payment). Nor will you find a clearing firm to clear the transactions. It is simply in violation of the 1940 Investment Advisors Act.
Dan Carroll likes to post so lets see if he will actually tell us what formal assurance he has received from either the SEC or FINRA.
Go to http://www.adviserinfo.sec.gov…..earch.aspx and type in kaching and click the resulting name link. Then look at Schedules A and B. You will see that Andy Rachleff invested in and became CEO of kaChing more than two years ago. The only news this year is the merger with FSX (Dan Carroll) in January and some angel money from Rachleffs friends in June (I doubt any of them know how to spell FINRA). So this is just a fluff announcement to appear to have something fresh. It will only mislead the truly uninformed.
Brad: thanks for your comment. You raise an interesting point.
Even though kaChing and Covestor are technically effecting trades, I’m not sure if they’d fall under the definition of a “broker” since the actual trades are being executed in the user’s brokerage account.
Even so, I believe these types of services are problematic for a number of obvious reasons and one has to wonder if the SEC is eventually going to have to take a closer look at them (assuming they gain any traction, which is questionable).
I’m not an expert on securities law so I might ask a friend who is next time I speak with him.
The one thing I do know: kaChing’s filing with the SEC seems grossly inaccurate.
I went to look at your comment on TechCrunch and noticed that someone had posted a reference to this post. Dan Carroll responded:
Unfortunately, he really didn’t address my concerns. His response is basically “Trust us, we have the best lawyers.”
That may be so, but I’d be very interested in knowing why he’s playing up management fees in his blog post when kaChing’s application with the SEC specified that compensation was through “ADVERTISING” and “percentage of assets under your management was not checked.
Hi Guys
I am sorry I didn’t reply to your previous post, i had missed the response
Again I have to say we would agree with much of your analysis. Virtual trade replication does throw up a number of complications and I don’t know how they plan to handle these.
On our part, in following real activity, you are right that we are not a broker or broker dealer. As an RIA we would of course have ultimate responsibility to our clients (and the same burden of regulation/compliance as any RIA re suitability, record keeping etc). In that sense you are also right that were we (or even Kaching) to simply blindly follow investors into every trade this might not be the best approach.
The areas though i would hope we also would’t disagree, and Madoff also teaches us, is that greater transparency can only be a good thing and that just because someone does not have a ‘professional’ registration says nothing about the basis of their model as being more suitable, consistent or profitable for a client (particularly where unlike the ‘professional’ they are putting their own money at risk).
Perry: thanks for the response. Nice to know that you care about your fiduciary duties to your clients.
Again, even if the type of “portfolio mirroring” we’re discussing here is permitted, the most problematic things about kaChing (besides the fact that their users are building portfolios based on virtual trades) are that there seem to be glaring misrepresentations/omissions in its application with the SEC and the CEO’s pitch to his users (suggesting that some, perhaps without any experience, could become real managers with $20 million in assets “under management”) is not only unrealistic but entirely irresponsible.
As for Madoff, I agree – just because someone is a “professional” does not mean that he has a suitable (or workable) strategy. At all times investors must be prudent. Investors who don’t do due diligence usually learn that due diligence eventually does them.
Although Madoff is an unusual case that unfortunately, probably isn’t the only big fraud lurking out there, I would point out that some of the people hurt by his fraud will have potential recourse. A substantial amount of money was invested with him by third parties on behalf of their clients and I would be shocked if some of these clients did not explore legal action against the third parties they trusted to handle their money with a reasonable amount of care.
As you’ve probably heard, many knew Madoff was up to something. His returns simply didn’t make sense. Complaints were filed with the SEC and there were articles published questioning his business.
Therefore it’s clear that there were managers of funds of funds and investment advisers who were asleep at the wheel and probably did little to no due diligence whatsoever.
In looking at it this way, perhaps one of the greatest challenges to even the most legitimate investment services involving the management of investments by third parties is that people have lost a lot of trust in the system. They know that most professionals can’t do what they say and that there are a lot of dishonest “professionals” out there.
A lot of money has been pulled out of the market and in general I think there are a lot of retail investors who will be weary of getting back in anytime soon.
Drama, re: Dan Carroll’s TechCrunch post in reply to mine, actually his was a 10:18am reply to another regarding the ADV. Mine was posted at 8:19pm, 10 hours later. Carroll has not replied and won’t. “Being counseled by the top securities attorneys” is irrelevant (and I’m sure even none of these has willing to give kaChing an opinion letter). Wait until one of his “managers” hears from the SEC and is on the wrong end of the many inevitable investor lawsuits (this applies equally to Covestor).
I can’t comment on Kaching or their SEC filing as I don’t know their case.
To be clear though ours are not ‘managers’. We have never called them managers, do not treat them as managers and they do not act as managers. Our fiduciary duty is the most important thing to us. Drama 2.0 is correct – someone has to have legal/fiduciary responsibility to clients and in our case that will be us.
Perry, the “manager” label itself is not important. The act of getting paid is. So here are the two simplest and most direct questions for Covestor …
1. Have you received any formal ruling from the SEC that supports your FAQ pledge to Covestor “members” that they will be able to generate a data fee from each account that tracks [their] investments”?
2. Do you have a formal agreement from a reputable broker dealer AND clearing firm to establish and trade these accounts, putting themselves and their licenses in harms way (from FINRA and as “deep pockets” in the inevitable investor lawsuits)?
Or like kaChing, are you and your investors just praying it works out (even thought there is no mention of such prayers on your website)?
Hi Brad
I can’t comment on the specifics of the execution at this point but when it is up and running I would value your input as we are obviously working to do this in full compliance with regulation
All the best
Perry
Perry: I’m glad you seem to be taking your duty to clients seriously but I am interested in how you will compensate your users, even if you’re not calling them managers.
Your FAQ states:
So Covestor earns a management fee that I’m assuming is a percentage of the total funds in the account being managed? What will the data fee for the member being tracked be? Is it a flat fee that is not based on the size of the account?
How much information will members who are being tracked have about the accounts that are tracking them? This is an important point depending on how your system works. For instance, one of your most “successful” members, Tim Sykes, trades penny stocks. Take for instance IDAE, which he last traded in October. Average daily volume is about 30,000 shares for a stock that was $2 at the time he was trading it. If you have a sizable account, no real money can be made trading a stock like this and the risk is huge because one big block trade caused by automatic execution could distort the market.
Which brings me to the question: how are trades handled and trade sizes determined? The big problem I see is that unless the members who are being tracked are Covestor employees (or investment adviser representatives), you’d have to (or want to) have an employee validate each and every trade before you allow it to be executed for the client. After all, if the client believes that there is some protection because you’re a Registered Investment Adviser, the last thing you want is to be responsible for decisions made by tracked members who have no real fiduciary duty to (or direct relationship with) Covestor’s clients. Bad trades are not limited to bad “picks” but also to bad position sizes.
In my opinion, these types of issues are more important than any SEC issues. Even assuming that everything is kosher as far as the SEC is concerned, the last thing I’d want is to be responsible for a bunch of really bad trades that were made by members and that I was accused of endorsing even though I had not vetted them before they were executed.
And that’s the biggest problem I see with all of these services. Having some control of other people’s money and investments is not only a huge legal burden, it’s a huge ethical burden. There’s a lot of responsibility. Giving the Average Joe the ability to put his money into the hands of another Average Joe and vice versa seems like it’s inviting trouble, especially in these treacherous markets.
Perry: missed your response to Brad. Fair enough.
I look forward to seeing how this space pans out.
given the plethora of absolute idiots i have come across who run real money in the markets and indeed the ‘intelligent’ ones who have made an absolute hash of it this year; i think people’d probably take their chances…
you know what a load of rubbish there is in the Series 7 exam… does it really mean you know what you’re doing? De jure maybe… de facto? who are you kidding?…
Richard: this is not an either-or proposition. Trusting “professionals” blindly and not doing due diligence doesn’t make sense. Swinging the other way and trusting “amateurs” blindly and not doing due diligence doesn’t make sense.
I think people need to understand one thing: these markets are extremely difficult to trade. They’re slaughtering professionals and amateurs alike.
Right now, a lot of money has been pulled from the market and I’d suggest that the money flow is coming primarily from short-term traders who are playing the swings.
For most people, being in the market now is a bad idea regardless of who you’re trusting with your money.
This blog has lost all credibility with this article. Kaching is backed by Kliener Perkin’s Kevin Compton (Verisign angel investor and San Jose Sharks Owner) The founders of OpenTable and Netscape. And the CEO is Andy Rachleff a co-founder of Benchmarks (the founders of ebay, twitter, AOL, 1800flowers,Palm,Ariba, and Juniper Networks just to name a view). This Blog is a joke they know nothing about silicon valley venture capitol, because if they did then they would understand that they created blogging and when they did everyone criticized it. They thought that “it would illegitimatize” the industry. People thought that no one would read them because they would be the sources of mass confusion. Other than looking like a dumb ass, you have also illegitimated the creators of your occupation. con grats drama 2.0
O and you are generally mis informed, because in order to become a “genius” Kaching runs a comprehensive background check on you