Covestor Review

If you are naive enough to fall for the usual Wall Street marketing pitch that you need to become (or to hire) a master stock picker to invest successfully, boy oh boy do I have a deal for you! It is called Covestor and it lets you mirror moves made by an "expert" trader for a low, low fee of 0.5% to 2.5% (plus, you know, the usual trade commissions, bid-ask spreads, taxes on capital gains... but who's counting, right?)

Covestor presents you with a list of nearly 200 "experts" who trade actively in their own accounts along with some performance statistics about each one. You are free to pick which expert you wish to mirror and you are free to dump him and pick another at any time. As your chosen expert executes trades in his account, Covestor automatically mirrors them in your own brokerage account. As mentioned, the privilege to mirror the expert hits you with all the usual frictional costs involved in trading plus between 0.5% and 2.5% management fee (split 50/50 between the expert and Covestor).

Covestor Pros

You are never locked in with Covestor and there are no loads or exit fees of any kind. You are free to quit Covestor at any time at zero cost. You should take advantage of this opportunity immediately.

Covestor Cons

Everything else. But let's go through some of this mess in detail...

Fees

This is as basic as it gets. The higher your expenses the lower your returns. Covestor did choose a very low commission brokerage in Interactive Brokers, but you will still pay the usual frictional costs of commissions, bid-ask spreads, and taxes on any capital gains in taxable accounts. It's not clear from Covestor's website if they support IRA accounts which would eliminate capital gains tax issues. I assume that all Covestor accounts are taxable since their experts are allowed to sell short and that is not possible in IRAs.

Some of the Covestor experts perform dozens of trades monthly. You will be on hook for commissions and bid-ask spreads for each one and then face the aforementioned taxes on capital gains if you happened to make money. On top of that you will be paying a fee of between 0.5% and 2.5% for the privilege of using Covestor service. Eyeballing the average Covestor fee it's right around 1.5%.

It's hard to put an exact number on the constant drag produced by all these costs since it depends on so many factors, but conservatively we can peg it to be around 4% annually. I would not at all be surprised if it averages much higher than 4%. I would be shocked if it's any lower. We'll come back to this number when  we look at actual Covestor subscriber returns.

Unless you happen to discover the next Warren Buffett among Covestor experts you are essentially guaranteed to lose money to the market over long period of time with a 4+% annual drag. Of course, over a shorter period like a year or even five years it is inevitable that some of Covestor experts will be lucky enough to overcome this drag. Those lucky experts will be featured by Covestor as proof that their system works and plenty of individual investors will eat those lies right up. Until the average investor learns statistics, Covestor and the active investment management racket in general are safe.

Risk

I got a good laugh from Covestor's risk rating assigned to each expert. The scale is 1 to 5, 5 being highest risk. With a scale like that any sane investor would assume that 1 is something like a 20% equities + 80% fixed income portfolio and 5 is the inverse. Not in Covestor world! Most of Covestor experts don't even seem to realize that fixed income investing exists. There is about a dozen who allocate to fixed income at all and for some of those allocating to fixed income means double- or triple-leverage bond ETFs. For the rest of experts asset allocation appears to be confined to stocks at x% leverage (where |x| >= 100) and cash. Risk rating of 1 means a "conservative" approach of going only long large cap stocks, with no shorting or leverage. And it only gets riskier from there. 5 means that anything goes. Go all in double-short silver ETF? You'd be crazy not to!

Experts

The experts, or managers as Covestor refers to them, appear to come from all walks of life. Anybody can apply to become a manager. I don't know how Covestor picks its managers and, more importantly, how it decides to dispose of them. Why is that important? Well, Covestor appears to have been formed in 2005 and launched its service in 2007. Yet the vast majority of its managers have started in 2010 and 2011. I only saw a handful who dated back to 2009 and none who dated to 2007 or 2008. Now, I did not click on every single manager, but casual examination suggests that very few if any of the old-timers made it.

Why did Covestor's old managers disappear? Either they failed to perform over the years and faded away or they performed so well that they moved on to bigger and better things. You can decide for yourself which of the two explanations is more likely. I'll give you a hint. If these old managers performed so well that they left Covestor and started their own hedge funds, don't you think Covestor would be proudly trumpeting the outstanding returns achieved by these ex-Covestorites? No such trumpeting is to be seen.

Returns

Here we get to the most fun part of the entire exercise. We don't have to speculate whether the high frictional costs of active trading combined with Covestor management fees can be overcome by skilled managers. We don't have to wonder what happened to Covestor's original group of managers. All we have to do is look at actual Covestor subscriber (i.e. individual investors paying for Covestor service) returns which Covestor helpfully provides. They will tell the story better than anything else ever could.

I would love to have enough free time to fully examine subscriber returns for every single expert listed on the site, but unfortunately I don't have that luxury. Instead I will look at the actual subscriber returns for 10 best of the best of Covestor managers and another 10 I'll randomly select from the rest. My methodology for determining the top 10 Covestor managers will be:
1. Sort managers by returns for past 365 days (1 year) as of today, April 12, 2012.
2. Skip over managers for whom there is no subscriber return data for the same past 365 days.
3. Select the top 10 managers by following steps 1+2.

Note the return figures provided by Covestor do not include taxes on capital gains, so the real-world returns are 25-35% lower. But we'll ignore that little detail here. For the record, S&P 500 which is used as the benchmark by Covestor, returned 4.2% in the same 365 day period that we are looking at.

The top 10 managers I identified using the above methodology are:

1. Timothy Sykes, 44.6% manager return for past 365 days, -4.1% average subscriber return for past 365 days
2. Michael Arold, 25.1% manager return, 16.3% subscriber return
3. Suncoast Equity, 18.6% manager return, 10.4% subscriber return
4. 401 Advisor, 12.0% manager return, 8.0% subscriber return
5. GEARS, 11.6% manager return, 0.6% subscriber return
6. Gator Capital, 9.6% manager return, 6.6% subscriber return
7. Oceanic Capital, 7.2% manager return, 5.8% subscriber return
8. GEARS (again, different strategy), 6.8% manager return, -0.2% subscriber return
9. Atlas Capital, 6.8% manager return, 4.1% subscriber return
10. AlphaMark Advisors, 6.5% manager return, -0.9% subscriber return

At this point, before I go on to pick out 10 more random managers it might be interesting to see the average returns for these top 10 managers and their subscribers. These figures are: 14.9% average 365-day return for top manager and 5.5% average 365-day return for their subscribers. Remember how I said that I wouldn't be surprised if average subscriber returned trailed average manager return by more than 4%? Well, I am not surprised.

Even when only looking at the best of the best managers we find that their subscribers only barely beat S&P 500, 5.5% versus 4.2%. If we take taxes into account, then the subscribers for the top managers trail the market. 

Let's see if adding in 10 more random mangers changes anything. My methodology for these 10 random picks is to continue going down the list of managers sorted by 365-day returns, skip about 10 managers at a time, and then look for the next manager for whom there exists 365-day subscriber data.

The 10 random managers, to go along with the top 10 we identified earlier, are:

1. Robert Freedland, 6.2% manager return for past 365 days, 1.5% average subscriber return for past 365 days
2. Dan Plettner, 4.7% manager return, 2.5% subscriber return
3. Braver Wealth, 1.6% manager return, -1.2% subscriber return
4. Quantemonics, -0.9% manager return, -2.4% subscriber return
5. Atlas Capital, -2.4% manager return, -3.6% subscriber return
6. Robert Freedland (again, different strategy), -5.5% manager return, -9.8% subscriber return
7. Len Fox, -7.4% manager return, -8.9% subscriber return
8. William Smith, -18% manager return, -37.4% subscriber return
9. Patrick Clark, -19% manager return, -8.7% subscriber return (maybe Patrick Clark should become a subscriber)
10. Douglas Estadt, -48.4% manager return, -49.7% subscriber return

Let's add up the numbers for our 10 random managers. These figures are: -9.7% (negative 9.7%) return for the average manager, -11.8% (negative 11.8%) return for average subscriber.

Putting our top 10 and random 10 numbers together we arrive at average manager return of 2.6% and average subscribe return of -3.2% (negative 3.2%).

We see that both the managers and the subscribers trail the S&P 500 benchmark (4.2% return) for the past 365 days. As we suspected, average subscriber return trailed far behind average manager return, by 5.8% annually for our informal study. And all this despite the huge bias in our selection of managers to focus on the best of the best! Fully half of our managers came from the top 15%. Way above average in Covestor translates to way below average in actual returns.

And we didn't even take taxes into account, which would further cut average manager returns. Ironically, since our average subscriber lost money, taxes would actually help him. So there's another plus for Covestor: your losses are tax-deductible!

Conclusion

If statistics and logic were not enough to convince you that a service like Covestor (and active investing in general) is an excellent way to lose money, then the examination of actual returns should have done the trick. There is simply no reason for any sane individual investor or speculator or trader to use Covestor.

Bonus

With a little more digging I learned that Covestor's big competitor from a few years back, using essentially identical business model, was a company named KaChing. At some point KaChing appears to have realized the hopelessness of the expert-mirroring approach (as my post clearly shows) and re-invented itself as an index-based, lowish-cost investment manager that I recently reviewed (in much more favorable light), Wealthfront! From what I gathered, after initial change from KaChing to Wealthfront the company was still dedicated to active investment management, though by professionals instead of amateurs. Only some time later on did Wealthfront finally decide to ditch the active model altogether and become converts to passive investing. Better late than never. Needless to say, Covestor would be wise to follow a similar path and the sooner the better for all involved.