Have you ever had to endure the tedium of listening politely to a loquacious individual at a party brag about (a) the killing he made through investing in stocks, or (b) the stunning returns his little-known investment manager has generated? If you’ve wondered whether there’s a way to get in on the action, mirror trading or investing may be the answer. Before you plunk down your hard-earned savings into a mirror trading account, you should know that this fad has a number of drawbacks that may restrict its appeal to a tiny slice of the investing populace.
What is Mirror Trading?
The concept of mirror trading was introduced in the foreign exchange market in the early 2000s, but it took a few years to catch on for the equity market. Mirror trading basically means replicating the trades in your account by linking it to another account that is managed by someone who you believe is a savvy investor. Thus, every time the savvy investor executes a trade in his or her account, it is duplicated or “mirrored” in your account. The choice of whom you want to follow and link your account to depends on the brokerage offering the service. Covestor, perhaps the best-known proponent of mirror investing, has over 150 managers whose portfolios can be studied and mirrored with a Covestor account. Ditto Trade, an online brokerage that commenced operations in the summer of 2012, allows anyone (yes, even the party braggart) to become what it calls a “lead trader.”
How Does It Differ from Copycat Investing?
While mirror investing is sometimes referred to as “copycat investing,” there are a couple of important distinctions between the two. Copycat investing attempts to duplicate the investing ideas of reputed investment managers, but without the actual physical link between accounts (seriously, what are the chances that you could link your account to that of Berkshire Hathaway's Warren Buffett or Pimco's Bill Gross?). The time lag is another major difference. With copycat investing, the period between the time a money manager acquires or disposes of a stock, and the time that this information is made public, can be measured in weeks. With mirror trading, this time lag may be virtually non-existent, since the buy or sell order from the portfolio manager (or lead trader) and mirror account orders are grouped together and sent to the exchange as a single batch.
Mirror Trading Players
Some of the major players in mirror trading are:
- Covestor: Founded in 2007, Covestor claims to be the pioneer in bringing separately managed accounts (SMAs) online in a transparent marketplace. It bills itself as a forum for discovering exceptional portfolio managers, who collectively cover a complete range of strategies, sectors and risk levels. Covestor enables its clients to save money through low trading costs and automated software like its Portfolio Sync technology, which replicates portfolio managers’ trades in mirror accounts.
- Ditto Trade: Ditto Trade’s technology allows an investor to mirror the trades made by lead traders and signal services, or receive actionable alerts that can be acted on (or ignored). The trading services that an investor can follow include professional traders, registered investment advisors, trading services, and even friends and family members. While Ditto has thousands of lead traders, they did not have much of a fan following as of September 2012, with an average of only three to five followers per trader.
- TD Ameritrade’s Autotrade: Offered by its thinkorswim subsidiary, Autotrade is an automated trading service offered to subscribers of participating advisory firms. If you sign up for Autotrade, you authorize thinkorswim to execute trades in your thinkorswim account based on the strategy and allocation you have selected from your advisory newsletter. As of November 2013, there were 29 investment newsletter providers participating in the Autotrade program.
Pros and Cons of Mirror Trading
Here are some of the points in favor of mirror trading:
- Piggybacking on someone else’s expertise: You do not have to come up with your own investing strategy or style, but can piggyback on a portfolio manager or other investment expert’s investing acumen.
- Low cost: Covestor’s portfolio managers charge between 0.5% and 2% of assets per year. The lower end of the range compares favorably with the average 1.21% average annual expense ratio for mutual funds, according to Morningstar. Autotrade does not charge a separate fee for mirror trading, while Ditto Trade allows its lead traders to keep 100% of fees charged by them.
- Transparency: Firms that permit mirror trading generally have full transparency for the accounts being followed.
Now for the drawbacks:
- Limited performance history: Because of their relatively recent entry into the marketplace, there is limited history available on the performance of portfolio managers and other traders who allow investors to mirror their accounts. The vast majority of performance records start after 2009, when the bull run commenced, so investors have no idea how these presumed experts will fare in a severe bear market.
- Style drift: You may sign up to mirror an expert based on his or her investing strategy and style, but what if the expert changes the strategy (say, from long-term value to short-term growth) to one with which you are not comfortable?
- Losing the Midas touch: This goes back to the first point about the limited performance history. If your mirror trading guru loses the Midas touch that you were hoping could be continued indefinitely, you may be saddled with large losses.
- Little value generation: Even if you only pay 1% as a management fee, that’s 1% too much if mirror investing results in little value generation for your account.
- Can they really beat the market? When even the majority of professional investors and mutual fund managers are unable to beat the market on a consistent basis, what are the chances that anyone else can? With the plethora of investment choices available, an investor may be better off spending a little time and effort in structuring his or her own portfolio using a combination of exchange traded funds (ETFs) and blue-chips.
So Should You Even Consider Mirror Trading?
Mirror trading may not be suitable for the majority of investors for the reasons outlined above. But if you are seriously considering hitching your account to cousin Bob’s portfolio, a few precautions may be in order. First, conduct your due diligence. Make sure Bob really knows his stuff when it comes to investments, and is not a wannabe trader who thinks he is an expert because he regularly scans the business news and online investment portals.
Second, check performance records. Bob may have a killer investment strategy that he wants to try out, but if he does not have the track record to back it up, why should your account be the guinea pig?
Third, limit risk by only allocating a small portion of your total capital to this mirror account. If Bob does turn out to be the next Buffett, you can always increase the funds allocated to the account in a measured manner. But if Bob blows up the account and you had a sizable amount in it, you may find it difficult to recover from that loss (not to mention that family reunions will be very uncomfortable affairs).
Finally, ensure that Bob’s investment philosophy reflects your own (this is mirror trading after all). If your personal investment style is to seek steady rather than spectacular returns in large-cap stocks, while Bob’s approach is to shoot the lights out by speculating on microcap stocks, do you really think Bob ought to be managing your money?
The Bottom Line
Mirror investing in equities could well be a fad that only appeals to a limited number of investors. One large mirror investing firm, Wealthfront, has already bowed out of the business and instead offers investments using index ETFs. Mirror investing does offer transparency and the ability to benefit from someone else’s investment expertise, but given the wide range of investment choices available to investors presently, these advantages may not be enough to offset its risks.