Guru Networks Sell Social Investing to Copycat Traders

Internet social networks that let users follow investments the way they track status updates on Facebook are attracting record interest, turning top performers into market stars for individual investors.

Accounts at Tel Aviv-based EToro, the largest social-investment network, have climbed to 2.85 million from 1.75 million in 2011. ZuluTrade in New York says users have more than tripled since 2011. About 17 percent of brokerages serving individuals offer the ability to copy other users' trades, according to a survey of 254 firms compiled by Aite Group LLC between October 2012 and April 2013.

In contrast to the secrecy that exists elsewhere in the investment world, where hedge funds protect their strategies and brokerages keep identities of private-banking clients confidential, the networks make positions visible to everyone. Users of EToro can duplicate bets made by the top traders, known as gurus, who may have as many as 100,000 followers and 10,000 copiers, raising concerns among professional investors.

"I don't mind sharing what I'm doing," said Santosh Tiwari, a 37-year-old technology consultant from Reading, England who became an EToro guru as bets on the British pound helped produce a return of 11 percent over the past 12 months. "EToro has evolved into such a big network, it has become a rich information source."

Disrupt Markets

Gurus may be able to disrupt markets as thousands of followers buy or sell the same securities, according to Justin Urquhart Stewart at Seven Investment Management Ltd. in London. Traders may just be seeing "glimpses of someone's portfolio" without being privy to a guru's overall trading strategy, Urquhart Stewart, who helps oversee about $6.8 billion, said in a telephone interview on June 3.

Copying someone based on past performance can be dangerous, according to Raimund Saxinger, a fund manager at Frankfurt-Trust Investment GmbH, which oversees about $22 billion.

"If you have a big universe to cho! ose from, someone will always look good, just by the laws of numbers," Saxinger said in a telephone interview from Frankfurt on June 19. "It reminds me of Barton Biggs's account of a national coin-flipping contest where, after six months, there would be 32 contestants left from 200 million entrants. These 32 gurus would be interviewed on their finger-flipping technique and whether they used a special nail polish."

Biggs, the Morgan Stanley strategist who predicted the bull markets in U.S. stocks that began in 1982 and 2009 and urged investors to sell technology shares in the late 1990s before the dot-com bubble burst, died last year.

'Survivorship Bias'

Gains in global equities over the past four years may have increased the potential for "survivorship bias" to create a distorted picture of leading gurus' skills, Saxinger said .

"I'm not sure if people are looking at the performance of trading gurus on a risk-adjusted basis," he said. "Investors need to take into account the risks taken by these gurus in order to obtain the returns that they make."

While gurus can earn as much as $10,000 a month in commissions for attracting people to duplicate their trades, they are often motivated by peer status in addition to money, according to Yoni Assia, EToro's founder and chief executive officer.

"Knowing that there are thousands of users who think you're special in some way or other gives people the chance to experience a sense of self-fulfillment," Assia said. "Most investment houses do not want to open up their customer base. On EToro, you can see who is buying and selling."

Mirror Trading

Social-investment networks started appearing in the middle of the last decade. Most focused on currency trading at first, as foreign-exchange markets allow 24-hour trading in highly liquid assets. Tradency Inc., a company founded by Lior Nabat, began offering a mirror-trading platform in 2005. EToro, which started in 2007, made technol! ogy stock! s such as Google Inc. and Apple Inc. available to its users in September last year and plans to add trading in well-known consumer companies.

Social investing attracts younger users and has a potential audience of hundreds of millions, according to Aite Group. Most clients have an interest in finance without the time or resources to be classed as a professional investor, Assia said.

ZuluTrade, a social network focused on currencies, says its user base has jumped 280 percent since 2011 to 500,000 members. Transaction volume reached about $40 billion a month, according to the company.

'Strawberry Rhubarb'

Collective2 allows customers to copy more than 15,000 trading programs designed by other subscribers. The systems have names such as "EUR Scalper" and "Strawberry Rhubarb FX" and can make buying and selling decisions for foreign exchange, equities and derivatives.

A program called "sp500-trading.com" trades U.S. stock-index futures and claims an annual return of 75 percent. The "enigma24 Eurostoxx" system focuses on European equity derivatives and has posted an 8 percent annual loss.

"The Internet is great at breaking down barriers to entry, particularly in the financial world where going to the right schools and university still carry so much weight," Matthew Klein, CEO of Collective2 in New York, said in a phone interview. "If you are a genius who has developed a trading-software program in a basement in Moscow, you can use C2 as a distribution channel for the program you have developed to brokerages across the globe."

Virtual Money

At EToro, which plans to move its head office to London next week, clients can set up an account in minutes via their Facebook login. After practicing with virtual money, funds are deposited with a credit card. A minimum of $50 is required to start trading for real. Traders must also upload a copy of their passport and a utility bill.

"We don't think it is a fad," Assia said. "Soci! al invest! ing democratizes the world of investment. It allows people to see when people succeed and when they fail. You find all the secrets of the market."

EToro acts as a market maker, using derivatives known as contracts for difference to provide its users with exposure to stocks. CFDs are a leveraged product that allow people to bet on the movement of a stock without owning shares. The social investment network reached 50 million trades by users in May, 64 percent of which were copied.

Tiwari says becoming a guru felt like a natural progression and the status gives "validation" to his skills. He has about 3,500 copy traders and 72,000 followers, having used EToro since 2008, Tiwari said in a phone interview.

S&P Bets

Tiwari has a second account where he makes bets on the Standard and Poor's 500 Index and Germany's DAX Index (DAX). He doesn't encourage people to follow these trades as he's just "trying out new ideas." The DAX climbed 1.1 percent to 7,899.65 at 10:22 a.m. in Frankfurt today.

Julio Rus Fernandez, a guru from Spain who trades under the name Malsolo, is a firefighter who has about 7,600 copy traders and has become a celebrity on EToro, according to Assia. Describing himself on his EToro profile page as a part-time trader, Fernandez writes that he takes on little leverage, using technical and fundamental analysis to place bets on global currency markets.

"We invited him to attend a user event in Barcelona where he was warmly welcomed by all those attending, who wanted to finally meet him," Assia said. "Malsolo is very much liked by the community and he regularly engages with his tribe to maintain and build his relationship."

Javier Paz, a senior analyst at Aite Group in Boston, said social investing allows inexperienced investors to benefit from the wisdom of crowds. He is concerned about the amount of borrowing traders use to increase the size of their bets.

'Dumb People'

"Crowd sourcing gives members of ! community! linked insight as they pick up insight from each other," Paz said in a phone interview. "Leverage means they risk losing a large portion of their original investment, which typically is a few hundred dollars. Leverage can be akin to using a credit card. Smart people will make use of it in an intelligent way, dumb people will just use it too much."

Collective2's Klein said social investment networks need to promote responsible investing so uninformed traders don't suffer large losses. Users of EToro, which has obtained authorization under the U.K.'s Financial Conduct Authority, can see the performance of a guru over the past year and the company is considering lengthening that, Assia said.

Social-network users still may not have sufficient information to judge the returns of fellow traders, according to David Jones, chief market strategist at IG, a London-based firm that offers spread betting, a way of placing wagers on stocks without owning them.

Closed Positions

"Some companies only show the trading history of closed positions," Jones said in a telephone interview on June 5. "A profit and loss could be skewed if some positions are still open. Maybe you are not seeing the true performance picture."

Alexander Thirlby, 37, a software developer for Microsoft Corp. in London, discovered EToro via an advertisement on Facebook. Copying the positions of more experienced traders has proved a winning investment strategy, Thirlby said.

"You get access to a vast amount of experience," Thirlby said in a telephone interview. "The social network brings into play the wisdom of crowds. If you are going into battle, it is better to do it with 1,000 people."