Social investment networks the new craze?

The Internet revolutionized trading in the ’90s with online trading platforms. Suddenly, everyone could open a brokerage account and trade at any time without calling anybody or sitting through a sales pitch. A decade later, the hive mind of the Internet is buzzing around the idea of social networking for investors.  

Several big social investment networks already exist, and more are emerging every day. Investors can message each other and read what others say about trading and investments, but that’s nothing new. There are countless free message boards and forums available for those sorts of services. The hook of social investment networks is the ability to link your account to other traders and have their trades quickly replicated in your account automatically.

It sounds like a great deal — but keep in mind a lot can go wrong when making speculative trades using leverage. Trusting other people to decide how you should trade adds another level of risk to an already uncertain endeavor. Market and trading risk aren’t the only hurdles on the way toward profits; fees could definitely eat into any possible returns. Just so you know: Bankrate doesn’t endorse any of these companies. Social investing networks could be the wave of the future — or they could be a new-fangled way to lose lots of money.

Trading in the 21st century

Though many social investing sites trade the foreign exchange market, or forex, some sites do offer the ability to buy stocks and other investments, and they let investors follow and automatically copy the trades of stock, futures and options traders.

The sales pitch essentially says investors no longer need to pick winning investments; they can just copy the trades of people with a history of winning and reap the rewards. But there are a couple of catches. First, buyer beware: Past performance is no indication of future returns. Investors should always do their homework and understand what they’re investing in.

Second, these social investment networks generally charge fees. Can individual investors generate enough returns to outstrip the costs of trading? Maybe, but while profits are only hypothetical, fees are certain.

“Large costs associated with the services themselves should definitely be the major concern for the investors. One must try the paper-trading accounts for as long as possible and not follow those traders which trade a lot, as this will result in a lot of commissions for the trades executed,” says Arseniy Korobchenko, director of marketing at On Budget and Time Ltd., a financial technology consulting firm.

Paper-trading accounts are just like real accounts — but with fake money. The demo accounts let investors test the waters before committing real funds.

That’s important because forex brokers are very willing to lend money for trading, enabling investors to use leverage, which amplifies returns as well as losses.

Beware of borrowing

Leverage is a double-edged sword. Investors can risk less of their own money upfront but could incur big losses if their trade ends up losing lots of the money they’ve borrowed.

“The problem with forex is that it is highly leveraged. When you buy 100 shares of IBM for $10,000, you either put up the money or buy it on margin,” says Tim LuCarelli, chief analyst of FXAddicts.com.

By buying on margin, an investor would put up part of the cost to purchase the security and borrow the rest. It’s the same in forex trading, but more widespread.

“It is a way of getting more meaningful trading results from forex’s low volatility by making forex trading available to users that wouldn’t have such an opportunity to trade without it,” says George Kollias, publishing director at ZuluTrade.

Investors may be lured in by the thought of easy money, but that street goes both ways: Losing it can be just as easy.

Copycats

Each social investment network does things a little bit differently, but the basic idea is that investors can interact with one another, peruse news and research, see other people’s trades, and pick traders they want to copy.

The fees vary from site to site, as do the ways trade leaders are chosen. On some sites, the leaders apply and go through a vetting process. At least one site, Collective2, allows anyone to set themselves up as a leader, and natural selection takes its course: If they do poorly, they will fall down in the rankings, and no one will follow them.

EToro was founded in 2007 as an attempt at making trading more fun.

The exalted traders on eToro are called social gurus, and anyone can apply to be one as long as they meet the requirements. In addition to trading reasonably well, potential leaders must have a picture of themselves on their profile, share their trading performance and have at least 10 copiers.

There are two trading platforms built into the eToro website. One of eToro’s platforms, called OpenBook, lets investors view other investors’ messages and rankings and easily copy trades. The other platform, WebTrader, is similar to typical forex trading platforms with a control center and charts to view.

Account minimum

The minimum to get started is $50, but it depends on the method you use for funding. The minimum to fund the account with a credit card is $50, while the minimum for a bank wire is $500.

Types of investments available

Though investors do have the option to buy some stocks through eToro, they don’t actually own the stock after making the purchase — a drawback, since they have no shareholder rights or ownership stake in the company. Instead, the purchase is of a “contract for differences,” or CFD. A CFD is a derivative contract; the underlying security is not traded. Instead, investors speculate on the future price of the asset.

When you buy a stock through the eToro account, the company agrees to pay you the difference between the price at which the security was bought and sold when you close the position. One benefit of their system is that you can buy as little as you like — for instance, a fraction of a share.

There’s a small transaction cost for purchasing one of the handful of stocks available on the site. Investors can also buy contracts for differences on commodities as well as some of the larger stock indexes from the U.S. and Europe, including Standard & Poor’s 500, the Nasdaq 100 and Germany’s Dax 30 index, among others.

How much does it cost?

There’s no cost to use the service, but there is a cost per trade. EToro charges a fixed spread between the price a seller can get for selling his asset and the price at which you can buy it, called the bid and the ask.

“There is a fixed spread; we don’t believe in dynamic spreads. It’s a fixed commission per instrument. Some instruments are very volatile, and the instruments that are more liquid, the commission is lower,” says Alon Levitan, head of product marketing at eToro.

Risk management

To protect investors from themselves, eToro restricts the amount of money investors can devote to any one trade or trader.

“You cannot put more than 20 percent of your balance on any one trader, and never at one time put more than 20 percent of your balance into one single position,” Levitan says.

On other social investment networks profiled here, such as eToro and ZuluTrade, investors can try out strategies on demo accounts before signing up. But on Currensee, “lookie-loos” are locked out unless you sign up for an account with one of its brokerage partners.

What makes Currensee, founded in 2008, a bit different from other social investment networks is the proprietary trade leader selection process. Instead of letting just anyone in the trade leader door, Currensee handpicks their traders.

“We find foreign currency traders, professionals, anywhere in the world. We find them and analyze their performance. We vet them essentially the same way that hedge funds would vet traders for themselves. They go through our analysis, and if we deem them suitable, we present them on the Internet on the leaderboard to customers,” says Dave Lemont, CEO of Currensee.

Account minimum

Investors must deposit $5,000 to start, and there are minimum capital requirements for trade leaders “to ensure that you are not over-leveraged,” according to the Currensee website.

“We suggest a minimum account size of $5,000 or equivalent to allow for reasonable diversification of leaders in your portfolio. Individual trade leaders have minimum allocations from $1,000 up to $6,000, so you may need more capital to invest in some leaders or to construct certain portfolios of leaders,” says David Karp, vice president of marketing with Currensee.

Types of investments available

Currensee limits itself to investments within the forex market.

How much does it cost?

On a monthly basis, investors pay a 2 percent annualized fee on assets. Plus they fork over a success fee of 20 percent of profits per month per trader. If you have no profits, you don’t pay a success fee.

“In general, 15 percent of the success fee goes to the trade leader, while 5 percent goes to Currensee — but the deals vary among trade leaders,” Karp says.

Risk management

Investors have a few levers for controlling risk. The maximum drawdown can be set, leverage capped and currency pairs can be limited.

“These controls are available to clients on a per-trade leader basis,” says Karp.

Setting your maximum drawdown allows you to stipulate the lowest you want your account to dip from either the account’s high watermark or from your initial investment in that trade leader. It is expressed in percentage terms. Investors can also decide which currency pairs they are comfortable trading.

ZuluTrade was founded in 2006. Like the other sites, the website has an easy-to-read dashboard that shows the traders available to be followed, known as signal providers. Investors can compare them based on statistics such as return on investment, maximum drawdown, the number of dollars following them and number of followers.

ZuluTrade provides the framework for following signal providers, but investors must sign up for an account with one of the brokerage partners.

Account minimum

The minimum account balance varies between brokers, but the ZuluTrade website recommends a $15,000 minimum for standard accounts and $500 for mini accounts.

Types of investments available

Only currencies through forex are traded on ZuluTrade.

How much does it cost?

“There is no cost for investors for using ZuluTrade. It is totally free,” says Kollias. “ZuluTrade is compensated by the collaborating brokers.” The trading costs and commissions vary among currency pairs traded and from broker to broker.

Investors don’t have to worry about paying the signal providers either. They are compensated by ZuluTrade. “Signal providers are compensated by ZuluTrade for each traded lot that is copied on a follower’s account, with the exception of the U.S., where signal providers are compensated on a variable monthly membership fee scheme,” Kollias says.

Risk management

ZuluGuard, the proprietary risk management system, monitors the trading behavior of the trade leaders. If a trade leader abruptly changes their trading patterns or just performs really terribly, ZuluGuard closes the open positions following that signal provider, takes that trader out of the investor’s list and replaces it with another one.

There’s also a risk meter bar that illustrates the amount of leverage used. By moving the bar, investors can allocate the number of contracts to trade with each signal provider. It indicates the amount of capital that will be at risk in the worst-case scenario based on the historical data of the trade leader.

“In other words, the risk meter bar calculates the worst past performance of the trader that the user has chosen to follow and by comparing this to the user’s settings and equity, shows the maximum amount of the user’s equity that will be at risk should this performance occur again,” Kollias says.

Unlike the other networks profiled, Collective2 is a marketplace for signal providers. Anyone can come up with a trading system and hang a shingle as someone to be followed. Investors can have trades automatically replicated in brokerage accounts, but they have to license the software to do so, which means more fees.

“The end result of having an open platform where anyone all over the world can submit their strategy and be a ‘signal provider’ in our lingo: You get thousands and thousands of really bad strategies,” says Matthew Klein, founder and president of Collective2.

“Any open platform, whether it’s investing platforms or “American Idol,” the reality is that out of those thousands who submit, 950 are terrible. What’s great about having the software that Collective2 has, you can just discard them,” Klein says.

The signal providers are ranked, with the best performers highlighted for investors.

Account minimums

Collective2 has no minimum investment “other than common sense,” says Klein. “For example, you wouldn’t want to autotrade a system in which you expect a drawdown that is higher than the amount you plan to invest.”

Collective2 does offer simulated brokerage accounts to try out autotrading, but the individual signal providers set the availability of free trials for their systems. More than 50 percent of the signal providers offer free trials, according to Klein.

Types of investments available

On Collective2, investors sign up with brokers that are compatible with the site and can follow currency, stock, options and futures traders.

How much does it cost?

With a wide array of brokers and instruments traded, fees are all over the place. For instance, Collective2-compatible forex brokers may charge no commission; they earn money from the spread between the bid and ask. The trading commission for futures contracts varies, and the commission for stocks is between $1 per order and $5 per trade. Options contracts vary between $0.75 per contract to $0.95 per contract, with a $2.50 minimum.

The fee for the autotrading license varies among instruments. For forex, it’s $1 per minilot traded. A footnote tells us that means the fee is charged per 10,000 currency units traded. The fee is charged after the security is sold.

Autotrading costs $1.99 per futures contract, and there is a flat $99-per-month fee for stocks and options.

Also, the individual vendors or signal providers set their own fees. “It’s not Collective2 that decides what you pay; they typically charge a monthly fee,” says Klein. “Maybe $100 a month for a strategy, sometimes less. People just introducing themselves to the site may charge $10 a month.”

Risk management

Collective2 goes to great lengths to stress the importance of risk management and the pitfalls of autotrading. Every time investors start a session on Collective2, they get a big warning screen that reviews the dangers and underscores that results are hypothetical.

The platform emphasizes that the results of individual investors will likely vary somewhat from the signal provider; that’s why everything is labeled as hypothetical. (Even the photographs of the employees at Collective2 are deemed hypothetical; Klein bears a striking resemblance to George Clooney, for instance.)

There are a few reasons why results and statistics are hypothetical rather than actual, according to Klein.

“The hypothetical results Collective2 shows are based on real-life results — they’re not imaginary. For example, if you see within a trading record on Collective2 that, for example, the system ‘bought at price 123.45,’ that price will actually be determined as follows: by taking the volume-weighted average price of the actual prices received in real-life brokerage accounts,” he says.

Your mileage can vary for other reasons as well, including slippage, or the change in price between the time the signal provider executes the trade and the followers receive it.

More From Bankrate