Member Article

Social Trading - Is It That Good?

We have all seen the numerous adverts online and undoubtedly had the recommendations from friends and acquaintances, in regards to social trading. Market leaders E-Toro and Darwinex provide everybody with the opportunity to invest in financial markets, without the need to have experience, expertise, time or even the motivation and willingness to manage your own account for yourself - though you can if you wish.

In simple terms, social trading involves ‘delegating’ your own funds to different profiles by copying their trades based on the active, discretionary management of their own portfolios. The profile owner (i.e. the fund manager) therefore generates performance fees on profits generated.

It is great to see that a merge between something as widely discussed as investment is linked socially through technological advancement. However, as with any innovation, there are teething problems or worse, flaws, and this revolution is no exception.

1. Use Of Leverage

Leverage is often what entices unsuspecting retail traders into trading their own accounts, without a sound realisation of the true risks involved. Many professional market wizards have publicly acknowledged this problem from earlier in their careers and relate to the consequences thereafter, including Linda Raschke and Paul Tudor Jones.

Leverage allows you to maximise profits and this is an optimal selling point for brokers to collect commissions and fees. Lateral thinkers will also realise that your losses are magnified too. Trading up to 1000x leverage with a £150 account ultimately means your first trade will need to be a ‘home-run’. Based on the fact that professionals only experience home-runs rarely, extrapolating this would logically suggest that the likelihood of experiencing this, as an amateur, is significantly lower.

These social sites can also ‘disguise’ leverage used by not publicly illustrating the selected level of margin used by the fund manager. This means that those who are trusting others with their capital, and indeed the fund manager themselves, can be gravely unaware of the true extent of the risks they are undertaking, every time a trade is executed - only to be left at the side of the road when things go horribly wrong.

2. Account Size

It is fairly common to see massive fluctuations in account values due to the account opening minimums. Under this setting, much like barristers, you are judged based upon your last performance - in this case, your last trade. As mentioned in the previous point, fund managers can open these accounts with £100 and within a short space of time, typically within a working week, you will generally either see an account go bust - succumbing to the pitfalls of over-leveraging, stay flat, or rise upward of 200% or more (which I have personally witnessed). Others in-between these extravagant-looking profit values and break-even are often pressurised into taking on extra risk to keep up, and they ultimately become fodder for the beast.

This is not a sustainable level of growth and potential investors should be wary at this stage. It usually points to a situation whereby the fund manager has only funded their own account minimally. The fact that this appears to be the case illustrates a higher level of moral hazard - it would be unlikely that a return of this magnitude would be achieved if more collateral was posted by those making the decisions and the true risks were fully understood.

As assets under management (AUM) grows, whether copied or deposited via traditional investment schemes, you would be looking to see the fund manager increasing the value of their own capital within the fund through re-investment of profits. This is in order to maintain a certain percentage of the fund and seeks to increase investor confidence showing that the fund management team is serious and believes in their capabilities as a going concern.

Unfortunately, information is asymmetric and therefore, there is currently no way of knowing the capital levels of fund manager accounts with any of the social trading sites thus far.

3. Professionals Do Not Use These Sites

It is good to diversify with any capital that you put to work in financial markets. As we have noticed already, it is difficult to properly categorise who is consistently profitable, or who is just adjusting their leverage levels on a small account. It would be easy to just state that looking at longer-term track records would be the way forward, but here lies a different issue.

Those who are consistently profitable will inevitably move away from social trading sites, going out on their own to avoid being associated with some of the negative connotations in relation to these sites. It’s the economic problem of ‘lemon-filled markets’.

Moving forward, these sites should try to focus on the quality of content being posted. For a period of about two days last year, I looked into creating an account with the constant stream of ‘it’s a solid buy’ or ‘get out now!’ based comments with no sound thought or evidence quickly forcing me to re-evaluate my initial decision. The need for greater data-mining and filtering proved a distraction in accordance with sound technical thought - those who had done their analysis would end up double and triple checking in order to ensure they had not missed anything of relevance, only to find it was usually just noise by those ill-informed.

Fund managers should be required to provide greater details in terms of their experience and understanding of financial markets, and more so, their understanding of how these markets operate and move in accordance with the behaviour of market participants.

4. No Relationship

I truly believe that in order for any working relationship to flourish, you need to work with, not against any stakeholders of your business. This includes your investors. Keeping information hidden not limited to your strategy, leverage levels or depth of understanding or experience adds worry and uncertainty. Investors are looking for a reason to invest in you - withholding information is not going to endear yourself to them fully.

As we have outlined throughout, there appears to be a non-visible shield being held up by fund managers towards their clients. As my business motto outlines, in order to capture the trust and capital of any investor, you have to be completely open and transparent in all aspects of your business from day one.

Closing Remarks

In summary, I am personally of the view that these sites are okay if you are aware of the risks involved and understand the probabilities of success are low in terms of capital appreciation. This is due to the moral hazard involved and the lack of barriers to entry in order to attain clients.

A lack of information on a person’s background and understanding can prove highly detrimental to your bottom line. Even with diversifying your capital across multiple account holders, the expected risk is often unknown by the fund manager if they are not experienced in using leverage, and by definition unknown to yourself. Question their core values along with sense of accountability and responsibility.

Although you might see periods where your doubt is unquestioned, you will be left with your head in your hands should you not have all the information available to you regarding the in’s and out’s of the trader in charge of your destiny…

This was posted in Bdaily's Members' News section by Christian Evans .