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The Online Wager

The Online Wager

Hedge fund manager Joel Greenblatt and online brokerage pioneer Blake Darcy recently opened an online managed account service for retail investors. Can Greenblatt's star power take asset management online?

In May, prominent hedge fund manager Joel Greenblatt and online brokerage pioneer Blake Darcy rolled out their online managed account service for retail investors called Formula Investing. They're not the first to try managed investing on the web. A handful of online managed account firms launched in the 1990s, but the model never quite caught on. Could Greenblatt's star power attract more interest this time around? Some say, yes.

Not everyone in the financial services industry knows Greenblatt, but to those in the value investing game his name should sound very familiar. Now 52, he first rose to prominence as the manager of hedge fund Gotham Capital, which reports posting average annual returns of 40 percent over 20 years. But what really launched him as a value investing guru was his bestselling book, The Little Book That Beats the Market. Published by Wiley in 2005, that book laid out the simple long-term value investing strategy behind Formula Investing, and behind the free online stock-screen service “Magic Formula Investing” that preceded it. (In the simplest of terms, Greenblatt's magic formula recommends putting together a concentrated portfolio of stocks that have both high earnings yield and high return on capital.)

Within a few years, Greenblatt had legions of followers and dozens of blogs tracking the formula's performance. Had you followed this formula between 1988 and 2004, you'd have earned an annualized return of 31 percent, more than double the return on the S&P 500.

Some analysts and industry insiders think Formula's online model holds tremendous appeal, and predict that other investment managers and financial advisors will soon follow Greenblatt's lead onto the web. Online managed accounts fill a gap in the market, catering to investors who fall somewhere on the continuum between strict do-it-yourselfers and those who want full-on comprehensive wealth management advice. And the web-based model makes it easy to build scale, something that many RIAs struggle with in the high-touch personal advice business.

“Marrying this online brokerage idea with the advice component is not a bad one,” says Aite Group analyst Alois Pirker. “There are a couple of things that play into that. With the crisis, clients still need advice, but they want to see their assets, so having an online capability is an added bonus.”

Of course, there are detractors, too, who say Greenblatt's investing strategy could underperform, that back-tested results are useless, that he charges too much, and that most investors really want a face-to-face relationship.

Thinking Big

Whatever the outcome, Greenblatt and Darcy have big ambitions. The duo officially launched Formula Investing in October, and Darcy says that within five years, they expect to be managing “billions” of assets. So far, through mid-December, the firm has accumulated $25 million in a couple hundred accounts (they declined to be more specific). That's not a bad start. “This is not meant to be a little niche business,” says Darcy. “We constructed it so it can be leveraged up in a very large way.” Darcy, who started one of the first online brokerages, DLJdirect, back in 1987, is a strong believer in the web. “One of the next waves of change in the financial services industry is a movement towards more being done in the online world, that is customers going directly into money management products on the web, where managers will communicate via webcast,” he says. “That is going to happen. The tools are increasingly getting there.”

Formula itself offers paperless account opening, an e-sign in for customers, online performance reporting, real-time access to account holdings and a way for customers to communicate with the managers through email. Its portfolios are truly customized — clients can select individual stocks they don't want to hold. They are also as liquid as a mutual fund, and rebalanced quarterly. Formula charges a one percent annual asset-based fee, which includes all transaction costs, with breakpoints at $1 million and $10 million. The account minimum is $25,000 for the first account, and $5,000 for each additional account, but the average account holds around $60,000.

Greenblatt's investing strategy is simple. The firm rates the 3,500 largest companies traded on U.S. stock exchanges based on its own calculations of two popular metrics — return on capital and earnings yield — and the companies with the best combined scores are selected for the portfolio. Formula Investing actually offers a self-managed account option, where investors can decide how many stocks they want to buy, and can pick individual stocks from Greenblatt's list, but these clients correspond to just 5 percent of accounts at this point. The other 95 percent have opted for the fully managed version of Formula Investing, which starts off with the 24 stocks that receive the best ranking according to their formula. Once a quarter for the first year, the bottom ranked six stocks from what remains of that original portfolio of 24 are sold, and the top ranked six stocks in the universe of 3,500 stocks that aren't already in the portfolio are bought to replace them. The following year, they begin to sell securities when they have been held for a year. They also begin to manage the portfolio for tax-efficiency, harvesting tax losses just before the one-year mark and gains just after the one-year mark. Of course, Formula Investing hasn't been operating long enough to have an established track record, but between May and September 30, the Formula Investing portfolios outperformed the S&P 500 by 16.60 percent, according to composite results.

Formula Investing has no intention of cutting out the middle man. The firm plans to roll out its managed service to RIAs in the first quarter, either serving as an outside manager or a select manager on platforms like Lockwood Advisors and Envestnet. For subadvisory accounts, Darcy says Formula will charge 50 basis points or less. (For some cost perspective, according to Morningstar, fees for an active separate account average around 71 basis points, and passive separate account fees average 13 basis points.) The firm also plans to roll out other managed portfolios online. Some long-short strategies have been running in accounts since June, and Darcy says they will begin offering these to clients in the first quarter, when they will also launch an international strategy portfolio.

Will advisors bite? Darcy says the firm has already spoken to a number of interested advisors. But its appeal may depend in part on its performance in the next year. “I do think advisors will be interested in it,” says Jason Wenk, founder and principal of RIA Retirement Strategies. “The reality is if it performs well, then who cares where it came from. But I do think a certain number of semi-lazy advisors would like to position themselves alongside an expert.''

Onto The Web

Some analysts and financial advisors agree with Darcy that the migration of money management onto the web is inevitable. With costs rising, and asset levels falling, RIAs are trying to increase scale these days, which can be difficult to do in a business that requires a lot of face time with each individual client, says Aite's Pirker. Putting the web between the expert and the client could partially solve this problem.

But there is an element in Greenblatt's model that could be difficult for the everyday advisor or money manager to replicate: celebrity. “What he is playing off of as well is social networking,” says Pirker. “You have this public personality and reputation, and how can you leverage that in the industry. You want to scale that reputation further, be able to service more business with that.”

There are already a number of self-directed investing websites that attempt to harness the celebrity of other famous investors, or have a social networking component. AlphaClone, cofounded by Cambria Investment Management portfolio manager Mebane Faber, allows investors to research and mimic the performance of the world's best hedge fund managers and institutional investors by tracking their holdings at the website. And online portfolio sharing service Covestor, launched in 2008, offers a variation on this theme. Individual self-directed investors and established managers can throw their own portfolios up on the site, which tracks each portfolio's performance. The individual managers can then charge other users fees to follow their investment decisions in real time. kaChing, launched in October 2009, offers an almost identical service and already boasts 400,000 users — both on their website and through applications on Facebook, Yahoo, and the iPhone.

There are also a handful of websites that recommend model portfolios for a fee. One such website is FolioFN, which offers Folio Investing, an online trading and investing service through which investors can buy “Ready-to-Go-Folios” that are built around a particular investing strategy.

Interest in online managed accounts seems to be growing, according to Jagdish Rangwani, chief operating officer of iNautix, a division of Pershing, which built the custom-made client web portal Formula Investing is using. He says a number of advisors who wanted to begin offering clients accounts online approached the firm in the second half of 2009. “This is almost like a new breed of advisors who are coming into the market to offer these services online, and not in a traditional way,'' says Rangwani. “They have some investment models that they want to offer to their customers and they want to build this whole thing online.''

Michael Edesess, partner and chief investment officer at RIA Fair Advisors, author of The Big Investment Lie, published in 2007 by Berrett-Koehler, and a Ph.D. in math, is one advisor who is considering a move onto the web. He and his partner already offer traditional personalized face-to-face advice, but are planning to add an online advice component next year when they have worked the kinks out of their program and ironed out legal issues.

“The main business challenge is how to serve clients at low cost to them while including just enough of the personal element of service to cater to the client's preferences,” says Edesses. “Some clients really want a lot of face time and hand holding, but many only need to know that their advisors are knowledgeable, wise and honest and are truly pursuing their interests. Once they are satisfied on these accounts they will be happy with an automated or semi-automated service — and it will consume less of their valuable time too. We would mostly expect it to draw new clients, though of course we'll let existing clients know about it.'

The Challenge

Of course, not everyone thinks Formula Investing will be a game changer for the investment management industry. If Greenblatt's investment strategy blows up on him, the whole thing would be kaput, say a few detractors. Despite his own interest in the online advice model, Edesses thinks Greenblatt's model relies too heavily on a blind faith in value investing. “Back-tested results tell you nothing,” he says. “It is an ironclad rule that whatever strategy outperformed the market in the past — after adjusting for risk — cannot be expected to do so in the future. Unless the ‘value investing’ strategy — Greenblatt's strategy — somehow eludes this rule it will not succeed in the future.”

Greenblatt himself admits that the strategy will have its down years, and says that in order for it to work for investors they will have to be willing to stick it out for the long-term. But his critics predict that most clients will not have the fortitude to do that, especially without a strong personal relationship with a financial advisor to keep them on track. “I'm curious to see how that business model performs when he goes through an underperforming period,” says Scott Schermerhorn of RIA Granite Investment Advisors.

And then there are those who worry that because of the transparency of his strategy, he will be front-run by other investment managers or traders. Greenblatt's response? Most quants are looking for short-term gains or consistent monthly annual returns, while Formula's strategy rewards long-term investors. Darcy also says that it is harder to front-run than it might seem. Though the free do-it-yourself service does offer you a list of stocks to invest in, they are presented to investors in alphabetical order rather than in order of ranking. Whoever wanted to copy the strategy exactly would have to come up with their own formulas for calculating earnings yield and return on capital for each stock on the list. “There are a number of ways you calculate these things,” says Darcy. And they do not share their secret.

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