Covestor and VesTopia: Winners and Losers from Peer to Peer Investing

 |  Includes: AMTD, ETFC, SCHW, TST
by: David Jackson

Two innovative startups are about to change the face of the financial industry. Today sees the launch of Covestor, and over the next few days we'll see the emergence of VesTopia. Here's how they work:

covestorAnyone with a brokerage account can sign up for Covestor. After sign up, Covestor gathers data about your portfolio and trades in one of two ways. Either Covestor pulls data in real time via account aggregation service Yodlee, which interfaces with the big five online brokerages (Ameritrade, E*Trade, Scottrade, Fidelity and Schwab). Or, investors can manually upload trades to Covestor themselves. Reported trades are later verified by cross checking against the investor's brokerage statements.

Covestor begins to track your performance, and then ranks investors by performance. Visitors to the site can view investors by style, portfolio type and a range of performance statistics, including risk-adjusted performance (Sharpe Ratio). And once a visitor has found an investor with consistently great performance, the visitor can pay to "subscribe" to that investor's trades. Covestor shares the fees with the investor.

vestopiaVesTopia is very similar: after an investor with an online brokerage account signs up, VesTopia directly pulls information about your portfolio and trades, using a desktop client that automatically scans the pages of the online brokerages' web sites. Like Covestor, it works with all five leading online brokerages. Visitors can pay to view investors' trades and portfolios, and VesTopia shares the fees with the investors.

The differences between Covestor and VesTopia are mainly in initial target investors and degrees of transparency. Covestor encourages everyone to sign up, allowing individuals with outstanding performance to bubble up to the top via Covestor's performance rankings. VesTopia, in contrast, will highlight a carefully vetted group of high performing investment professionals, though it plans to widen its service to individuals soon after. Covestor allows pseudonyms and anonymity, betting that performance is all that matters, not someone's name. VesTopia promotes finance professionals with real names and biographies. Covestor allows investors to mask the actual size of their porfolios by reporting only percentage allocations, whereas VesTopia also provides actual position sizes and the dollar size of portfolios.

Covestor and VesTopia are the eBay of money management. Just as eBay allowed anyone to become a store owner, these peer-to-peer investing sites allow anyone to make money from being a great stock picker. You no longer need to set up a hedge fund; just trade as you always would, and watch as the number of paying subscribers to your successful ideas grow.

Both services may even allow hedge funds to outsource research. If you're looking for an analyst to cover Chinese stocks, why not just subscribe to the stock picks of the top stock picker of Chinese stocks on Covestor or VesTopia?

Now, I'm certainly biased: I'm personally friendly with founders of both Covestor and VesTopia, I own a small stake in Covestor, and both companies are potential partners for Seeking Alpha. We held back from offering portfolio games or shared portfolios on Seeking Alpha because we saw real portfolios and real track records on the horizon. Who cares about stock picking competitions and socially-networked play portfolios when you can rank investors by their real trades with real money?

There are challenges. Covestor and VesTopia need to convince investors that there's no risk of online brokerage accounts being compromised. Both claim that they have that nailed, but perception and reality are different things.

Who benefits from the rise of peer-to-peer investing? This could be good news for the online brokerages, including Ameritrade (NASDAQ:AMTD), E*Trade (NASDAQ:ETFC) and Schwab (NYSE:SCHW), because it raises the potential profit of having an online brokerage account.

Who might lose?
In the long term, by facilitating the discovery of great stock pickers and providing a new economic model for them, Covestor and VesTopia may end up challenging mutual fund companies (which are already facing an onslaught from ETFs), such as Legg Mason (NYSE:LM), Blackrock (NYSE:BLK), and T. Rowe Price (NASDAQ:TROW), and even hedge funds like Fortress Investment Group (NYSE:FIG).

And full service brokers who offer investment advice, like Merrill Lynch (MER), Morgan Stanley (NYSE:MS), Ameriprise Financial (NYSE:AMP), and Citigroup's (NYSE:C) Smith Barney, may now face increased competition.

Full disclosure: I own stock in Covestor and have personal friendships with founders of both Covestor and VesTopia. My children own ETFC; I have no other position in any other stock mentioned here.