This form of DIY investing might be compelling for individual investors, but all parties involved must follow the rules and be aware of the risks
by Bradley Gerrard
Social trading involves observing the trading behaviour of other traders (expert or otherwise) and following their strategies using either copy trading or mirror trading.
Copy trading, as the name suggests, refers to the practice of investors copying the trades of another.
Mirror trading is similar to copy trading and is often used in forex markets. A mirror trader uses algorithms to determine the best general strategy based on the actions of a group of traders.
Copy trading’s rising appeal is easy to understand: the amalgamation of technology and a perceived democratisation of investing makes for a compelling offering.
But like all investment sectors, those offering a service should ensure that all parties are clear on the rules and regulations around copy trading.
And those using it should also be sure of the service provider’s credentials and be certain that the offering is something that fits with their risk profile and investment preferences.
Global research by The Insight Partners suggests that the social trading platform market share will surpass US$3.7bn by 2028, a compound annual growth rate of 7.8% from the US$2.2bn figure in 2021. This estimate suggests that more people will be turning to copy trading to help them gain access to investment markets, but as the sector matures, it will be vital that it ensures the highest levels of compliance are maintained to help protect clients.
In the UK, copy trading falls under the FCA’s regulated activity of ‘managing investments’, which brings with it a requirement for copy trading firms to assess the suitability of users’ financial circumstances and attitude to risk. This categorisation applies when the firm provides the facility for copy trading to take place without the copy trader making individual decisions on each trade. It means the firm offering the facility must meet the same standards as a wealth management firm. It does not apply to the trader being copied.
The regulator states that the provision of trading signals can amount to regulated advice, and that advising on investments without FCA authorisation is a criminal offence.
If, for example, the trading signal communication provides details of a specific transaction that could be expected to produce a profit then that is likely to amount to a recommendation constituting advice.
In terms of the responsibilities of individual traders, if they are simply trading for themselves, they may not require regulatory authorisation even if they are being copied, said an FCA spokesperson.
And, it adds, even if copied traders are trading by way of business, they may be able to rely on certain exclusions in the Regulated Activities Order of the Financial Services and Markets Act 2000, namely Article 15, as they may not be holding themselves out as engaging in the business of trading.
Elsewhere, the copy trading industry is similarly heavily regulated in the US and Europe under broader legislation.
The key factor for all regulators appears to be the discretionary basis upon which copy trading relies The US Dodd–Frank Act of 2010 covers certain functions that are intrinsically part of copy trading. For example, the Securities and Exchange Commission states in a paper that copy trading in securities “may raise regulatory concerns under US federal securities laws, including potential broker-dealer and investment adviser status issues”.
Similarly in the EU, copy trading is technically covered by the Markets in Financial Instruments Directive 2014 (MiFID II), which provides the basis of the UK’s rules. In a 'supervisory briefing’ on copy trading, the European Securities and Markets Authority states that copy trading services are “not defined” by MiFID II, but how the copy trading is conducted and which part of the process a firm is involved in determines what part of MiFID II qualifies.
The briefing says that, where trades are made automatically for the individual copying trades, this is usually considered as portfolio management under Article 4(1)(8) of MiFID II.
And a firm that collects trade signals – the information about which trades should be copied – may be considered as providing investment advice, and therefore must be mindful of Article 25(6) of MiFID II, which relates to suitability, as well as other relevant Articles, covering aspects such as reception and transmission of orders (RTO).
This means firms engaging in copy trading in the EU are likely to require authorisation, which then triggers associated ongoing regulatory obligations, including the suitability assessment, other conduct of business obligations, and the provision of periodic reports to clients and regulators.
Copiers should ask themselves whether they are exceeding the level of risk they would take in the absence of copy trading The key factor for all regulators appears to be the discretionary basis upon which copy trading relies; because copy trading platforms can implement investment decisions without any intervention being necessary by the client, other than the initial agreement between the two parties about the nature of the discretionary service to be provided, they are regarded as providing a regulated service.
One of the more prominent platforms is eToro, which was founded in 2007 as RetailFX and launched its OpenBook social investment platform and copy trader feature in 2010.
Edward Drake, UK chief compliance and operations officer at the firm, says that the company is required to provide clear information regarding the products it offers and the likely costs for its clients.
Referring to the platform’s ‘popular investors’ (PIs) – traders that earn money by other individual investors copying them – he says that information relating to their historical and current performance, trading history, portfolio composition, and risk score level “must be clearly articulated to ensure that users have the relevant information at their disposal to give them the best chance of success”.
Any profile that is public on eToro can have its portfolio copied, but the PI programme must be completed for a trader to earn money from investors copying them.
Beyond regulation, ethics come into play, too. Without any formal framework surrounding ethics and copy trading, it is incumbent on copied traders to ensure they are acting with integrity, whether they know they’re being copied or not. For example, it could severely damage trust in copy trading if those being copied urge their followers to sell a stock, only for the trader to then purchase it at a depressed price.
Copiers should ask themselves whether they are exceeding the level of risk they would take in the absence of copy trading. In 2019, a study into copy trading by the Universitat Pompeu Fabra in Barcelona found that providing information on the success of others leads to a “significant increase in risk-taking of subjects”, which is “even larger when subjects are provided with the option to directly copy others”.
The researchers suggest that copy trading provides an “institutionalised framework for imitation”, whether individuals indirectly emulate them or use a copy trading platform to copy them exactly.
And perhaps counterintuitively, the study finds that the more risk averse a subject is, “the more likely they are to copy others”.
Regardless of the risks, copy trading appears to have robust demand.
Data from US-based copy and social trading platform Zulu Trade shows that in the 12 months to October 2022, 37% of its clients that opted for ‘hands-off’ copy trading – where an investor automatically copies every trade of a popular trader – had lost money, compared with 54% of those who had opted to do their trading manually.
While this may seem compelling for an end investor, it’s vital that retail clients maintain an awareness of the risk involved. For example, new users considering signing up to eToro are warned that 81% of retail investor accounts lose money when trading CFDs with it.
Brian Byrnes, head of personal finance at Moneybox, a savings and investment app, said copy trading could help individuals overcome the inertia that has prevented them from investing until now. Investors tend to be attracted to funds where managers have “skin in the game”, said Byrnes, adding that this would likely be the case with copy trading.
“But, on the flip side, the traders might have completely different goals to the people following them and could be investing with different time horizons in mind. They could also have different risk tolerances and may have been investing for ten years or more and be used to market fluctuations, unlike some of the people following them.”
He adds that just like so-called star fund managers who, through a mixture of skill and luck outperform their competitors over long periods, their funds gather large amounts of assets and then the outperformance wanes. “It’s likely to be the same with copy trading,” he says. “Traders will attract attention but it’s very difficult to outperform the market.”
"Traders might have completely different goals to the people following them and could be investing with different time horizons in mind" Some platforms, such as eToro, have copied traders with different levels of experience. Traders can progress through a programme, subject to maintaining positive performance metrics, to become more distinguished. Those who wish to progress to ‘Elite’ status must pass a qualification, typically a Chartered Institute for Securities and Investment level 3 in either Capital Markets or an International Certificate in Wealth and Investment Management, while those wanting to become Elite Pro must pass an advanced qualification, typically the CISI level 4 in International Advanced Wealth Management or similar.
Drake adds that all PIs on eToro must meet set criteria, including defining an investment strategy. This is actively monitored and any deviations from the strategy are investigated.
UK-based online trading broker AvaTrade states on its site that its traders are all “audited and vetted”, with many having “years, if not decades, of trading experience”.
It states that it continues to observe all its traders after they are vetted to “ensure they continue performing at their best”.
Clarity and transparency are key in all aspects of copy trading, and while this can simply involve traders sharing what they are doing (often known as social trading), thus allowing others to choose to follow or not, rather than trades being copied automatically, it’s vital that regulations are followed.
The FCA has previously acted against so-called signal providers, which provide information, usually based on technical indicators, which may suggest an opportune time to buy or sell an asset.
In 2020, the FCA brought a claim against 24HR Trading Academy and its director Mohammed Fuaath Haja Maideen Maricar on the basis that they had been transmitting trading signals and making other investment recommendations via WhatsApp, which amounted to advice.
The FCA says in a statement published in March 2021 that the High Court had delivered a summary judgment against the company and Maricar in which it finds that the provision of trading signals was in contravention of the Financial Services and Markets Act 2000. The judge ordered Maricar to pay compensation of over £530,000 to investors.
The digital dovetailing with investment is only likely to continue, and perhaps explains why the US Securities & Exchange Commission (SEC) released a paper in August 2021 seeking information and comments on broker-dealer and investment adviser digital engagement practices (DEP).
The paper says that the SEC is seeking to develop a better understanding of the market practices associated with firms’ use of DEP, including behavioural prompts, differential marketing, game-like features such as contests with prizes and interactive graphics in connection with account opening, and “other design elements or features designed to engage retail investors”.
Focusing on goals
Brian Byrnes said all parties involved in copy trading need to be clear about factors such as fees, investment time horizons and risk appetite and that “there should be information available to allow traders and the people copying them to know that their interests are aligned, and that there are no ulterior motives for earning extra money on the traders’ behalf”. Under the UK and EU rules mentioned above, the firm is responsible for the suitability of the trading decisions made.
Trality, the automated algorithmic trading firm, elaborates on this point in its ‘Ultimate guide to copy trading’.
It says that in spite of attempts of complete information transparency by copy trading platforms, copy traders need to ask themselves how much they really know about the trader they mimic. “Can you trust them with your hard-earned cash or coin?” it says. “And how can you tell if their follower numbers are legitimate or simply inflated through nefarious black hat techniques? The age-old adage applies: caveat emptor or buyer beware.”
Another key consideration for investors is how much to invest in copy trading, and how prominent it should be within their broader portfolio.
A conventional-style strategy that offers a broad mix of asset classes through a variety of funds could provide an exposure akin to a common pension strategy, however, if a copied trader is focusing on individual stocks within niche industries, individuals might want to seriously consider how much exposure they should have in their portfolio to such a trader.
"The age-old adage applies: caveat emptor or buyer beware" This all serves to highlight the importance of financial education. Platforms that readily offer information and clearly state what their charges are and who makes what, are likely to be among the better offerings.
It may also make sense for first-time investors to make use of virtual portfolios that are on offer on some platforms, including eToro, whereby investors can practice their trading skills with fictional money.
And just because copy trading is a form of investment that might feel easy to access, it doesn’t mean that investors can’t seek advice about how much and what to invest in if they wish to embrace copy trading as part of their investment portfolio.
As the authors of the Universitat Pompeu Fabra report suggest, the implications of copy trading on risk-taking may be even stronger in the real world than their laboratory research indicates, because copiers might put more faith than expected in those they are copying. “In addition, whereas our experimental setup, by way of the simulator, allowed subjects to easily access how risky previous investments of other investors were, such an assessment is much more difficult in the real world.”
The authors add that from a social perspective, imitation encourages traders to follow similar investment strategies and could lead to financial risk through resulting herding and contribute to the formation of financial bubbles.
This suggests that copy trading platforms, and the copied traders on them, may need to prioritise a code of ethics to protect all parties involved.