When Steve Wallman surveyed individual investors' options from his seat on the Securities & Exchange Commission in the mid-1990s, he didn't like what he saw. Traditional brokers urged customers to go for the big score by picking individual stocks rather than building balanced portfolios. Diversifying to reduce risk was expensive: Even at a discount online broker, it might cost $450 just to assemble a basic 30-stock portfolio. Mutual funds offered diversification, but their fees ate into returns--as did the unwanted tax bills they imposed on investors, who couldn't time the funds' stock trades.
So when Wallman left the SEC in 1997, he set out to create an investment vehicle that combines the diversification of funds with the advantages of individual stocks. The result is Folio[fn], his Vienna (Va.) online brokerage. Folio[fn] charges $295 a year for unlimited trading among the market's 2,500 biggest and most active stocks. Its approach features "folios"--groups of 9 to 50 stocks selected by Folio[fn] or by the customer to meet specific investment goals. So far, no one else has come close to offering investors this combination of customization and lower costs.
Wallman says his system, which has 10 patents pending, lets investors diversify and bet on broad trends, not on individual companies. "I'm convinced that biotech will be a big winner, but I can't predict whether Biogen or Genentech will be dominant," he says. "A biotech folio lets me buy the whole industry, which is both smarter and easier than trying to pick individual stocks."
Industries aren't the only way folios can slice the market. The 75 prepackaged folios now available on the firm's Web site (www.foliofn.com) let investors buy stocks selected by economic sector (basic materials, manufacturing), region (Asia, Africa), or country (Ireland, Israel). Three folios divide the Standard & Poor's 500-stock index by risk: One matches the "beta," or volatility, of the S&P 500, another is more conservative, while the "aggressive" folio is deliberately 35% more risky than the index (table).
The firm also offers folios that screen for companies with good scores on environmental or labor issues, gay rights, or African-American participation. A Nascar fan can even buy the "stock car champs" folio of companies that sponsor top drivers. If you want to try the folio idea before you buy, you can set up a "watch account" before investing.
There's no minimum for folio accounts or trades, and to make folios affordable, Folio[fn] can sell you fractional shares of stock. That means that an investor with, say, $100 can buy all 30 stocks in the Dow Jones industrial average--receiving one-twentieth of a share of each stock--and can reinvest the dividends.
The folio concept is appealing, says Jaime Punishill, an analyst covering online financial services at Forrester Research. "It's a nice, low-cost way to get into diversified investing," he says. But Punishill questions whether Folio[fn] can grab investors' attention long enough to explain the concept. Wallman responds that investor interest--including debates at Motley Fool and other investing Web sites--shows that the notion will catch on.
Folio[fn] holds down costs through a method called "window trading." The broker will buy and sell the 2,500 issues available for folios twice a day, at 10:15 a.m. and 2:45 p.m. The firm's computers will first look for offsetting buy and sell orders among Folio[fn]'s customers--trades that will cost Folio[fn] little to process. Any orders that can't be matched internally will be sent to dealers. Buyers and sellers will get the same price--between the market's bid and ask for a stock--which should be better than the price that market orders in those time slots would get. But customers using window trades can't pick the time of their trades or place limit orders to get a particular price. (The firm also offers traditional online trades at $14.95 per order.)
Wallman has compromised on one point: Folio[fn] will route orders it can't match internally to specific market makers in return for payments--a legal kickback mechanism. Although Wallman decried "payment for order flow" as an SEC commissioner, entrepreneur Wallman says it's a necessary evil because other online brokers use the payments to hold down commissions.
GREATER FLEXIBILITY. Folio[fn]'s real competition will be mutual funds, including the new exchange-traded funds that track indexes. Here, Wallman thinks he has advantages. Folios can cost less than funds: Instead of highly paid managers picking hot companies, Folio[fn] has computers screening stocks. Customers can be their own managers, modifying folios--striking tobacco giant Philip Morris, say, from the Dow-based folio--or creating their own with the site's tools.
More important, a folio investor owns the stocks, which can be bought and sold in groups or individually. That boosts investors' flexibility and can reduce tax bills. Fund investors face unpredictable tax hits because mutual funds must pass on trading profits and losses every year. With folios, "you decide when to take gains or losses," Wallman says. The site lets you specify whether to minimize short-term gains or to take losses to offset other income. Then, when you sell, the computer selects specific lots of shares that will best meet that goal.
Will customers be drawn to these advantages? First, they have to get over the sticker shock of a $295 annual fee in a market saturated with ads for $9.95 trades--and mutual funds whose fees are largely invisible. Wallman's answer: "We show people what their accounts are actually costing them--and usually, they're startled." Even at $9.95 a trade, investors would pay $300 to assemble a 30-stock portfolio, "and even more if they wanted to add to it or adjust it," he says. The average mutual fund charges owners 1.23% of assets each year, not including "loads," or sales charges. So Folio[fn]'s $295 fee is break-even for a fund investor with $24,000 in assets.
Folio[fn]'s annual fee rules out the smallest accounts, and its window-trading rules out hyperactive day traders. Wallman insists that everyone else could benefit. Still, folio investing is likely to appeal most to buy-and-hold investors--those who want the diversification of mutual funds with more control than funds offer. Folios could be a halfway house for fund owners on their journey to active stock investing.