Beware the bite of the little black box

The Australian Securities and Investments Commission (ASIC) recently issued a warning, telling investors and advisers to be aware of the pitfalls of share trading systems. Peter Kell explains the traps for the unwary and what to say to clients when they insist on using such systems.

The Australian Securities and Investments Commission (ASIC) recently issued a warning, telling investors and advisers to be aware of the pitfalls of share trading systems. Peter Kell explains the traps for the unwary and what to say to clients when they insist on using such systems.

ASIC has sent a warning to both consumers and promoters of computer share trad-ing software, in light of the increasing trade in sharemarket trading systems targeting retail consumers, some of whom may have little sharemarket experience.

ASIC is particularly concerned about what are called 'black box' systems, which provide trading advice or recommendations (such as buy, sell or hold orders) in addition to purely factual information about securities. You can't tell how this advice is formulated, and whether the risks taken by the system are risks you would be comfortable with. The message we have been sending consumers is that they might end up losing money on an investment decision they wouldn't usually consider.

Anyone who sells this kind of software must also be operating under licence is-sued by ASIC (they must have their own licence or be a representative of a li-censee). If the provider is licensed, the distributors can sell the software as a representative of the provider. If not, they must hold their own licence to be able to distribute the product.

They must also not make exaggerated claims about the performance of their prod-ucts, as this may breach the misleading conduct provisions of the ASIC Act.

ASIC licence conditions usually require that the software provider give a promi-nent written warning when marketing the software that:

* in providing the software, the licensee did not take into account the invest-ment objectives, financial situation and particular needs of any particular per-son, and

* before making an investment decision on the basis of the software, the pro-spective investor needs to consider whether the advice is appropriate in the light of their particular investment needs, objectives and financial circum-stances.

ASIC has already been active in taking action against software providers who have not been licensed as investment advisers. For example, we recently final-ised an action against two Internet-based software retailers who gave undertak-ings to the Supreme Court of Western Australia not to distribute two computer securities analysis packages marketed as WinWaves32 and The Collective. We have sent a clear signal that if promoters are breaching the Corporations Law or the ASIC Act, we will take enforcement action.

Thinking of buying?

We have suggested to potential purchasers of these products that they take the following steps before deciding whether to buy.

STEP 1: Work out your investment needs and whether you need a computer trading program.

It's important that investors work out what they want to achieve and how soon they want to achieve it. What is their budget? What sort of returns do they want and what sort of risks are they willing to take to get them?

A long term investor holding much of the same shares for many years (provided they do well) probably won't need such software. Only those people who wish to buy and sell shares frequently are likely to want to consider such a product.

STEP 2: Learn the basics of the share or futures markets before deciding to buy.

Investors should learn about shares and the market before spending lots of money on fancy tools they may never use. ASIC is encouraging investors to start with the basics - libraries and bookshops for good investment books and magazines, or Internet sites like ours at <I>www.asic.gov.au<I&gt; that explain the fundamentals. The Australian Stock Exchange and Securities Institute Education run courses on investing in shares. We have also pointed out that licensed financial advisers or stockbrokers can help.

We suggest that any investor seriously asks whether they really need to buy such software. They may well be better off not actively trading at all and sticking to longer term investments. Many active retail traders fail to outperform aver-age stock market returns over time. Day trading is particularly risky, stressful and time consuming. If they still want to actively trade, retail investors might be better off using a broker's or adviser's advice, or doing their own research.

STEP 3: If you still want a trading program, find out what the program does be-fore buying.

No piece of computer software can make you get rich quick, so investors shouldn't be taken in by inflated claims of success. Even the most experienced professional traders and investors, with the best computer power, make losses.

STEP 4: Shop around for good value and reputable providers.

Investors need to shop around to compare products. Some products out there that cost thousands of dollars may not be good value for money. A program costing only a couple of hundred dollars may be all they need.

Prospective purchasers should insist on a full demonstration before buying and should find out if anyone has independently tested the program in real market conditions. Can they test it at home over a couple of weeks doing imaginary trades? Otherwise, they should ask for a complete list of all trades the system has recommended over the past month or two. We have pointed out that a few suc-cesses are not reliable evidence of the trading success of the program, since there may have been losses on other trades.

We've asked prospective purchasers to read reviews on the program in computer and investment magazines or on Web sites, such as that of the Australian Techni-cal Analysts Association <I>(ataa.com.au)<I>. We also suggest they consult their financial adviser or broker about different products.

Helping your clients do their homework and checking whether such software pro-viders are licensed with ASIC, and indeed whether the client needs such soft-ware, will help them avoid throwing away their hard-earned money.

Peter Kell is the director of ASIC's office of consumer protection.

BREAK-OUT

What's on offer

The following chart summarises the types of programs available.

Sharemarket software programs

Non-Trading

Help you manage your shares. Records purchases and sales, dividends received, keeps track of investments and helps with tax.

May also include information about company earnings, balance sheets and cash-flows.

May suit both long term investors and traders.

Trading

Tell you when and what shares to buy and sell.

More suitable for active traders because these look at short-term movements in share prices.

White boxes or tool boxes

Tell you the reasoning behind the trading advice given.

You may even be able to change the reasoning and set your own trading rules.

Designed to help make your decisions quickly.

Black Boxes

Don't tell you reasoning behind trading advice given. So in using it, you put complete faith in the skill and reliability of the programmers.

You will not be able to properly assess the level of risk assumed in the program and whether it matches your own risk tolerance.

Warning: Buy 'black box' programs only from software providers holding an ASIC licence or who are properly authorised to represent someone licensed to sell such products.

Peter Kell is the director of ASIC’s office of consumer protection