Schwab’s Free-But-Not-Really Robo-Advice
A few months ago, Schwab announced it would enter the “robo-advisor” arena and that it would come out swinging, with an automated investment service that would be absolutely free to use. If that sounded too good to be true, that’s because it was.
A complicated and contorted SEC filing later revealed how Schwab would make money. By sweeping a certain amount of cash into an ordinary and very low interest (0.12%) bank account, Schwab could earn a tidy profit from clients of the new service.
There are still a number of unanswered questions; including how much would actually be held in cash on average. From Schwab’s own comments it sounds like the portfolios would hold anywhere from 5%-30% in cash depending on the client and market circumstance. This is a pretty extreme range, especially when you consider that the amount of cash in a portfolio has significant implications on the investment’s performance.
Unsurprisingly, both CEOs of Betterment and Wealthfront have scoffed at this “not-really-free” offering and have even accused Schwab of being “greedy”. We tend to agree and feel this is yet another complicated fee structure indented to confuse consumers and to hide fees. But how bad is it really?
First, let’s look at the opportunity cost. Assuming Schwab is right and clients would really want to keep cash, the simplest way to do that would be to hold a money market ETF like the Purpose High-Interest Savings ETF, which has returned 1.34% since inception. In the US these returns are a bit lower, around 0.85%-0.9%, so let’s say an investor with Schwab is leaving around 0.75% on the table with their cash savings. Overall this costs up to 25bps if 30% of the investment is in cash. Not high, but not free either.
The second, larger issue, is holding cash in your investment accounts. Schwab claims that robo-advisors are being “permanent bulls” by always being all-in in the market (completely ignoring the impact of diversification on volatility) and that clients should want to hold some cash during times when the markets are expected to underperform. This both implies that Schwab has the ability to time getting into and out of the market and that holding cash is an optimal way to do so. We have doubts. Very few investors or fund managers have demonstrated a consistent ability to time markets, and there are better ways to protect an investment from downside risks in the long run than cash. This also implies that Schwab will, in fact, be doing this market timing as an added service for its automated investment service clients and not just investing passively while holding some cash, which is yet to be seen.
The reality is after inflation, cash is a sure loser as an investment. We would ask, why would anyone ever want to hold a guaranteed negative return in their portfolio when simply adding uncorrelated asset classes is going to have a greater impact on reducing volatility while offering positive long-term returns? Finally, if someone requires the money in the short term using a high-interest savings account is still a better option.
There is also the issue of greed. Adam Nash says Schwab is being greedy, well just how greedy? How much can Schwab be making on these sweep accounts? A whole lot, it turns out. Schwab can loan this cash out to their margin clients at rates that start at 6% and go as high as 8.5%. At these rates, Schwab’s clients should be asking why Schwab isn’t paying them more to hold this cash. For a client with 30% cash, Schwab’s cut is between 2% and 3%, as much as a high-fee mutual fund.
In the end, it looks like the incumbent robo-advisors have it right. Schwab is being disingenuous at best. Their “free” service is highly unlikely to cost less than existing US robo’s. What’s worse, Schwab’s compensation structure puts them in conflict with the client, as Schwab has an incentive to hold more cash whether or not that is in the client’s best interest. It’s conflicts of interest like this that underline exactly why services like WealthBar were created in the first place, and why clients should always prefer to pay a transparent fixed fee to a hidden variable one.
Schwab’s cash strategy is another embedded commission in disguise, though it’s arguably worse for the client, who is paying for it twice: once for the profit that Schwab is making off lending the cash out and once again because they’re being forced to hold cash instead of real investment assets which, ultimately, will be a drag on their investment performance.
Even if Schwab really believes in the value of holding cash in their portfolios, it would still be preferable for them to charge their clients a fee directly and offer a higher return on the cash amount, say 1%. Then there would be no conflict. Instead, they chose to market their service as “free” when it clearly isn’t.
If you’re interested, you can also read Schwab’s response here.