On Monday, Charles Schwab culminated a mysterious, months-long advertising campaign by unveiling Schwab Intelligent Portfolios – the firm’s first foray into the growing algorithm-based investing marketplace. With its digitally-managed portfolio of low-cost ETFs across a wide range of asset classes, Schwab has boldly promised that “Investing has Changed Forever.” This remains to be seen, as the firm joins the battle for market share against a host of innovative start-ups and established heavyweights poised to jump into the arena themselves.
While no stranger to disruption and innovation, Schwab finds itself playing catch-up in the diverse, robo-advisor space. More well-known startups like Wealthfront and Betterment have respectively amassed roughly $2 billion and $1.55 billion in customer assets over their short lives. While these numbers pale in comparison to the $2.5 trillion in assets that Schwab manages, they have been growing at a steady clip through investments by the key demographic of largely younger investors.
Schwab is not the first established brokerage to test the waters. Vanguard has been quietly piloting its own low-cost, human-advised mutual fund portfolios – Personal Advisor Services – since 2013, to the tune of $10 billion under management. Similarly, Fidelity has yet to sate its voracious appetite for investing startups, having partnered with (Betterment) or outright purchased (eMoney Advisor) a series of startups to improve its internal RIA offerings. It’s easy enough to imagine – given the startup innovation and established resources brought under a single roof – that Fidelity has at least considered making a go of it themselves in the near future.
To counter this, Schwab brings some significant advantages to bear with the launch of Intelligent Portfolios – not least of which is its sizable war chest and reputation for disrupting the status-quo. However, Schwab Intelligent Portfolios service will ultimately rise or fall based on its ability to deliver the best returns to clients, and questions are already emerging over whose interests truly drive these portfolios.
Shining a Light on Questions of Cash
The chief selling point of the Schwab Intelligent Portfolios is the lack of an advisor fee; at first glance, this is a clear advantage over other digital advisors like Betterment or Wealthfront that charge an annual fee of up to 0.35% or 0.25%, respectively. Schwab will recoup this lost revenue in a variety of ways: through the fees attached to Schwab’s proprietary funds within a portfolio, selling trade orders to other firms, etc. However, the one method that has raised the most questions is the firm’s insistence on holding a sizable portion of the total portfolio strictly in cash.
For example, completing the initial Schwab Intelligent Portfolios IPQ on even its most aggressive risk tolerance still yielded a cash allocation of roughly 7%. Altering the answers provided within the IPQ can shift that allocation to upwards of 20% held in cash. This stands in stark contrast to robo-advisors like Wealthfront, which allocates roughly 2% cash to cover fees and expenses, or Betterment, which invests 100% of a client’s portfolio (though one has to wonder about the wisdom/tax implications of selling securities to cover fees). By holding a significant portion of the client’s portfolio in cash, Schwab can sweep that excess cash into FDIC-insured accounts and then reinvest it, paying the client the interest earned on the cash, while pocketing any earnings accrued. This begs the question of whether such a large cash reserve is truly in the client’s best interest.
Proposed Portfolio based on Hypothetical IPQ Answers
Schwab is clearly cognizant of this criticism, and devotes one of its six publically available white papers specifically to addressing the role of cash in its portfolio construction. The justifications include greater portfolio stability, inflation protection, and a mitigation of downside risk, among others. However, it seems disingenuous to pass off what is clearly a primary source of income for the firm as being in the best interest of the client. Perceptions matter – especially in an industry still facing a public trust deficit following the Great Recession.
Tip of the Robo-Iceberg
We feel that it’s likely that Schwab Intelligent Portfolios will simply be the tip of the iceberg as more established brokerages unveil robo-advisor offerings in the coming years. As the millennial generation attempts to recover from the effects of the Great Recession – lower wages, more debt – the appeal for low-cost, low-minimum investing advice will continue to grow, both as a necessity and based on lingering distrust of the financial services industry. As established brokerages move to capitalize on this demographic, it will be hard for many unaffiliated robo-advisors that have sprung up in recent years to compete with the resources of these established brokerages. Ultimately, it will be the Schwabs vs. the Fidelitys vs. the Merrills and so on that capitalize on the rise of algorithm-based investing advice. The Schwab Intelligent Portfolios are one of the first significant opening gambits in the robo-advisor movement – a movement that will ultimately redefine the existing financial advisor model.