I had high hopes for Charles Schwab’s upcoming robo advisor product Schwab Intelligent Portfolios. It’s supposed to have Schwab’s brand, scale, customer service, IT infrastructure, low-cost ETFs, and zero fees above the underlying ETF expenses.
However, Schwab had to make it not so clean-cut. What could’ve been a very compelling product all around is now a little difficult to explain. Instead of an unequivocal “sign me up” people are given some reasons to debate, hesitate, and possibly be consumed by procrastination and inertia.
Schwab revealed more information about Schwab Intelligent Portfolios in a series of FAQs. It’s going to use Schwab and non-Schwab ETFs selected through objective screening.
The 54 ETFs coming out of the funnel are qualified candidates. It doesn’t mean that the recommended portfolio will have 54 ETFs.
Schwab gave an example for a 30-year old with high risk tolerance saving for retirement. The sample portfolio consists of:
|US Large Company Stocks||10%|
|US Large Fundamental||16%|
|US Small Company Stocks||6%|
|US Small Fundamental||8%|
|International Developed Large Company Stocks||8%|
|International Developed Large Fundamental||12%|
|International Developed Small Company Stocks||4%|
|International Developed Small Fundamental||6%|
|International Emerging Market Stocks||4%|
|International Emerging Market Fundamental||6%|
|US Exchange Traded REITs||3%|
|International Exchange Traded REITs||2%|
|US Corporate High Yield Bonds||2%|
|International Emerging Market Bonds||3%|
|Gold & Other Precious Metals||3%|
That’s a total of 16 ETFs, with the required appearance of sophistication. Nobody in their right mind will want to contribute to and rebalance a portfolio like this on their own.
Many equity asset classes are broken down to 60% fundamental 40% market-weight. It’s interesting that Schwab places so much weight on fundamental indexing. By coincidence Schwab has a lineup of fundamental ETFs that other large ETF providers Vanguard and iShares don’t have. The other large provider for fundamental ETFs PowerShares is a Schwab ETF OneSource partner.
I worry that the heavy allocation to fundamental ETFs increases the blended cost of the underlying ETFs. Fundamental indexing proponents will say they increase returns and/or reduce risk. Are fundamental ETFs a poor man’s DFA? Only time will tell whether the added cost will be worth it.
Under the Hood
I ran the sample portfolio through Morningstar Portfolio X-Ray using some ETFs I think are good candidates for the asset classes. The result looked like this:
Compare it to a portfolio I ran from Betterment:
Compare it to a portfolio I ran from Wealthfront:
The Schwab portfolio allocates slightly less to stocks (85% vs 90%), more to small caps (17% of stocks vs 5-6%), and more to cash (7% vs 0%). It has similar tilt to value as Betterment, more than Wealthfront. Which one will do better? Who knows.
Cash at Schwab Bank
The allocation to cash is another monkey wrench that Schwab throws to its otherwise compelling offer. In the example above, 7% of the portfolio will be held as cash at Schwab Bank earning a money market yield, currently at 0.08%.
Schwab makes the case that cash acts as a stable foundation in a portfolio. At the theory level, it’s defendable, especially when you are also allocating more to small caps. It just so happens that Schwab Bank makes money from the idle cash, which it contributes to offset the cost of the program. This convenient coincidence weakens Schwab’s argument for cash. It makes people suspicious.
The arrangement isn’t necessarily a bad one. If the 7% in cash otherwise would earn 2%, which is subject to risk, not guaranteed, you are losing 0.14% from keeping it in cash. If you consider it the cost of using Schwab Intelligent Portfolios, it’s still very reasonable.
However, trying to explain it and making people do math just make it not very clean. It may be really true that holding cash is good for you but people love to see their money put to work. Schwab shouldn’t give people a reason to question its motive.
Incumbent robo advisors Wealthfront, Betterment and others must be breathing a good sigh of relief. Whether it’s significant, the cash drag is something obvious to point to.
Bottom line, Schwab Intelligent Portfolios is still a good product. It would be much better if Schwab didn’t mess with the cash part.
In the end it’s not about Schwab vs Vanguard vs Betterment vs Wealthfront. It’s about low cost indexing vs speculating vs active management vs high sales commissions and management fees. Whether investors choose the service by Schwab, Vanguard, Betterment, or Wealthfront, they ultimately benefit from low cost indexing. Rather than trying to pick hot stocks, timing the market, or being sold expensive load mutual funds or wrap accounts, they just send money over to the service of their choice. All the rest will be taken care of at a low fee.
[Photo credit: Flickr user bigbrand .]