Schwab Special Report: The Unseen Cost of Free Advice
Posted on August 30, 2021
- We estimate that Schwab’s high cash allocations in Intelligent Portfolios cost investors $1.13 billion in total earnings when compared with potential returns if Schwab invested the cash in the fixed income portion of its portfolio
- Charging a 0.30% management fee would have increased Schwab’s revenue by an estimated $369 million
Background: Generating revenue by holding cash
When Schwab introduced its digital advice product, Intelligent Portfolios, in 2015, we noticed that they held an unusually high amount of cash. For example, our Intelligent Portfolios account has carried around a 10% cash allocation since it was opened in 2015. Seeing that Schwab did not charge a management fee for this product, it became apparent to us that the high cash allocation was likely driven by their ability to generate revenue on the cash balances, not sound portfolio construction.
In July, Schwab disclosed that investors can expect a $200 million charge relating to an SEC investigation of Intelligent Portfolios and its past disclosures. It has been widely speculated in the media that this charge is directly related to the high cash allocations in its portfolios, although this is entirely unconfirmed and the details of the SEC investigation are not yet public. Currently, Schwab discloses how the cash helps generate revenue. Schwab sweeps the cash into Schwab Bank, providing the bank with a source of low-cost deposits. The less a bank pays on its deposits, the greater the profitability of its lending activities. Schwab states in the Disclosure Brochure for Schwab Intelligent Portfolios (SIP) that “Schwab does not charge an advisory fee for the SIP Program in part because of the revenue Schwab Bank generates from the Cash Allocation (an indirect cost of the program).”
The problem for SIP clients is that equity and bond markets have both experienced strong returns for the last six years, making cash a costly investment. Leveraging the knowledge we have of our account at Schwab, what it holds, and how it has performed since we opened the account in 2015, we set out to answer some questions: What did the high cash allocation cost clients? What did it earn for Schwab? And how would it have been different if Schwab charged a standard management fee?
To answer these questions, we simulated two portfolios: one with the cash invested in the fixed income portion of the portfolio, and a second with the cash fully invested in the same fixed income holdings as the current portfolio, but with a 0.30% management fee. Using published figures for Intelligent Portfolios’ Assets UnderManagement (AUM) over the period, we were able to calculate estimates for how much Intelligent Portfolios clients lost in portfolio growth.
The Results: How much growth did clients miss?
For the 6-year trailing period ending June 30th, 2021, we estimate that clients with SIP earned a total of $531 million less than if Schwab had simply charged a 0.30% management fee and invested the cash into the same fixed income assets that are held in the portfolio. Using a high cash allocation to generate revenue allows Schwab to market the product as carrying no management fee, and to the client, the cost of the high cash allocation becomes embedded in the performance of the portfolio. If we had not introduced this 0.30% management fee, we estimate the no-cash portfolio would have earned investors $1.13 billion more over this period.
This estimate results from our real, high-cash portfolio returning a cumulative net-of-fees return of 57.56%, the simulated no-cash portfolio returning 62.41%, and the simulated portfolio with no cash but a 0.30% management fee returning 59.55%. We estimate the no-cash portfolio would have returned a total of 4.85% more, while the no-cash portfolio with a fee would have returned a total of 1.99% more over the previous six years.
Clients would have been significantly better off had Schwab charged a straightforward and transparent management fee instead of deciding to earn revenue through high cash allocations. Although not charging a management fee may make sense from a marketing perspective, using a high cash allocation instead of a transparent fee has handicapped the performance of these portfolios and ultimately hurt clients.
Although Schwab currently discloses how it generates revenue from the cash sweep program, investors still do not know how much it is costing them in portfolio growth. If a client cannot answer the simple question of “what do you pay your investment manager?”, there is a transparency issue.
The Results: How much revenue did Schwab lose?
Moving on from the client experience, how did Schwab itself make out by implementing this strategy? Schwab disclosed in the first quarter of 2021 that Schwab Bank earned around 0.97% on an annual basis on the cash invested, net of what it paid to clients in the program. By estimating Schwab earns roughly 1% in revenue on cash, and portfolios held on average 10% of their portfolios in cash, we can estimate revenues for Schwab.
We estimate that Schwab earned approximately $185 million in revenue from the cash. Had they charged the 0.30% management fee they would have earned $554 million. So, not only did clients lose money, we estimate Schwab lost $369 million in revenue by choosing this model.
Methodology and Notes:
We simulated a portfolio return using the equity-only and fixed income-only returns of our SIP account, which is invested in a moderately aggressive portfolio. A weighted average calculation was performed on these asset class returns as if the weight of the fixed income holdings also included the weight of the cash holding. These weighting calculations were performed on a daily basis using the real returns and the real weights of the cash, equity, and fixed income asset classes in our account. To introduce a 0.30% annual management fee, we added management fee transactions at each quarter-end. These fees were calculated as .075% (¼ of 0.30%) of the quarter-end value of our account. The resulting portfolio is as if Schwab had invested all of the cash in the portfolio into the same fixed income holdings as the original account and also charged a 0.30% annual management fee assessed quarterly.
To calculate the total cost to clients, we analyzed each year in the period from 06/30/2015 to 06/30/2021. We used ending year AUM figures published by Schwab to calculate an average AUM for the period. We then used the performance of our Schwab account and the simulated Schwab portfolio performance to estimate how much assets would have grown based on the average AUM for the period. We then summed the differences of these figures for each period to arrive at our total cost to clients figure.
This analysis is based on the performance and cash allocation of our account, which averaged around 10% cash for the life of the account. Schwab discloses that SIP cash allocations can vary between 6% and 30% depending on the model selected for a client. On this note, Schwab provides an example in its disclosures of how much revenue it might earn on a theoretical account here. In this example, Schwab itself assumes an account with a 10% cash allocation, the same as our account. If Schwab uses a 10% cash allocation account in their own disclosures as an example account, we are comfortable also using a 10% cash allocation account as the basis for these estimates.
This analysis focuses on the cash component of these portfolios and its role in revenue generation. Schwab also generates revenue by methods other than a management fee, which can be found in Schwab disclosures. SIP Premium also charges a program fee in the form of a one-time start-up fee and then a flat dollar monthly fee. Our understanding is that Intelligent Portfolios Premium portfolios also mandate high cash allocations.
Currently, Schwab discloses conflicts of interest and other matters regarding the cash allocation. The CRS and Disclosure Brochure for this product suite can be found here: https://www.schwab.com/public/file/CMS-BDL100049 or on the IAPD website: https://adviserinfo.sec.gov/firm/summary/539
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