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Pragmatic Capitalism

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What is “Cash” in a Brokerage Account?

The recent spat between WealthFront and Charles Schwab has shed light on an opaque part of the financial universe – the “cash” position in a brokerage account. The spat arose over Schwab’s recommended holding of some cash in their Robo portfolios. There are some good lessons in here so bear with me for a few minutes.

This morning Betterment jumped on the WealthFront bandwagon criticizing cash in a portfolio. They wrote:

“It’s pretty plain and simple: Cash is not a good investment. After taxes, inflation, and its current expected return (zero), you are actually losing money when you hold cash in your investment portfolio over the long term.”

The first line in their post is incorrect. First of all, “cash” in a brokerage account is a sweep account. What that means is that the custodian doesn’t generally hold 0% interest bearing “cash”. It’s not like they’re sitting on a pile of dollar bills. They sweep the cash into an interest bearing account of some type. If you look at your “cash” position in a brokerage account you’ll notice that it’s usually a money market mutual fund or an interest bearing account of some type. These accounts are usually made up of Treasury Bills and other short-term interest bearing notes. Today, those accounts earn 0% interest or close to it because the Fed’s overnight interest rate is about 0%. But that wasn’t always the case. In fact, “cash” has been a pretty good investment over the last 50 years and has earned a 5% compound annual growth rate:

cash

Cash hasn’t been a great holding in recent years, but as Schwab made it clear in their press release they aren’t predicting the future of the Fed’s overnight interest rate in their model. Their model is necessarily long-term and so they assume that cash will earn interest in the future.  That’s a very reasonable position.

Further, Betterment and WealthFront both used misleading examples where cash earns 1% or less and tried to prove that cash is a huge drag on returns. But again, they are making a short-term forecast (something they claim they don’t do in their “passive” approach) and assuming that interest rates will be forever low. Historically, a 10% cash position has not had a significant impact on a portfolio. In fact, cash, being the ultimate form of permanent loss protection, might be a totally reasonable holding for even the most aggressive investors because it will smooth returns over time.  Below we can see the difference between holding a 60/30/10 (stocks/bonds/cash) vs a 60/40 (stocks/bonds). There is virtually no difference in the portfolios because the “cash” is essentially a short-term form of the “bonds”.  And what you lost in nominal dollars ($roughly 40K) you make up in risk adjusted returns (Sharpe of 0.41 vs 0.45) because you added protection against permanent loss in exchange for some reduction in purchasing power protection.

cash2

Both firms also made a big stink about Schwab’s required cash position. I don’t like this requirement. And it’s clearly a conflict of interest  because Schwab is also a bank and they can earn a profit on the cash their clients hold at the bank after it is swept from the broker. But financial firms deal with these sorts of conflicts all day every day BY NECESSITY. In my view, it’s very unfair to imply that a Broker Dealer is being nefarious just because they also have a bank and don’t recommend that all of their clients be 100% invested in non-cash holdings at all times.  That is obviously an unreasonable assertion since some broker dealer somewhere ends up holding cash at the end of every day. Schwab doesn’t have “broken values” (as Adam Nash asserts) any more so than every other bank who NECESSARILY holds some cash in their client accounts. So this whole discussion about how Schwab is “charging” a fee by requiring a cash position is nothing more than a gigantic fallacy of composition created by people who aren’t thinking of the banking system in aggregate.

Is there a potential opportunity cost by holding cash? Of course. Then again, the Robos require that you not hold cash and in a bear market that requirement will look like a huge “cost” so the argument cuts both ways. Is the cash position a real cost borne by the customer? No. The real cost here is due to the advisory fee being charged by the smaller Robos who can’t make money on the underlying ETF’s. They can’t compete with Schwab’s zero fee so they’re trying to imply that there are lots of opportunity costs in Schwab’s model. But of course, the other Robos are simply taking more risk by not holding any cash so there’s opportunity cost in their model as well (because cash increases in relative value when other assets decline).

Whether the profit here is being “paid” by the customer who isn’t fully invested is not a defensible assertion. Yes, cash will look silly in a big bull market with 0% interest rates, but it could look quite wise in a bear market or even a rising interest rate environment where short duration bonds will perform much better than long duration bonds. The smaller robos appear to be constructing portfolios that are designed almost entirely to protect against purchasing power protection while foregoing substantial permanent loss protection. So, if the stock market falls 20% in the next 12 months the small cash position at Schwab suddenly won’t look like such a big “cost”. There is a necessary trade-off here between purchasing power protection and permanent loss protection. You aren’t “paying” someone else every time the stock market goes up just because you weren’t 100% invested. The assertion that Schwab is essentially charging a fee by not being 100% invested is wildly inaccurate.

To be clear, I think Schwab should give investors the option of removing their cash position if they want, but the fact is, someone somewhere ends up holding the cash in a sweep account and so some other broker dealer with a bank ends up with a “conflict of interest” if they don’t recommend selling the hot potato. But if you don’t hold the cash in your Schwab account then you will choose to hold a riskier asset and someone else will hold the cash somewhere else (and their bank will sweep it) and then people can accuse that new bank of having a “conflict of interest”. Betterment and WealthFront CHOOSE to take more risk in the client portfolios. That will work great in some years and it will work against them in some years (like it did last year when their aggressive portfolios did far worse than the S&P 500).  But the cash position is not necessarily the nefarious allocation that these firms have made it out to be. If that were true then the fact that someone somewhere is holding cash means that the mere existence of cash in brokerage accounts is always and everywhere a bad thing for the client. In other words, any broker dealer that recommends a cash position is being nefarious just because they might make a profit on the net interest margin. That’s just silly since some bank somewhere ends up holding cash at the end of the day thereby implicitly recommending a position that isn’t 100% non-cash.  Betterment and WealthFront have essentially accused the majority of the rest of the financial industry of having conflicts of interest just because they don’t recommend 100% non-cash positions and are forced to hold some cash at the end of the day.

I know that the smaller robos must fight back. They simply can’t compete with a free model of the same thing they’re doing. But I don’t think that this sort of misleading commentary and highly accusatory rhetoric is a very productive way to achieve anything.  Also, I don’t have a dog in this fight. In fact, Schwab is a much bigger threat to my business because my clients can switch to the Schwab Robo with the click of a mouse. But what is really bothersome is the appearance of some misunderstandings about what “cash” really is and its necessarily positive role in (someone’s) portfolio. I hope this added some clarity.

Shorter version:

  • Cash has actually been a fine investment historically generating 5% annual growth over the last 40 years and still providing protection against permanent loss risk. While the smaller robo firms choose to be more aggressive and not hold cash, the reality is that cash will look like a strong relative asset class during bear markets. But 6 years into a big bull market everyone seems to think cash is now worthless….
  • It is highly misleading to accuse Schwab of being underhanded by recommending a cash position because some bank somewhere in the financial system will incur the position if Schwab doesn’t. If Schwab thinks cash is a wise allocation to protect against permanent loss then this is not unreasonable. But some bank somewhere will end up implicitly recommending a cash position of some size because all securities issued are always held at the end of every day.  The banking system cannot “get rid” of this cash position and so some firm ends up with a conflict if they don’t also recommend holding 100% non-cash (which simply passes the hot potato conflict to another firm where people can then accuse them of being conflicted). Of course, all bank broker dealers can’t recommend 100% non-cash to their clients and some bank ends up holding cash at the end of every day. Therefore, some bank in the system ends up with the conflict that Betterment and WealthFront assert is so nefarious. To call this a “cost” is highly misleading given that some firm somewhere is imposing this “cost” on its clients by no choice of its own. Their micro analysis of Schwab’s cash position is a fallacy of composition that exposes their own misunderstanding of the financial and banking system.

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