A big fight broke out in recent days as a result of Schwab’s entrance into the Robo Advisory business. Schwab has unveiled a product that is virtually identical to what many of the other Robo Advisory firms are doing (like Betterment and WealthFront) with the big difference being that Schwab’s service is free except for the internal fund fees. Schwab is essentially making money on the underlying funds which they issue. The Robos can’t compete with this because they charge you the internal ETF fee (which they don’t own) and then must charge you an advisory fee on top of that. At its most basic level Schwab has a huge competitive advantage here because it makes no sense to use the Robos with their added fees given that Schwab is offering the same basic product for a lower overall cost. Using one of the other Robos is just giving money away.
Naturally, the new Schwab product really ticked off the Robos who have been establishing some good footing in this space over the last few years. Adam Nash, the CEO of WealthFront wrote a scathing post claiming that Schwab has “become Merrill Lynch”. The gist of the post was that Schwab advertises a free product and then hits you with fees on the back-end.
Now, having worked at Merrill Lynch in the past and being fully aware of their fee structure and banking operations during the financial crisis I can tell you that Adam is being hyperbolic, to say the least. Charles Schwab is not Merrill Lynch. Further, I find it ironic that WealthFront is so quick to disparage false advertising when they claim on the front page of their website that they can generate an “estimated additional return” of 4.6% using a passive indexing strategy. A passive indexing strategy, by definition, is designed to capture the market return and not attempt to exceed it. Talk about false advertising! As I showed in my 2014 review of Robo Advisor performance WealthFront’s most aggressive portfolio is a near perfect replication of the Vanguard Total World fund. They are charging people a 0.25% fee for their own version of a closet indexing strategy and then aggressively bad mouthing competitors. This is financial marketing at its best!
But the bigger concern raised by Nash is regarding the cash position that Schwab will hold in accounts. Nash says that Schwab is being deceptive and will cost their investors huge sums of money by maintaining a cash position. The basic gist is that Schwab is holding the cash so that they can reinvest it at higher rates. Schwab called Nash’s claim “very misleading” and I tend to agree with them. Nash used an example of a 25 year old with a long time horizon who holds 30% cash and forgoes $500K in gains over the next 40 years. The only problem is that Schwab’s platform doesn’t recommend that an aggressive 25 year old should hold 30% in cash. In fact, Schwab’s most conservative allocations only result in about a 12% cash position. The vast majority of the asset allocations are between 6-10% cash.
Nash also asserts that Schwab is being underhanded in their management of cash. But this too is misleading. Someone ends up holding cash at the end of the day and the practice of using a sweep account is standard industry practice. There is nothing abnormal or evil abouts Schwab’s use of a cash sweep account. Nash might not be aware of this because WealthFront isn’t a Broker Dealer so they probably don’t deal with this stuff, but it’s very normal. I wish Schwab gave the option to eliminate the cash position if the investor wanted to, but it’s not nearly the big deal Nash makes it out to be because if you risk up then someone somewhere else is risking down thereby holding the cash somewhere else where some other firm is probably sweeping it. Wealthfront chooses to risk up which leaves someone somewhere else holding cash. If Schwab believes a small cash position makes sense as an asset allocation component then big deal.
Schwab defended their position stating that cash has been a good historical position and their platform isn’t designed to time when interest rates rise and fall. This again, is true. To be clear, “cash” in a brokerage account is not actually anything like physical cash. It’s generally a sweep account that holds t-bills and other short-term notes. Historically, a “cash” position has done quite well. Since 1972 a cash account has generated a nominal annual return of 5%. Obviously, that hasn’t been the case in recent years, but Schwab says they aren’t trying to time the market with their cash positions. I don’t think that’s an unreasonable position.
What I don’t like about the Schwab position is that they don’t give investors an option to eliminate the cash position. They give you the flexibility to remove up to three of their ETFs in their model portfolios, but they won’t let you remove the cash. I don’t like that one bit.
More generally, the question in the headline is a fallacy of composition. Of course, when I sell stock I take over someone else’s cash position. We don’t actually remove cash from the system when we exchange shares of anything so someone ends up holding a cash equivalent no matter what. But I think that should be each investor’s choice. If you’d prefer not to be the person holding the cash you should be able to remove it. Personally, I always keep a bit of cash on hand for the use of optionality, a la Warren Buffett. A small cash position is just fine if you’re able to ignore comparisons to cashless benchmarks and just remain patient. But that’s just me. So I guess the answer is that it depends. Historically, cash has been a fine holding. And for those who perfer optionality it will continue to be a fine holding even at 0% rates.
Overall, I love this whole back and forth because it’s a sign that competition works. The biggest players in the financial services industry are now being forced to innovate and compete with smaller players. The disruption is positive in the aggregate even if there will be losers. Frankly, I don’t find the whole Robo Advisor platform all that special relative to a Vanguard account so I still find myself rejecting both Schwab and the other Robos at the end of the day. But it’s sure fun to watch the innovation, the rise of low fee products and the filtering of more sophisticated investment options down to everyone and their mother. We’re all better off for it.