Look under the hood of Charles Schwab Corp.'s “robo-adviser” and you'll find a good amount of cash and the handiwork of a goateed gentleman named Rob Arnott.
Schwab will make extensive use of index-based investment strategies popularized largely by Mr. Arnott in a digital investment offering it plans to unveil soon, according to an
InvestmentNews analysis of disclosures made by the brokerage.
Schwab Intelligent Portfolios, the firm's first big push into the booming world of digitized wealth management and investment portfolios, is scheduled to launch before the end of March.
In
an extensive set of disclosures about the fund-selection criteria, the San Francisco-based firm has given its first indication of how it will construct portfolios for clients of the service (think, passive), which products it will use (think, ETFs) and how much it will cost investors (it's complicated).
Neither Mr. Arnott's name nor that of his Newport Beach, Calif.-based firm, Research Affiliates, appear in the disclosures. Yet among the more eye-popping revelations in those documents, Schwab will make substantial allocations to a range of its own proprietary products that rely on indexes developed and popularized in large part by Research Affiliates.
A Schwab spokesman, Michael Cianfrocca, said officials were not available for comment.
Schwab will make sizable allocations of investor money to cash held at a Schwab-affiliated bank, a fact which has drawn attention because Schwab is earning a good portion of its revenue on the program from reinvesting those dollars. The allocations could be about 7% for a hypothetical 30-year-old, aggressive investor and 15% for a more conservative 65-year-old, according to the disclosure.
Schwab's choices drew skepticism from financial advisers, whose profession
continues to grapple with the implications of a small-but-growing group of robo-advisers that may threaten their role in the delivery of some investment guidance.
“It seems that Schwab is hard-selling having a cash position in the portfolio, which gives me pause since it has become clear that will make a not-insignificant portion of the expected revenue,” said James D. Osborne, a financial adviser and president of Bason Asset Management in Lakewood, Colo. “Most investors have meaningful cash allocations outside of their portfolios, in savings accounts, money markets or other liquid funds. I am not convinced, especially for more aggressive investors, that a cash allocation adds meaningful benefit to a diversified portfolio.”
Meanwhile, Liz Miller, president of Summit Place Financial Advisors in Summit, N.J., called smart beta a “fad.”
“Schwab's approach across asset classes embraces some of the latest research as well as some of the latest investment fads such as smart beta, absolute-return goals and risk allocations,” said Ms. Miller. “It may be a good marketing approach to include these, but if we embrace individual investors as long-term investors, these approaches may not prove meaningfully more durable or successful as traditional approaches.”
Schwab defends both approaches — its use of cash and smart beta — at length in the disclosures.
“The introduction of smart beta strategies is one of the more exciting developments to hit institutional money management in recent years,” Schwab wrote. “For some time, Schwab has been a thought leader in how investors can best use these strategies. In Schwab Intelligent Portfolios, we've extensively built them into the portfolios as opposed to just providing commentary on the topic.”
The service builds different portfolios for clients with different goals, but sample portfolios included exposures of up to 48% to five “fundamentally” weighted, Schwab ETFs. These funds use numbers in corporate earnings reports, rather than their stock's market capitalization, to determine how much of a stock to include in an index.
That “fundamental” approach has been trademarked by Research Affiliates and has been championed as generating superior risk-adjusted returns by Mr. Arnott in years of speeches and academic papers. And for people who see the concept as a fad, Mr. Arnott is also a lightning rod.
But the approach is just one offshoot — and a profitable one at that — of smart beta, a concept rooted in the work of academics, including Nobel laureate Eugene Fama, who attempted to identify phenomena in financial markets that, exploited properly, provide superior returns for the same risk.
A growing number of proponents are fund companies marketing products for retail investors, Pacific Investment Management Co., another Research Affiliates client, as well as BlackRock Inc. and Dimensional Fund Advisors, which market their own variants.
“Ten years ago, there was a robust debate about whether this was a sensible strategy or not,” said Chris Brightman, chief investment officer at Research Affiliates. “Today, it’s less about whether it’s a sensible strategy and more about the different firms’ position to participate in the growing market segment.”
Schwab has also been an enthusiastic supporter, launching its own lineup of fundamental funds and hiring industry veterans such as Anthony B. Davidow, a former ETF industry and Morgan Stanley Consulting Services Group executive, who now travels around the country for the firm's research unit, acting as a kind of emissary for smart beta.
Schwab says it uses cash in these portfolios for several reasons. First, because investors are risk averse, they need exposure to defensive assets. Second, according to the firm's research, cash is less volatile and risky than other defensive assets, including short-dated bonds and gold. Third, cash has a low and stable correlation to other asset classes, also according to Schwab research.
But on the program, cash is also a major source of revenue for the firm, along with payments by third-party fund managers and a practice known as payment for order flow, in which trades are routed to traders who compensate Schwab for their business. Schwab keeps the excess gains it earns reinvesting clients' cash allocations.
Schwab said the service will charge no fees on top of the 54 underlying ETFs that currently meet its screening criteria. Investors will pay only the costs of the underlying products, all of which are ETFs with annual expense ratios ranging from 0.04% and 0.48%.
Expense ratios are just one of the costs of investing an ETF, but the easiest for an investor to control. Schwab said it tries to limit other costs as well by limiting its selection of ETFs to those with greater assets under the assumption that those funds are less likely to close and make a distribution to investors that would be taxable. The firm has also limited the number of ETFs with high bid-ask spreads and tracking error, both of which measure costs that can erode investment returns.
