Schwab tossed a big bone to robo-advisor watchers with the recent publication of "About Schwab Intelligent Portfolios." This guideline to Schwab's asset allocation and ETF selection strategies outlines what investors can expect from Chuck's robo-advisor service, now that it has been launched.
For me, it was a juicy invitation to return to my seven blogs on robo advisor portfolios, with a new focus on Schwab's robo service.
Schwab's portfolios—at least the one that I looked at, aimed what the company called "Investor #2"—really stand out from the competition. Not so much for their headline-grabbing cash allocation or foray into strategic beta as for their actual asset allocation. You see, Chuck has bet big on small-caps.
Schwab's large allocation to cash and their inclusion of Fundamental ETFs—funds based on indexes that select or weight securities based on information in corporate balance sheets or income statements—have generated lots of press, and rightly so. Cash can drag down portfolio returns in a rising market, and could be costly to access if doing so triggers rebalance trading.
Fundamental funds seem like a big departure from the dirt-cheap cap-weighted funds in high-profile robo portfolios, but shifting robo portfolio exposure away from the unbiased opportunity set isn't new, as I explained last summer. Betterment and Future Advisor have been including value funds in their portfolios for some time now, while Wealthfront allocates to the Vanguard Dividend Appreciation ETF (VIG | A-69). None of these portfolios is quite as vanilla as it seems.
But neither of these aspects matters as much in the end as the overall asset allocation. As always, that's what drives returns over the long term. That's why I was delighted to see that Schwab offered three sample portfolios for robo-watchers to examine.
I decided to focus on Schwab's sample portfolio for someone they call Investor 2. That's kind of impersonal, so I'm going to call him "Chuck."
Getting To Know Chuck
To be clear, Schwab has presented only three model portfolios so far. There's no way of knowing whether Chuck—that is, Investor 2—has a typical portfolio.
Let's focus on what we do know. Chuck's middle-of-the-road portfolio holds 61 percent equity, 34 percent fixed income/cash and 5 percent commodities. Call it a classic 60/40 split. Using Schwab's ETF selection process guidance, I filled in tickers and fund names for the equity portion of this portfolio. I left the fixed-income portion for another day, because I wasn't confident I could deduce its exact holdings.
Here's what I think Chuck's holding, equitywise:
Chuck's Probable Equity Allocation
|Probable Fund Name||61%|
|US Large Company Stocks||SCHX||Schwab U.S. Large-Cap||7.0%|
|US Large Fundamental||FNDX||Schwab Fundamental U.S. Large Company||11.0%|
|US Small Company Stocks||SCHA||Schwab U.S. Small-Cap||4.0%|
|US Small Fundamental||FNDA||Schwab Fundamental U.S. Small Company||6.0%|
|International Developed Large Company Stocks||SCHF||Schwab International Equity||5.0%|
|International Developed Large Fundamental||FNDF||Schwab Fundamental International Large Company||7.0%|
|International Developed Small Company Stocks||SCHC||Schwab International Small-Cap Equity||3.0%|
|International Developed Small Fundamental||FNDC||Schwab Fundamental International Small Company||5.0%|
|International Emerging Market Stocks||SCHE||Schwab Emerging Markets Equity||3.0%|
|International Emerging Market Fundamental||FNDE||Schwab Fundamental Emerging Markets Large Company||5.0%|
|US Exchange Traded REITs||SCHH||Schwab U. S. REIT||3.0%|
|International Exchange Traded REITs||VNQI||Vanguard Global ex-U.S. Real Estate||2.0%|
All these funds fit Schwab's criteria of being the cheapest of their type, being broad-based, with a healthy asset level, reasonable spreads and acceptable tracking error. Schwab stated that its intelligent portfolios would use 14 Schwab ETFs, so it's safe to assume they'll use Schwab ETFs wherever possible.
I'm pretty sure I've nailed this, unless Schwab decides it just can't use any Vanguard funds. I'm just sayin'.
Chuck Vs. The Competition
I can now compare Chuck's exposures with similar ones from Wealthfront and Betterment. Wealthfront's sample portfolio allocates 59 percent to equity, while Betterment's has an even 60 percent. These are all essentially 60/40 portfolios.
The Vanguard Total World Stock ETF (VT | A-100), broad-based, cap-weighted global equity fund, makes a good foil for all three—for their equity allocations, that is.
ETF.com's ETF Analytics tool gives me the ability to analyze each of these robo portfolios. Here's how they stack up.
|Weighted Average Market Cap (Billions)||56.6||88.5||76.3||83.9|
Data: Schwab, Wealthfront, Betterment, Vanguard, ETF.com. As of March 1, 2015.
Compared with Wealthfront and Betterment, and even VT, Chuck's portfolio has a far-smaller-weighted average market cap and costs more on a price/earnings basis, though it's cheaper price/bookwise. The market cap size is striking, as it's 67.5 percent that of the global equity market.
Schwab's $56.6 billion weighted average market cap is slightly smaller than South Korea's. For reference, the U.S. clocked in at 111.6 billion.
Fundamental Isn't The Same As Small
I wondered if Schwab's fundamental funds helped tilt the portfolio to the small-cap side. So I did a quick experiment. I rebuilt Chuck's portfolio using only Schwab's vanilla funds, and I ran it through the same analysis I used initially.
The shadow portfolio's weighted average market cap came in just $600 million higher than the published one. Now, $600 million is a lot of money, but in this context, it's nothing, as you can see in the table below.
|Portfolio Statistic||Chuck's Portfolio||Vanilla Version|
|Weighted Average Market Cap (Billions)||56.6 Billion||57.2 Billion|
The use of fundamental funds barely moves the needle in terms of equity portfolio exposures. It's largely cosmetic. So what made Chuck's portfolio tilt so small? It turns out to be shockingly simple.
Big Allocation To Small Stocks
Chuck's portfolio holds lots of small-cap funds. In the asset-class breakdown below, you'll see that Schwab's allocation to small-caps is much higher than either Wealthfront's or Betterment's.
|Small/Micro Cap Weight||17.8%||4.9%||4.8%||7.5%|
Data: Schwab, Wealthfront, Betterment, Vanguard, ETF.com. As of March 1, 2015.
It's useful to see how each of these firms allocates by asset class. Here's a breakdown:
|Equity: U.S. - Total Market||0.0%||30.0%||11.6%|
|Equity: U.S. - Large Cap||18.0%||0.0%||0.0%|
|Equity: U.S. - Large Cap Value||0.0%||0.0%||11.6%|
|Equity: U.S. - Mid Cap Value||0.0%||0.0%||3.7%|
|Equity: U.S. - Small Cap||10.0%||0.0%||0.0%|
|Equity: U.S. - Small Cap Value||0.0%||0.0%||3.2%|
|Equity: Developed Markets Ex-U.S. - Total Market||5.0%||13.0%||24.7%|
|Equity: Developed Markets Ex-U.S. - Large Cap||7.0%||0.0%||0.0%|
|Equity: Developed Markets Ex-U.S. - Small Cap||8.0%||0.0%||0.0%|
|Equity: Emerging Markets - Total Market||3.0%||9.0%||5.2%|
|Equity: Emerging Markets - Large Cap||5.0%||0.0%||0.0%|
|Equity: Global Ex-U.S. Real Estate||2.0%||0.0%||0.0%|
|Equity: U.S. - High Dividend Yield||0.0%||7.0%||0.0%|
|Equity: U.S. Real Estate||3.0%||0.0%||0.0%|
Data: Schwab, Wealthfront, Betterment, Vanguard, ETF.com
Schwab's small-cap allocations hits hard in two ways: the size of the allocation, and the way Schwab draws the line between large- and small-cap.
Schwab's 10 percent to U.S. small-caps and 8 percent to developed market ex-U.S. small-caps takes up 29.5 percent of Chuck's equity allocation. Yet the Schwab U.S. Large Cap ETF (SCHX | A-95) covers roughly 89 percent of the investable U.S. market, leaving only 11 percent for the Schwab U.S. Small Cap ETF (SCHA | A-94).
The developed markets ex-U.S. situation is identical.
This means Chuck has nearly 30 percent of his portfolio allocated to 11 percent of the cap spectrum—an almost 3:1 ratio. Simply put, Chuck's got about three times as much weight to developed-market small-caps as he would if he just held VT.
That's definitely a distinctive portfolio.
The Price Of A Small-Cap Tilt
Schwab's big bet on developed-market small-caps might be perfect for Chuck, given his profiled above-average risk tolerance and his 15- to 19-year investment horizon. That is, if small-caps continue to outperform versus the overall market, as they have for the past five years. But small-caps can be quite risky, falling harder than large-caps when markets turn south.
That's what makes this such a big bet, and why it's clear that this new so-called intelligent portfolio isn't just a me-too product. It might not be for everyone, but that's OK. Investor choice is a good thing, especially when competition drives innovation.
It's good to get a glimpse of what Schwab robo-portfolio investors can expect from this new service. We're all eager to see the full rollout later this month. Let's just hope investors take a careful look under the hood, and understand what their exposures are. I'll be right there with them.
At the time this article was written, the author held no positions in the securities mentioned. Contact Elisabeth Kashner at [email protected].