Cash Not King In Robo Portfolios

This week, Schwab launched its long-awaited “Intelligent Portfolios,” aka the Schwab Robo Advisor. Everyone’s talking about the new service, especially because Schwab’s claiming it to be 100 percent free. Who doesn’t like free?

Adam Nash, chief executive officer of Wealthfront, the asset leader in the expanding robo space, is hopping mad. He’s out to prove Schwab’s service is actually expensive. Nash had a few choice words for Schwab, including “criminal,” “client-unfriendly” and “self-motivated.”

This is a messy catfight, because it touches directly on the conflict of interest between investors and their advisors. It all centers on Schwab’s use of cash, potentially up to 30 percent of their portfolios. Schwab Bank makes money on cash deposits, avoiding upfront robo fees while still generating plenty of robo revenue.

Schwab claims that cash acts as ballast, and helps deliver superior long-term risk-adjusted returns. Nash, whose firm now has more than $2 billion in assets, portrays cash as a drag on returns.

ETF.com As Arbiter

I get to play referee, targeting the long-term interest of investors. My verdict: Nash is right on cash, but for the wrong reasons. Every investor should hold some cash, just not in a robo advisor.

The Spat

Nash, Wealthfront’s CEO, sent a nastygram to Schwab. The accusation: putting Schwab’s interests ahead of its clients.’ Nash argued that Schwab’s inclusion of ultra-low-yielding cash will cost clients significantly, largely because risky assets offer better long-term returns.

Nash implied that Schwab was playing dirty pool, making its robo advisor look cheaper than the competition, while the opposite is actually more likely, since cash drag has a cost.

Schwab wasted no time in publishing a retort, emphasizing the virtues of cash as an asset class. Then it added fuel to the fire by tagging Wealthfront’s advisory fees as “sunk costs” that drag on investor returns.

Meeeeow!

The Nitty-Gritty Of Cash

Let’s get one thing straight. Both Wealthfront and Schwab include cash in their robo portfolios. What’s really at issue is the cost to investors, and each firm’s business model.

Wealthfront keeps a small cash reserve to cover its advisory fees. The Wealthfront portfolio I looked at this morning had a 0.2 percent cash holding. Schwab’s service holds significantly more—15 percent, in one example.

Cash As An Asset Class

Schwab uses cash as an asset class; Wealthfront uses it for liquidity. By definition, cash is a low-risk, low-returning asset class. In bull markets, cash acts as a drag on portfolio returns.

Cash drag has been quite real over many historical periods, but not all.

Anyone who remembers the dot-com crash and the housing bust can tell you there are times in the market when cash really is king. Schwab’s defense—that cash helps smooth portfolio volatility and perhaps even boosts long-term risk-adjusted returns—could well turn out to be valid.

Still, Nash’s main point—that cash’s expected long-term return is lower than that of a blended portfolio of risky assets—is largely inarguable. All risky asset classes must offer a premium over the risk-free rate to attract investors.

It’s just that the long term is made up of a series of short terms, and some short terms can be brutal. Nash’s argument for full investment will be correct most of the time, but Schwab’s cash allocation will have its moments.

Liquidity Matters

The question is not whether to hold cash, but where. There are real downsides to including cash in a robo advisor.

Let me explain ...

Cash has two distinct uses: ballast and liquidity. Schwab’s gambit of including cash in its robo portfolios emphasizes ballast at the expense of liquidity. This is really a big deal for investors, but not for the reasons that bug Nash.

None of us knows when we’ll need a chunk of cash. We could lose our jobs, fall ill, suddenly need to replace a car, or go hog wild in Vegas. We could finally be ready to make a down payment on a house, or write that fat check to Harvard. That’s why most financial planners recommend everyone keep at least three to six months’ worth of cash in a stable, liquid account.

Anyone interested in using Schwab’s Intelligent Portfolios will have to keep their emergency money in an outside account. This means, effectively, that they’ll have to overallocate to cash, with some in the bank and some in the robo portfolio. That’s a problem.

Robos Trap Cash

Unlike human advisors, robos rebalance portfolios every time their asset allocation gets out of whack. Put another way, robo portfolios have target allocations for each asset class. When one asset class gets too big (or too small) relative to its target weight, the robo advisor automatically sells a bit (or buys more), to keep allocations on target.

This means taking cash out of a robo account is not the same as taking it from a managed account, or from the bank. Because if you take your cash out of a robo, you’ll likely trigger a rebalancing. Specifically, the robots will sell a bit of each of your holdings, to raise more cash, until your cash levels are back within the target range.

Selling assets can trigger capital gains. It also reduces your overall exposure to risky assets, even if your risk profile hasn’t changed. Oops.

Human advisors don’t have to rebalance every time they disburse cash to a client. Some may choose to hold cash for liquidity’s sake.

Mutual fund managers hold cash largely to meet client redemptions. That is the reason most mutual fund managers hold 1 to 3 percent cash.

Robo clients can’t really access the cash in their robo accounts. If they need liquidity, they’ll have to keep cash elsewhere, like in a bank. When Schwab pointed out that holding cash is normal for asset managers, it dangerously ignored the liquidity issue.

Robo Fee Wars

Nash isn’t blameless, though. He’s right to assert that robo clients should consider all-in costs, rather than just the headline numbers. But he might be exaggerating Schwab’s cash-related costs.

He’s surely seen Schwab’s pitch for no fees, commissions or account service fees. He must hate how Wealthfront’s meager 0.25 percent fees look expensive in comparison. But he’s overstated his case.

Schwab’s cash allocation most likely replaces fixed income rather than equity. I’ll admit I haven’t yet been able to analyze Schwab’s fixed-income portfolios, because Schwab has chosen not to disclose the funds it’ll be using. So instead, I’ll compare a cash yield with Wealthfront’s taxable fixed-income portfolio yields.

Last time I analyzed Wealthfront’s portfolios, on June 30, 2014, the weighted average yield to maturity in its 60 percent equity/40 percent fixed-income taxable portfolio was 3.21 percent. It’s probably slightly different now.

Schwab’s sample 60/40 portfolio had a 10.5 percent cash allocation.

Forgoing 3.21 percent on 10.5 percent of a portfolio would cost investors 0.33 percent per year. That’s hardly free, but it’s not the 0.75 percent that Raymond James estimated, either. Cash doesn’t pose interest-rate risk or credit risk, so it’s not an apples-to-apples comparison.

All told, Schwab’s use of cash will probably cost most investors between 0.20 and 0.40 percent per year. Wealthfront’s fees are at the low end of that range; Betterment is cheaper still for accounts over $100,000.

These fees are all super-low. And though every basis point counts, the difference in headline fees shouldn’t be anyone’s deciding factor, because, in the long run, asset allocation and ETF selection will prove a far bigger driver of overall returns. That’s a far bigger deal than any catfight.

Elisabeth Kashner keeps some cash in the bank. You should too. Contact her at [email protected].