The Cost of Free

Charles Schwab, the $40B retail investment behemoth, recently launched a free automated online tool designed to simplify investing. Ill show why the tangled world of finance is anything but simple.Disclaimer: I have no vested interest here.

I derive great pleasure from understanding and explaining how finance, businesses and the economy work. Schwab, Wealthfront and Betterment all have some of my money and I have generally been pleased with their services. In addition, I am not long/short any stock or options in any of these entities and this should not be considered as an endorsement to buy/sell anything.

Consult your financial advisor/CPA/CFP before making any financial decisions.Last Monday, the gloves came off in the robo advisor arena with Charles Schwab officially launching its version called Schwab Intelligent Portfolios (SIP) . For those not familiar, robo advisors are a new breed of personal finance services that automate investing across numerous asset classes using Exchange Traded Funds (ETFs) via an app or website.

There are no human advisors, hence the name robo advisor. Portfolios are structured based upon various risk tolerances and financial objectives determined by answering a series of questions. Depending on answers to these questions, the robo advisors selects from a variety of ETFs across different asset classes.

They charge between 0. 15%0. 35% depending on the amount of assets, well below the fee charged by human financial advisors, which average 1.

31% of assets according to a study that Wealthfront cites. In addition, investors bear the cost of financial instruments (ETFs) in which they are invested, which average 0. 44% of assets but can be as low as 0.

04%. The rub for competing robos: Schwabs service did away with the 0.15%-0.

35% management fee and offers SIP to its clients for free.After the Schwab announcement, the robos went into action with sharply worded blog posts from Wealthfront CEO Adam Nash here and Betterments Director of Behavioral Finance and Investing Dan Egan here. Schwab shot back with a tersely worded press statement defending its use of cash in portfolio allocations.

There are three main critiques of Schwabs new SIP:Cash allocations benefit Schwab through its cash sweep programCash allocations are a drag on portfolio performance for investorsSchwabs choice of its own smart beta ETFs is self serving because of feesTo understand the answer to these questions requires an understanding of how Charles Schwab and modern day brokerages make money.What happened to my $8.95?

If youve been a customer of discount brokers like Charles Schwab, TD Ameritrade, or E-Trade, you might think that they make all their money off the fees you pay when you place a trade. Nothing could be further from the truth. The reality is that Schwab makes only a small portion of its money from your $8.

95/trade fee. According to its most recent 10-K (annual summary of financial performance), Charles Schwab made only 15% of its $6.1B in revenue on trading commissions (and principal transactions).

For E-Trade and TD Ameritrade, this percentage of total revenue is significantly higher. However, the launch of the new app Robinhood, which doesnt charge anything for trades, begs the question of why even charge $8.95?

As for Schwabs other revenue segments, Asset Management and Administration Fees (42%) and Net Interest Revenue (38%) account for the majority of the companys revenue with Other Net, a seemingly innocuous but actually important line, making up the the remaining 5%. The Net Interest Revenue line is the one youll want to focus in on to better understand Wealthfront and Betterments cash conflict complaint. The core of the argument is that Schwab makes more money on keeping your money in cash, where they can invest in short term securities to the benefit of themselves.

For this privilege, Schwab pays its investors very little. This premise is true, as it is for all banks, brokerages and similar financial institutions. Unbeknownst to you probably, cash sitting in your bank or brokerage account is being used by your financial institution to either purchase or originate securities that generate interest income for the benefit of the company.

Unbeknownst to you probably, cash sitting in your bank or brokerage account is being used by your financial institution to either purchase or originate securities that generate interest income for the benefit of the company. Your cash deposits are liabilities of the financial institution and the instruments they own are their assets. At Schwab it looks like this:As you can see, investor deposits supporting their assets are paid very little.

Banking deposits (excess cash from Schwabs SIP are swept into a FDIC insured bank account) were paid an average balance of 0. 03%. Payables to brokerage clients, funding from margin lending, were paid an average 0.

01%. Schwab also has a $1.9B in long-term debt which cost them 3.

84% last year. On that base, Schwab invests in a variety of securities, $138.9B in total last year, and earned an average rate of 1.

71% or $2. 4B. Its funding costs were $0.

1B or 0. 07%. Schwabs Net Interest Revenue Margin is 1.

64%, meaning it earns more by placing investor money in cash than it does by investing it in one of their ETFs.This is a clear conflict of interest for Schwabs SIP product, which is disclosed if you know where to look. The Schwab Wealth Investment Advisory, Inc.

Schwab Intelligent Portfolios Disclosure Brochure had this to say:Schwab Bank earns income on the Sweep Allocation for each investment strategy. The higher the Sweep Allocation and the lower the interest rate paid the more Schwab Bank earns, thereby creating a potential conflict of interest. The cash allocation can affect both the risk profile and performance of a portfolio.

To mitigate any potential conflict, SWIA instructs CSIA to construct the Program strategies pursuant to modern portfolio theory, which seeks to construct an optimal return goal for a portfolio based on the level of risk an investor is willing to take.As for the interest rate it pays for client cash balances, this is what the disclosure brochure has to say:In accordance with an agreement with Schwab, Schwab Bank has agreed to pay an interest rate to depositors participating in the Sweep Program that will be determined by reference to an index. Currently, that index is the national average of money market deposit account rates at the $10,000 level as calculated by RateWatch.

The current rate and RateWatchs methodology can be found at you can see, national rates are low everywhere. That is a byproduct of low interest rates in general and excess reserve capacity at most banks. The average money market rates for $10,000 balances, Schwabs benchmark, are currently at 0.

08%. Last year, Schwab paid 0.03% on average for cash deposits from banking clients.

Someone with a RateWatch login should make sure theyre being honest, although I have no reason to believe theyre not.As an addendum, its in Schwabs best interest that rates rise. They can reprice their interest earning assets faster than raising rates they pay to investors.

Cash Is a DragThe second critique leveled by the robo advisors is that cash is a drag on portfolios and here the devil is in the details. It depends on what factor you are measuring.First, Nash of Wealthfront claimed that cash would rob a 25 year old $573,000 in retirement and then Betterment claimed a 10.

5% weighting to cash would cost investors $73,417 over 30 years. Schwab shot back with its cash management whitepaper, defending their decision to allocate 6%-30% to cash. Cullen Roche performed his own analysis which indeed confirmed that adding cash to a traditional 60/40 equity/bond portfolio does indeed drag down performance, even though the return on cash over the long term has been around 5% annually.

I have no reason to doubt any of the math performed, however it is totally misleading.To understand why, you have to understand modern portfolio theory (MPT). Its a bedrock of finance and the intuition behind how all mean variance optimized (MVO) portfolios are created, including the ones by all the robo advisors.

Its also the concept that is touted by many services as cutting edge when it is in fact one of the oldest concepts in finance. It was first developed in 1952 by Harry Markowitz, who was awarded the Nobel Prize in 1990 for his work. The basic concept is that individual assets have both an expected return and risk and they can be assembled together in a manner to maximize the entire portfolios return per unit of risk.

This optimally arranged portfolio can have higher or lower returns simply by raising or lowering risk.The analysis missed by everyone (Schwab almost got it) is that an addition of cash could improve the expected return per unit of risk for all portfolios. Of course adding cash to a portfolio reduces returns over the long term.

It has a low historical returns. That isnt particularly insightful analysis though. Can it be used to create portfolios with higher Sharpe ratios (return per unit of risk)?

Thats what I want to know. Show me that math. If all investors are looking for is the highest returning investments, regardless of risk, none of these robos deserve your money.

Go put it all in a small cap equity ETF and sit by the pool and drink pina coladas for the next 30 years.If all investors are looking for is the highest returning investments, regardless of risk, none of these robos deserve your money. Go put it all in a small cap equity ETF and sit by the pool drinking pina coladas for the next 30 years.

Smart Beta ETFs Are Of No Benefit To InvestorsWhile MVO and MPT are not new theories, Smart Beta or Fundamental Index portfolios are new marketing slogans for a practice which has been around for a while, quantitative asset management. While fundamental investors like Warren Buffett pick stocks by assessing a companys strategic and financial prospects, quants manage money by betting on statistical data. What active quantitative strategies attempt to do is to weight their holdings based on factors or market anomalies that show persistence over long periods.

Those bets are spread over numerous securities so essentially they end up betting on averages. Some broad categories of popular factors are:Price momentumValuationCompany SizeEarnings qualityI wont bore you with all the research but if you want to dig into Smart Beta, I recommend this paper from AQR and this paper from Research Affiliates to get you started.Smart Beta is still a contested topic.

Are these factors sources of unexplained returns or are they simply risk factors? The position taken by Burton Malkiel, a well respected and influential academic who also happens to be on the management team of Wealthfront, is that Smart Beta factors represent additional risk factors and therefore these products produces results by taking higher risk. Plus, the track record of actual of products in the market falls short of academic expectations.

He continues to advocate for low cost ETFs based on market cap weighted benchmarks.This is a missed opportunity. Smart Beta and quantitatively managed products represent a possible product extension for a company that is now being directly undercut by Schwabs free SIP product.

The way robo advisors make money is by charging customers to efficiently structure and periodically rebalance index betas in their clients portfolio. They then use someone elses low cost ETFs (Vanguard, Black Rock, State Street, Charles Schwab, etc) to replicate those betas, effectively sending fees out the door to potential competitors. Essentially they are selling pies with someone elses ingredients.

Wealthfront has caught onto this with its direct indexing but I havent seen anyone else follow. The investing world is bifurcating: either you provide very low cost beta (pick your index) and gather huge scale or you are going to provide alpha and charge a lot for that. You can envision a product that charges clients a nominal fee for its market beta, whatever the benchmark ETF costs, and then earns a percentage of its alpha.

Thats a properly designed product that incentivizes active managers to outperform versus gather assets.Not Mutually Exclusive. Completely ExhaustingIt should come as no surprise that Schwabs SIP puts you in a lot of either their own in-house ETFs or one of the funds from their OneSource platform.

Of the 54 ETFs the SIP has approved for structuring portfolios, 14 are Schwab ETFs and another 8 come from their Schwab ETF OneSource platform. For in-house ETFs, Schwab receives a management fee based on the expense ratio. For OneSource ETFs, third party ETF creators pay Schwab a fee of up to 0.

20% of assets when Schwab customers buy their ETFs. This conflict is disclosed. Schwab doesnt disclose a full list of 54 ETFs they use, but you can make a pretty good guess on the in-house and third party OneSource ETFs.

Also, individual portfolios will vary, but these are probably the most used instruments.The odd thing about Schwabs portfolio construction is that there is a significant mixing of betas with significant overlap with purely passive cap weighted index ETFs and their version of Smart Beta ETFs, which they label as Fundamental ETFs. This is clearly beneficial for Schwab.

Its Fundamental ETFs carry fees that are significantly higher than their purely passive counterparts. For instance, their US Large Company Stocks ETF (SCHX) carries an operating expense ratio of 0.04% while the Smart Beta version, the US Large Company Fundamental ETF (FNDX) carries a fee of 0.

32%. However, it may be beneficial to the customer as well if the Fundamental ETF outperforms the purely passive index by an amount greater than the differential cost of the ETFs. Here the story is mixed.

Schwab launched its family of Fundamental ETFs on August 15, 2013. However, its not as simple as comparing the passive ETF vs. its Fundamental competitor.

If you did, youd find that the large cap passive ETF beats its Fundamental competitor (SCHX vs FNDX) even before the fee difference, while the Fundamental versions of US Small Caps (SCHA vs FNDA), International Large Caps (SCHF vs FNDF) and International Small Caps (SCHC vs FNDC) all more than earn their cost. As a note, this is not a long operating history by any means.The reason why you cannot directly compare them is because they have entirely different index benchmarks.

For instance, SCHX uses the Dow Jones U. S. Large-Cap Total Stock Market Index while FNDX uses the Russell Fundamental Developed Mark Index.

Not only are these two entirely different index creators, Dow Jones and Russell, their indexes differ materially in their attributes, construction and rebalancing methodology. These differences become more apparent when dealing with indexes with longer operating histories. Just take a look at two small cap indexes, the Russell 2000 and S&P 600.

David Swensen discussed these index differences at length in his book Pioneering Portfolio Management. Go read it, but heres the data circa 2003:The short of this is that in order to judge the performance of the Fundamental ETFs, you need to compare it to a better index or ETF, which is not its passive brother from the Schwab family. The following chart shows the differences in the comparison of the ETF indexes Schwab illustrated, along with their benchmark (Bloomberg codes) and tracking error.

I illustrate this to show that even though you may be comparing two ETFs of similar style, their underlying benchmarks may differ significantly.If I were to change Schwabs allocation of ETFs, Id create a base model portfolio using mutually exclusive indexes from the best single index provider for each asset class, and then layer on Schwabs low cost passive ETFs. As an option, clients should be able to turn on a higher performance option using their Fundamental ETFs for potentially higher risk and a higher fee.

The robos have this ability as well, if they are willing to accept that quantitative management strategies work.Call The PlumberIf the robos really wanted something to gripe about with Schwab, its how they execute your trading orders. The thing is they dont.

UBS Securities LLC does. In 2004, sold Schwab sold its order execution business along with Soundview Capital to UBS Securities LLC for $265 million. This agreement was last renewed in 2011 according to the Wall Street Journal, although I can find no record of it on file with the SEC.

Why is this problematic for Schwab customers? Let a man far more entertaining than me tell you. The UBS dark pool happens to be, famously, a place to which the stock-market orders of lots of small investors get routed.

The stock-market orders placed through Charles Schwab, for instance. When I place an order to buy or sell shares through Schwab, that order is sold by Schwab to UBS. Inside the UBS dark pool, my order can be traded against, legally, at the official best price in the market.

A high-frequency trader with access to the UBS dark pool will know when the official best price differs from the actual market price, as it often does. Put another way: the S.E.

C.s action revealed that the UBS dark pool had gone to unusual lengths to enable high-frequency traders to buy or sell stock from me at something other than the current market price. This is from Michael Lewiss recent article in Vanity Fair, which hasnt even hit newsstands yet.

This was first detailed by Lewis in his book Flash Boys. If you havent read it, watch his 60 Minutes segments while youre waiting for the book to arrive. UBS got in quite a bit of hot water for what went on inside of its dark pool which was not a level playing field for all customers and did not operate as advertised according to Andrew J.

Ceresney, Director of the SECs Division of Enforcement. UBS recently paid a $14.4 million fine to the SEC for numerous violations.

It is unclear to me how the treatment of customer orders has changed at the UBS dark pool. What is clear is that UBS still executes virtually all of Schwabs customers orders.This is not an uncommon arrangement, but it clearly has benefits for Schwab.

Remember that 5% of Other net revenue? It totaled $343 million last year. Some of that is payment for order flow from companies like UBS.

From Schwabs most recent 10-K:Other Revenue NetOther revenue net includes order flow revenue, nonrecurring gains, software fees from the Companys portfolio management services, exchange processing fees, realized gains or losses on sales of securities available for sale, and other service fees. Other revenue net increased by $107 million, or 45%, in 2014 compared to 2013 primarily due to a net insurance settlement of $45 million, net litigation proceeds of $28 million related to the Companys non-agency residential mortgage-backed securities portfolio, and increases in order flow revenue.We can eliminate the insurance claims and litigation proceeds from the $343 million, which leaves a potential maximum of $270 million in revenue for order flow.

I dont know the exact number but this is what Michael Lewis wrote in Flash Boys (some of his dates and numbers are off):The bigger Charles Schwab, whose order flow was even more valuable than TD Ameritrades, had sold its flow to UBS back in 2005, in an eight year deal, for only $285 million. (UBS charged the high-frequency trading at Citadel some undisclosed sum to execute Schwabs trades). Schwab left at least a billion dollars on the table, Nagy said.

Charles Schwab made a statement last year about high frequency trading, right after Flash Boys came out. The company was either oblivious as to what was going to their customer order flow at UBS, or they turned a blind eye. Im not sure which I prefer.

The guys over at Themis Trading have an interesting opinion here.By the way, remember that hot new trading app called Robinhood that doesnt charge a trading commission? They intend to sell your order flow as well.

There is a serious debate going on right now about the role that high frequency trading (HFT) plays in the markets. The two sides of the argument are 1) that HFTs improve liquidity, narrow spreads and improve prices for market participants 2) HFT is a form of legalized front running that scalp real investors (read Michael Lewiss book). I understand both sides of the argument, and if you want to see the two sides go at in the most uncomfortable way, watch this video.

Having experienced first hand the issues created by HFTs, I prefer clarity and an even playing field for all market participants.RecommendationsI havent done a complete analysis of portfolio allocations and performance for robo advisors but a couple of recommendations are immediately obvious:Create portfolios based on indexes that are mutually exclusiveChoose the best in class index providersReduce the number instruments per asset classOffer style tilts like Smart Beta as a separate optionQuantify the cash impact on Sharpe ratiosFind ETF alternatives to cash allocations (short term Treasurys or TIPS)Be more forthcoming about conflicts of interestMaybe theres room for another player or multiple players (Vanguard, BlackRock, State Street) that address some of these concerns. According to Goldman Sachs, the market for automated advisory services is conservatively $400B in assets.

Thats a spicy meatball even at 0. 35% fees. ConclusionMy goal is that institutions and individuals make better informed investment decisions.

Hopefully, Ive been able to do that in a fair and even handed way that is both entertaining and informative. Despite their differences, robo advisors and low cost ETFs represent a significant improvement in the ability for many people to reach their financial objectives. The caveat is the devil is in the details.

There is significantly more analysis that could be done on portfolio construction and ETF/index selection but Ill save that for another time. I welcome questions, comments, and of course, corrections. RELATED QUESTION Furniture: What's the best chair for designers?

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