The Securities and Exchange Commission (SEC) charged Charles Schwab $187 million on June 13, 2022 over a failure to disclose that the company’s Robo-advisor, Schwab Intelligent Portfolios (SIP), was benefiting from the cash allocation in its clients' portfolios.
Schwab allocated between 6% and 29.4% of clients’ portfolios in cash;
It directed the cash balances to its affiliate bank and loaned them to their clients;
Schwab benefited from the spread between the revenue generated on the loan and interest paid on cash balances;
The SEC said that customers were not aware of this process and they earned less money between 2015 and 2018;
Schwab entities were charged for misleading advertisement as they claimed free advisory services.
By explaining the case of Schwab Intelligent Portfolios, we will shed light in this article on the potential hidden fees that you might encounter while opening an account with a free Robo-advisor.
What is Schwab Intelligent Portfolios?
Schwab Intelligent Portfolios (SIP) is a Robo-advisor launched by Charles Schwab in March 2015. It provides investors with automated portfolio management services. The basic plan of SIP is free and offers various types of portfolios to fit your requirements. First, you reply to the questionnaire, then their algorithm assesses your goals, risk tolerance, and investment time horizon in order to recommend a customized portfolio.
When it comes to the investment process, they have chosen 51 ETFs that span more than 20 asset classes, and the weights in your portfolio depend on your investment strategy (Global, US Focused or Income-Focused) and on your risk profile (ranging from Conservative to Aggressive Growth). You can start investing with SIP starting at $5,000 and they do not charge any advisory fees.
On the other hand, SIP also has a premium service where you get unlimited guidance from Certified Financial Planners (CFP).
What did Schwab do wrong?
Although Schwab Intelligent Portfolios did not charge any advisory fees to its investors, they held part of clients’ money as cash in their portfolios, classified by the SEC as “cash drag”. So, instead of investing this portion of your portfolio, Schwab kept it in cash and deposited it with its affiliate bank, Charles Schwab Bank.
Later, similar to any commercial bank, Schwab Bank loaned the amount to other clients at higher interest rates than what it paid to its SIP clients. Hence, it retained the difference between the income generated on the loans and the interest paid to SIP clients. According to the SEC statement, by November 2018, Schwab was able to profit by almost $46 million from the spread of this cash allocation.
The SEC stated that each of the model portfolios held between 6% and 29.4% of clients’ assets in cash. This portion was predetermined (not generated by any algorithm) so that Schwab’s affiliated bank could earn a profit from the spread of this allocation.
How much is the charge and what is it for?
The company advertised its services as free of any advisory fees and failed to disclose that a higher allocation to cash under certain market conditions would lower clients’ returns (for example, when equities outperformed cash, part of the portfolio missed some of those returns). Thus, the clients could end up paying approximately the same amount of opportunity cost as paying a regular advisory fee would have.
Furthermore, the SEC found the advertisement run by Schwab regarding its SIP services was misleading, and lacked transparency. You can find below an example extracted from the SEC litigation document.
“Certain other advertisements were misleading, including the example below, because they implied that SIP investors would end up with more money as a result of not being charged an advisory fee—even though internal models showed that the cash allocations would reduce returns by a similar amount when other assets such as equities outperform cash.”
The SEC claimed that investors could not make fully informed decisions regarding their investment choices due to misleading advertisements and a failure to disclose this information.
Gurbir S. Grewal, Director of the SEC’s Division of Enforcement stated: "Schwab claimed that the amount of cash in its robo-adviser portfolios was decided by sophisticated economic algorithms meant to optimize its clients’ returns, when in reality it was decided by how much money the company wanted to make. Schwab’s conduct was egregious and today’s action sends a clear message to advisers that they need to be transparent with clients about hidden fees and how such fees affect clients’ returns."
In the conclusion of this order, without admitting or denying the SEC’s findings, Schwab will pay an amount of $187 million ($45,907,541 in disgorgement, $5,629,320 in prejudgment interest, and a $135,000,000 civil penalty). Schwab has also committed to appointing an independent consultant to review their policies and procedures relating to Robo-advisory disclosures and advertising.
Usually, Robo-advisors charge annual fees as a percentage of Assets Under Management (AUM). This fee is generally lower compared to traditional financial advisors, where the fee may reach over 1.00% of the AUM.
When it comes to free Robo-advisors, we advise you to check how the company generates revenue and why they are offering free services. Those companies may benefit from cross-selling other services and products or may benefit from interest on cash allocations. For instance, Ally Invest states clearly that if the cash allocation of your portfolio reaches 30%, you will be exempted from any advisory fees. (In other words, Ally Invest will earn interest on your cash balance equivalent to what it would have charged you as advisory fees).
Finally, we encourage you to do some research before opening an account with any Robo-advisor and check their websites. You may find it useful to read how their investment process is implemented, compare the fees charged, and make sure that the company is regulated.
Remember, if you have any questions, feel free to leave a comment below.
A reminder that the above should not be construed as investment advice and should be considered information only. Investors should do their own research and due diligence about the services and opportunities best suited for their risk, returns, and impact strategy.