Schwab's Robo-Advisor Relies on 'Smart Beta' ETFs For 60% of Major Equity Asset Classes

Schwab's Robo-Advisor Relies on 'Smart Beta' ETFs For 60% of Major Equity Asset Classes

Schwab Wealth Investment Advisory’s chief investment strategist David Koenig clarified how assets are allocated in its online, automated service for consumers, Schwab Intelligent Portfolios. And it's heavily weighted toward so-called "smart beta" ETFs.

It’s been known since Intelligent Portfolios launched that portfolios created by the “robo-advisor” would combine cash allocations with a mix of market-cap and fundamental index ETFs, and Koenig said in a monthly call with the media that the software would allocate 60 percent of equity in five prominent asset classes (US large and small company stock, international large and small stock, and international emerging markets) towards smart beta. A spokesperson for Schwab later clarified that Schwab's other equity asset classes will receive different allocations, and the advisor-facing product, Institutional Intelligent Portfolios, will not require registered investment advisors to invest in fundamentally weighted ETFs. 

Koenig explained that the decision falls in line with Schwab’s overall philosophy that so-called “smart beta” strategies add greater diversification and improve returns over time. The use of these strategies is unique for a robo-advisor – competitors like Betterment and Wealthfront don’t allocate any assets to fundamentally weighted ETFs – and Koenig said it’s proof that Intelligent Portfolios offers more sophistication than other automated allocation services. 

Ellie Lan, an investment analyst for Betterment, said Betterment doesn’t use fundamentally weighted ETFs because they don’t agree that the strategies outperform market-cap rivals, especially after adjusting for risk in the long run. Though Lan didn’t want to pass judgment on Schwab’s strategies, she said she personally wouldn’t build a portfolio using such a high percentage of smart beta.

Another issue is the expense.

“Expense ratio is one of the main considerations in choosing an ETF,” Lan said, adding that the expense ratios of fundamentally weighted ETFs is often three to six times that of market-weighted ETFs.

“You would think that because these fundamentally weighted ETFs launched in 2013, they [would be] able to charge lower fees. The reality is the exact opposite.”

Koenig acknowledged the higher expense ratios, but said that what matters the most is the all-in cost to investors.

“Since Schwab is not layering on any advisory fees, investors are receiving more sophisticated portfolios for lower end costs,” Koenig said. “We believe that fundamentally weighted strategies are one of the most exciting innovations in investing in recent years.

“Institutional [investors] have been able to take advantage for years, and now its available to all investors.”

Tony Davidow, an alternative beta and asset allocation strategist at the Schwab Center for Financial Research, said fundamentally weighted index strategies capture the positive attributes of traditional indexing and active management, and places more of an emphasis on fairly valued stocks than popular stocks. Schwab also provided research to back up its claim that fundamentally weighted indexes outperform a market-cap-weighted equivalent.

This is unlikely to sway some Schwab detractors who argue that the use of smart beta ETFs is proof that the company has compromised its integrity with its robo-advisor. When asked about the 60 percent number, Wealthfront referred to a blog post written by its CEO, Adam Nash, who accused Schwab of creating a conflict of interest with Intelligent Portfolios.

“The average smart beta ETF that Schwab has selected not only has 3x the management fees of the average Vanguard ETF, but not surprisingly all are either proprietary Schwab ETF products or ETFs from issuers that pay Schwab to use them,” Nash wrote in March. “Charles Schwab is not stupid,” Nash said. “There is no question why it decided to create entirely new asset classes for smart beta in its allocations. All you have to do is follow the money.”

Aaron Klein, the CEO of Riskalyze, said the jury is out on whether Schwab will be right in its decision to emphasize fundamentally weighted ETFs, but said the decision is definitely interesting.

“It signals that Schwab is going to have a point of view instead of just passive indexing,” Klein said on Twitter. In a follow-up email, he said its similar to what Riskalyze and CLS are doing with dynamic asset allocation in their Autopilot product, and said (as others have) that the more troubling issue is the cash allocation feature.

“It’s problematic to have an automatically-replenishing barrel of cash that drives revenue to Schwab, and then calling the product “free” when the ADV clearly spells out that it isn’t and you have no choice on the cash.” 

Editor's Note: This article was updated to reflect that 60 percent allocation towards fundamentally weighted ETFs would only happen in five specific asset classes used by Schwab Intelligent Portfolios, and not not 60 percent of all client assets. We apologize for the error. 

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