Clients of Schwab Intelligent Portfolios (SIP), Charles Schwab’s robo-advisor, have received disgorgement checks stemming from a settlement with the SEC last year that accused the firm of failing to disclose certain asset allocations that prevented clients from obtaining their maximum returns.
The firm sent a letter out to its eligible clients last month informing them that eligible clients who held an SIP account between March 2015 through November 2018 would receive a check in the coming weeks. The firm is sending a total of $52 million to its eligible clients.
“Clients who are eligible for a distribution received their share of a fair fund distribution arising from a settlement Schwab reached with the SEC regarding certain historic language in Schwab Intelligent Portfolios disclosure documents and advertising for Schwab Intelligent Portfolios from March 2015 through November 2018,” said Alison Wertheim, a spokeswoman for Schwab. “This settlement resolves a matter which the SEC order acknowledges was resolved years ago.”
The checks are the result of a settlement the Westlake, Texas-based firm reached with the SEC in June, when Schwab was accused of failing to properly disclose that it had invested its SIP clients into cash despite that not being the best option.
“Schwab’s own data showed that under most market conditions, the cash in the portfolios would cause clients to make less money even while taking on the same amount of risk,” the SEC said at the time. “Schwab advertised the robo-adviser as having neither advisory nor hidden fees, but didn’t tell clients about this cash drag on their investment.”
The Commission accused three Schwab subsidiaries: Charles Schwab & Co., Inc., Charles Schwab Investment Advisory, Inc. and Schwab Wealth Investment Advisory, Inc. of the violation.
On its Form ADV, the firm never mentioned to clients that while it might be investing between 6% and 29.4% of clients’ assets in cash, it might not have been the option that would generate the most returns. Schwab also did not disclose that it was making money off these allocations, according to the SEC.
“Schwab made money from the cash allocations in the robo-adviser portfolios by sweeping the cash to its affiliate bank, loaning it out, and then keeping the difference between the interest it earned on the loans and what it paid in interest to the robo-adviser clients,” the SEC said at the time.
The firm claimed in its disclosures that the allocation decisions were based on what it referred to as a “disciplined portfolio construction methodology,” the SEC said. By investing in such a high percentage of cash when other options would have had better returns, the firm misled its clients, according to the SEC.
The Commission censured Schwab and required the firm to pay $52 million in disgorgement and prejudgment interest, and a $135 million civil penalty. Schwab acknowledged the dispersal of checks to its clients, but declined to specify the number of clients eligible.
David Goldstone, manager of investment research at Martinsville, N.J.-based Condor Capital Wealth Management, said while the firm is now disclosing its high percentage of money going into cash, it doesn’t mean that it’s a good idea.
“These cash allocations represent a long-term fundamental risk to the client,” he said. “[Over time] that cash will create a significant drag on the portfolio.”
He explained that while it makes sense for investors to have cash as part of their overall financial picture, it doesn’t make sense to include it in a robo-advisor such as SIP. If someone wants to take their money out if they need it, they will only be able to take it out in a 9:1 ratio because it is a part of the portfolio, according to Goldstone.
Schwab doesn’t charge a management fee for the use of its robo-advisor, which is why it generates its revenue through the cash allocation. However, Goldstone believes Schwab would have made more money with a straightforward management fee comparable to other similar products than this high cash allocation method of generating revenue.
Finally, it is difficult for a client to know how much they would be paying in lieu of the management fees.
“Because the cash has taken the place of management fees, investors don’t know what they are going to pay to have Schwab manage their portfolio without the use of hindsight,” Goldstone said.
Despite the criticism, Schwab has no plans to make any changes to the asset allocation structure of the SIP and keep cash at an average of 10% of the overall portfolio, the firm said.
“We stand firmly behind the design and construction of Schwab Intelligent Portfolios, and our belief that cash is a key component of any sound investment strategy,” Wertheim said.