The investment business is fiercely competitive, with the degree of competitiveness typically masked by surface bonhomie in public. Industry leaders mingle at many events, often sharing a stage together without generating fireworks or controversy. The historical context of polite competition makes bold statements by Betterment and recent public jousting in back and forth blog posts by Wealthfront’s Adam Nash and representatives of Charles Schwab particularly noteworthy.
The exchange of blog posts had more in common with “trash talk” from Seattle Seahawks’ player Richard Sherman than with most commentary published by financial services companies. The tense back and forth in public is a rare public display of open conflict, but tellingly reflects sentiments similar to what I’ve heard in private from many industry participants in recent months.
Comparing Spin and Reality
One of my business school professors, “Professor S.,” had a favorite saying: “You can paint stripes on a rabbit, but you can’t make it roar,” which was intended to encourage students to challenge posturing and “spin” often seen in the corporate world. We’re going to invoke the spirit of Professor S. to evaluate claims by leading entrants in the robo race:
Betterment: “We’re profitable on a per customer basis”
- Professor S.: “By what metric? Probably not under generally accepted accounting principles given assets under management that imply revenues of less than $10 million a year, and a cost structure that includes staff (reportedly nearing 100 employees), office space and advertising. Even with the most generous estimates of revenue, annual costs must be a multiple of the firm’s current revenue.
Betterment: “Betterment customers can expect 4.3% higher returns than the typical DIY investor”
- Professor S.: “This is my favorite eyebrow-raising kind of claim, one that’s based on simulations conducted under the most favorable of conditions. I’d like to see the actual results from the inception of their program receive the same prominence on the website as the simulated results.
Schwab Intelligent Portfolios: “Schwab Intelligent Portfolios charges no advisory fees, no commissions and no account service fees”
- Professor S.: I love a free service, but is this truly free? Schwab and its shareholders will expect to make a profit, so it’s reasonable to look into how that profit will be made In this case, although Schwab isn’t charging an explicit fee for the service, they will profit through indirect mechanisms such as spreads on cash balances maintained at Schwab Bank, ETF platform fees, management fees for Schwab ETFs included in the program and payments for order routing. This is the classic example of the co-dependent relationship between consumers and financial institutions, in which consumers embrace a service with low explicit costs while paying potentially high implicit costs.
Adam Nash, CEO of Wealthfront: “Charles Schwab has become Merrill Lynch”
Nash criticizes Schwab for the high cash balances included as a structural requirement within the program, highlighting the potential cash drag costing the client dearly over long periods of time while providing ample profits for Schwab. He claims that Schwab has abandoned its values. Nash also criticizes Schwab’s use of fundamental index products, citing John Bogle’s recent quote “smart beta is stupid” and Burt Malkiel’s critique of the smart beta phenomenon.
Schwab responded with equal vigor, defending cash as a legitimate investment in volatile markets and defending its use of “smart beta” investments.
- Dan comments: Although the back and forth is admittedly entertaining, there’s much not to like in the arguments coming from both sides. Nash compares Schwab unfavorably to Vanguard. Vanguard, a company owned by its clients, has a decidedly different financial structure than Wealthfront and Schwab. When Wealthfront’s venture capital backers start demanding a return on investment, Nash may be more sympathetic to Schwab’s pursuit of profits.
Both sides go through Cirque De Soleil-like contortions to challenge the other regarding Schwab’s use of cash in their portfolios. Nash uses what is likely to be an out of context example to illustrate a potential $573,000 shortfall in retirement that he labels as “almost criminal.” Schwab’s response is more measured but uses exaggerated examples to justify carrying higher cash balances. We typically see cash used for defensive purposes by tactical asset allocators and deep value managers, much less often by strategic asset allocators and long-only equity managers.
As an advisor, we do counsel clients to have cash reserves for emergency needs and for near-term goals. But we rarely commingle the cash reserves with the investment portfolio for a variety of investment and logistical reasons.
Seeing the quote, “smart beta is stupid,” reminds me of the movie A Fish Called Wanda. In one of my favorite scenes, the character played by Kevin Kline dangles the character played by John Cleese out of a window after Cleese fails to heed Kline’s warning, “Don’t call me stupid”! Although I’m entertained at the thought of Rob Arnott, one of the founding fathers of the fundamental indexing movement, dangling a nay-sayer out the window, I think our industry would be better served by a return to civil debate about the merits of different courses of action.
Let’s leave the trash talking to athletes and exaggerated claims and straw men to politicians.