The Securities and Exchange Commission has charged three Charles Schwab investment adviser subsidiaries for making “false and misleading statements” about the cash component of their robo-adviser service, Schwab Intelligent Portfolios, and failed to disclose that they were allocating client funds in a manner that their own internal analyses showed would be less profitable for their clients under most market conditions.
According to the SEC, Schwab’s robo-adviser portfolios kept between 6 percent and 29.4 percent of clients’ assets in cash. The amount of cash was pre-set so that Schwab’s’ affiliated bank would earn at least a minimum amount of revenue from the spread on the cash by loaning out the money.
Schwab did not disclose that, under market conditions where other assets such as equities outperform cash, the cash allocations in the investors’ portfolios would lower clients’ returns by approximately the same amount as an advisory fee would have.
According to the SEC, from March 2015 through November 2018, Schwab’s mandated disclosures for its robo-adviser stated that the amount of cash in the portfolios was determined through a “disciplined portfolio construction methodology,” and that the robo-adviser would seek “optimal return[s].”
Schwab’s own data showed that under most market conditions, the cash in the portfolios would cause clients to make less money while taking on the same amount of risk, the regulator said. 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 SEC said.
The SEC alleges that Schwab made money from the cash allocations 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.
“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,” said Gurbir S. Grewal, director of the SEC’s Division of Enforcement. “Schwab’s conduct was egregious and [the] 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.”
Without admitting or denying the SEC’s findings, Schwab’s investment adviser subsidiaries, Charles Schwab & Co. Inc., Charles Schwab Investment Advisory Inc., and Schwab Wealth Investment Advisory Inc., agreed to a cease-and-desist order, a censure, and to pay approximately $52 million in disgorgement and prejudgment interest, and a $135 million civil penalty.
Schwab agreed to “cooperate fully” with the SEC and will retain an independent consultant to review its policies and procedures relating to their robo-adviser’s disclosures, advertising, and marketing.