Portfolio Management September 16, 2016

    Putting your hard-earned money to work in an intelligent way is important to long-term investment success. Broad diversification can help position your portfolio for potential growth over time, while also helping to smooth the inevitable bumps along the way. That's why Schwab Intelligent Portfolios® invests in up to 20 asset classes in your portfolio—across stocks, fixed income and commodities, as well as an FDIC-insured cash allocation.

    Each asset class serves a purpose, such as stocks for growth, bonds and dividend-oriented stocks for income, real estate investment trusts (REITs) and Treasury Inflation-Protected Securities (TIPS) for long-term inflation protection. Cash investments serve several important purposes in a portfolio, providing stability, downside protection and diversification. Within Schwab Intelligent Portfolios, cash is held in an FDIC-insured bank deposit account, where it also earns interest. Benefits of a cash allocation include:

    • Cash is the most consistently reliable of the defensive asset classes. Other conservative asset classes can and do decline in certain market environments.
    • Cash has the most consistently low correlation with other asset classes.
    • Cash supports a portfolio during down or choppy markets, which occur more frequently than people appreciate.
    • Unlike any other conservative asset class, cash in a bank account is also FDIC insured up to regulated limits.

    But what about the impact of cash on portfolio return? While acknowledging that a cash allocation helps reduce risk, some have questioned its potential effect on long-term returns—the so-called "cash drag." Most of these critiques, however, make several flawed assumptions about asset allocation. Investors concerned about a potential drag on returns should consider the real drag that unnecessary fees represent.

    The cold hard truth about cash and cash substitutes

    In assessing how a cash allocation might affect expected returns, some people simply assume that they could redistribute the cash and potentially earn a higher return. This is a flawed analysis. Simply redistributing the cash allocation proportionally across the other assets in the portfolio would alter the investor's risk profile, likely leaving them with a riskier portfolio while not necessarily increasing the portfolio's return. This flawed assumption ignores the actual composition of the portfolio, making the comparison meaningless. A portfolio that was fully invested in equities might have a high long-term expected return. But that return would come with more volatility and potential loss than most investors could withstand. Ignoring risk and only considering potential return is unwise.

    A valid analysis would consider whether other investments, such as short-term Treasuries, were being used as cash substitutes in the portfolio to provide the ballast that cash can deliver. This is typically the case. So a more accurate analysis would consider how using one of these cash substitutes in place of cash would affect the portfolio's expected returns.

    Don't ignore how advisory fees reduce returns

    Fees add up over time and create a drag on investing performance. Investors should be conscious about trying to avoid paying unnecessary fees that eat into investment returns. Fees are an important component of any investment service when paying for important benefits (customization, wealth management insight, assessment, planning, etc.) but if given an option between an additional layer of fees for automated investment services without additional benefit, versus not bearing the burden of those fees, avoiding those fees is a better way to go. That's why Schwab Intelligent Portfolios charges no advisory fees, no trading commissions and no account service fees.

    Because expenses and fees matter, these must be considered in the analysis as well. Cash—as it is used in Schwab Intelligent Portfolios—does not include an operating expense or management fee. In fact, it earns interest for clients. By contrast, an exchange-traded fund (ETF) that invests in a cash substitute such as short-term Treasuries will have an operating expense ratio (OER). And when an advisory fee is included on top of that, our analysis finds that the portfolio with the cash allocation, as opposed to a cash substitute, would be superior in nearly all scenarios.

    The following analysis considers several hypothetical scenarios examining how cash compares with an alternate short-term investment, factoring in the effect of ETF operating expenses as well as an advisory fee. You be the judge.

    What is the impact on expected returns if ultrashort Treasuries are used instead?

    Our first analysis assumes two identical portfolios, one with a cash allocation and a second that replaces the cash with an ultra-short Treasury ETF. Ultra-short Treasuries typically have durations or effective maturities of less than one year.

    The OER for a typical ultra-short Treasury ETF is about 0.15%, while cash has no OER. However, ultra-short Treasuries would be expected to earn a higher return than cash. Based on the estimates of Charles Schwab Investment Advisory, Inc. (CSIA), ultra-short Treasuries would be expected to return 0.50% more than cash per year. The expected return difference does exceed the ETF management costs. However, if we layer on a typical advisory fee of 0.25%, then the alternate portfolio can have a lower expected return, depending on the amount of cash in the portfolio.

    Table 1 shows what would happen to the expected return of a conservative, moderately conservative and aggressive portfolio within Schwab Intelligent Portfolios—based on the level of their cash allocations if we used an ultra-short Treasury ETF instead of cash and applied an advisory fee.

    Assumptions (per year):

    • Ultrashort Treasury ETF OER: 0.15%
    • Advisory fee for the entire portfolio: 0.25%
    • Expected return spread, or how much more ultrashort Treasuries are expected to return over cash: 0.50%
    Table 1: Impact on Schwab Intelligent Portfolios return applying an advisory fee and using ultrashort bond ETF as a cash substitute (using forward-looking return expectations)
    Portfolio Equity Allocation Cash Allocation Return Difference vs. Cash Allocation
    Conservative 37% 13.8% -0.20%
    Moderate 65% 8.5% -0.22%
    Aggressive 94% 6.0% -0.23%

    The "Return Difference vs. Cash Allocation" represents how much the portfolio with the cash substitute would be expected to outperform or underperform the portfolio with the cash allocation. This return difference is calculated as = ((Return Spread-OER) * Cash Allocation) – Advisory Fee. For example, for the Conservative portfolio:

    Return Difference vs. Cash Allocation = ((0.50% - 0.15%)*.138) – 0.25% = -0.20%.

    As shown above, the ultrashort Treasury ETF is expected to return 0.50% more per year than cash, but it also has an OER of 0.15% per year. This annual cost reduces the expected additional return per year of the ETF to 0.35%. However, this additional expected return only applies to the portion of the portfolio invested in cash, so we need to multiply by the portfolio's cash allocation of 13.8%. This means that the expected additional return for the total portfolio from using the ultrashort Treasury ETF is just .048% per year. That expected additional return is less than the advisory fee of 0.25% per year, which means that the portfolio that uses the ultrashort Treasury ETF and charges an advisory fee has a lower expected return than the portfolio that uses cash and does not charge an advisory fee.

    This shows that the alternate conservative portfolio using ultra-short Treasuries actually would have a lower expected return than the portfolio with cash by about 0.20%. The return spread of the ultra-short ETF is higher than the OER of the ETF—which benefits the alternate portfolios, but that impact is more than offset by the advisory fee that's applied to the entire portfolio. The same analysis is then applied to the moderate and aggressive portfolios.

    What is the impact on expected returns if short-term Treasuries are used instead?

    Ultrashort Treasuries are not the only potential cash substitute. Some might instead use a short-term Treasury ETF. These typically focus on Treasuries with a maturity between one and three years. Table 2 shows what would happen to the expected return of Schwab Intelligent Portfolios if we used a short-term Treasury ETF instead of cash and applied an advisory fee.

    Assumptions (per year):

    • Short-Term Treasury ETF OER: 0.15%
    • Advisory fee for the entire portfolio: 0.25%
    • Expected return spread, or how much more short-term Treasuries are expected to return over cash: 1.10%
    Table 2: Impact on Schwab Intelligent Portfolios return applying a management fee and using short-term bond ETF as a cash substitute using forward-looking return expectations
    Portfolio Equity Allocation Cash Allocation Return Difference vs. Cash Allocation
    Conservative 37% 13.8% -0.12%
    Moderate 65% 8.5% -0.17%
    Aggressive 94% 6.0% -0.19%

    Again, the alternate portfolios have lower expected returns in all three cases, but note that the return gap is smaller than it was when an ultra-short ETF was used as the cash substitute. That's because short-term Treasuries have a higher expected return than ultra-short Treasuries. However, it's important to recognize that the higher expected return comes with higher risk. In fact, between 1990 and 2015, ultra-short Treasuries experienced 38 months with negative returns—a little more than 12% of months during the period. And short-term Treasuries experienced 66 negative months, or 21% of months, during the period. By contrast, cash experienced no months of negative returns during the period. (For more information, please see the whitepaper "The Role of Cash in Your Portfolio".)

    What is the impact on expected returns if we use current yields in the analysis?

    Charles Schwab Investment Advisory's estimates of expected returns for each asset class were used to build Schwab Intelligent Portfolios. However, we recognize that not every firm will have the same opinion about the expected future performance of the different asset classes. To account for this, rather than using CSIA's expectations, we can perform the same calculations as above but use the current yields of cash, ultrashort Treasuries and short-term Treasuries.

    Table 3 shows the results.

    In both cases we use the following assumptions (per year).

    • OER of the ETF used as the cash substitute: 0.15%
    • Cash yield as of December 31, 2015: 0.08%.
    • Advisory fee for the entire portfolio: 0.25%
    Table 3
    Return Difference vs. Cash Allocation
    Portfolio Equity Allocation Cash Allocation Ultra-short Treasury 8/31/2016 Yield = 0.44% Short-Term Treasury 8/31/2016 = 0.80%
    Conservative 37% 13.8% -0.22% -0.17%
    Moderate 65% 8.5% -0.23% -0.20%
    Aggressive 94% 6.0% -0.24% -0.22%

    Using the assumptions described above and yields-to-maturity as of August 31, 2016, the results for ultra-short bonds are similar to the results from Table 1. This means that ultra-short Treasuries as a cash substitute are not attractive in any portfolio under either scenario. Stated differently, the negative numbers in column 4 of Table 3 and Table 1 mean that the higher yield of ultra-short Treasuries over cash is more than offset by the advisory fee and the OER of the ultra-short ETF used.

    Turning our attention to column 5 of Table 3 and the short-term Treasury case shown in Table 2, we see that using short-term Treasuries as a cash substitute is actually less attractive if we use current interest rates than it was when we used CSIA's forward projections.

    Cash allocations serve an important purpose in a portfolio

    Schwab Intelligent Portfolios includes cash as part of a broadly diversified portfolio that also includes up to 20 asset classes across equities, fixed income and commodities. We believe that cash serves an important purpose in asset allocation, providing a source of stability, downside protection and diversification. Along with the important property of risk reduction that cash provides, our analysis shows that a cash allocation would provide a superior expected return relative to cash alternatives when the true costs of those alternatives are considered and does not result in a drag on portfolio returns. The real "drag" is paying too much in advisory fees.

    David Koenig CFA®, FRM®, Vice President and Chief Investment Strategist for Schwab Intelligent Portfolios®

    The cash allocation in Schwab Intelligent Portfolios is accomplished through enrollment in the Schwab Intelligent Portfolios Sweep Program (Sweep Program), a program sponsored by Charles Schwab & Co., Inc. (“Schwab”). By enrolling in Schwab Intelligent Portfolios, clients consent to having the free credit balances in their Schwab Intelligent Portfolios brokerage accounts swept to deposit accounts at Charles Schwab Bank through the Sweep Program. Schwab Bank is an FDIC-insured depository institution affiliated with both Schwab and Charles Schwab Investment Advisory, Inc. Cash balances held in the Sweep Program at Schwab Bank are eligible for FDIC insurance up to allowable limits.

    Schwab Intelligent Portfolios charges no advisory fee. Schwab affiliates do earn revenue from the underlying assets in Schwab Intelligent Portfolios accounts. This revenue comes from providing advisory and other services for Schwab ETFs™ and providing services relating to certain third party ETFs that can be selected for the portfolio, and from the cash feature on the accounts. Revenue may also be received from the market centers where ETF trade orders are routed for execution.

    The examples shown are hypothetical and provided for illustrative purposes only. They are not intended to represent actual investment performance.

    (0318-8J2V)


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