Schwab Intelligent Portfolios: Incomplete Rebalancing Algorithm

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Schwab Intelligent Portfolios

Schwab recently released Schwab Intelligent Portfolios (SIPs), “an automated investment advisory service.” It claims to “make professional advisory services available to anyone with $5,000 to invest.”

In reality, SIPs only offers one service: to “build, monitor and rebalance your portfolio,” and it doesn’t do that well.

We previously explained how SIPs builds a portfolio based on your risk tolerance, a useless measure. Now we review the two pros and nine cons of how Schwab monitors and rebalances portfolios.

Pro: Drift-Based Rebalancing

SIPs provides “daily check-ins ” where “excess ETF shares are sold, and the proceeds are used to buy positions . . . below their allocated percentage size.” This service of automated rebalancing requires a minimum investment of $5,000.

Many different algorithms can be used to rebalance portfolios. SIPs utilizes drift-based rebalancing. An asset class is given an amount that it is allowed to drift from the target before rebalancing measures trim it down through selling.

Drift-based rebalancing is better than always blindly hacking asset classes back to their targets.

The amount that an asset class is allowed to drift does matter, but Schwab does not report that number. Ideally, they should make the threshold a percentage of the overall portfolio. For example, $2,000 is fractionally out of balance for a $2M portfolio but largely out of balance for a $10,000 portfolio.

Furthermore, they should have multiple thresholds programmed based on the asset class and action. Trimming a category needs a higher threshold than adding to a category. The threshold for bonds ought to be lower than the one for stocks.

Lastly, oftentimes they should not rebalance back to the penny. Sometimes trimming shy of the target, for example, is helpful because upcoming market changes bring the portfolio back in balance.

Pro: Harvests Capital Loss

SIPs also offers tax-loss harvesting as a portion of their rebalancing algorithm. The service requires a $50,000 minimum investment but could save the client when it comes to their tax bill.

Con: Blindly Harvests Capital Gain

The first two steps of the SIPs rebalancing algorithm are to sell funds with a loss and to sell funds that have sufficiently drifted above the target allocation.

The problem with this is that SIPs doesn’t factor capital gains, only capital loss. Thus the strategy will likely generate a lot of capital gains tax by selling funds above the target allocation without heeding the tax consequences.

Con: The Algorithm is Sell-Focused

Every algorithm has to decide something to do first. Sales make sense, since their proceeds can be used for later purchases. SIPs sells losses and then sells what is over the targets.

However, a better algorithm for taxable accounts might be to sell losses that benefit the asset allocation, use the proceeds to purchase more of funds below the target allocation and stop there, leaving significant capital gains alone.

This lessens the amount of capital gains generated while effectively rebalancing the portfolio.

Con: Ignores Charitable Giving

When clients are charitably inclined, highly appreciated holdings that put the portfolio over its target allocation can be used to gift to their favorite charity. Then the cash they would have gifted can be placed in their portfolio instead to aid in rebalancing. Thus the portfolio is rebalanced while the client acquires a tax benefit, rather than cost.

However, because SIPs checks the portfolio daily and blindly sells appreciated holdings, clients lose these tax benefits.

Con: Large Cash Percentage

The portfolio’s allocation to cash often depends on client goals and objectives regarding upcoming withdrawals. Unfortunately, SIPs does not keep track of any regular flows in or out of the portfolio.

Paying interest and dividends to cash and using that cash to rebalance by making purchases makes sense. But selling appreciated stocks and realizing capital gains just to maintain a large cash position without some planning-related reason has little value. Some SIPs allocations have large cash positions for no other reason than reticence concerning investing .

Con: Lacks Knowledge of the Client

To be as good as a human advisor, specific tax consequences (or lack of them) as well as upcoming withdrawals or contributions on the account must be considered while rebalancing.

Without this information, a robotic rebalance could create the errors that a human is likely to avoid. For example, SIPs might invest all available cash just days before the client needs a withdrawal, sell funds to generate cash just days before a contribution, generate capital gains taxes unnecessarily by selling a highly appreciated security or fail to purposefully realize capital gains while the client is in a lower tax bracket.

Both time and money are wasted through these automated inefficiencies.

Con: Forces Your Security Selections

Schwab limits the investments to a finite list of ETFs. They count the effort of curating those funds as a benefit to SIPs clients. But in the process they may eliminate the option of better performing securities with lower expense ratios.

Con: Requires a Liquidated Portfolio

SIPs simplifies some of the automation problems by requiring every client to begin all in cash. This common practice among robotic advisors (and some human ones) simplifies rebalancing. An all-cash new client allows the advisor to hand-pick every investment and in-depth knowledge of all the holdings can be achieved much more simply.

However, asking new clients to liquidate their assets is normally very costly for them because of capital gains taxes and trading fees.

This is why many advisors take new clients as they are without liquidating. As tax-advantageous scenarios arise, we sell off unsatisfactory holdings and gradually steer clients toward our recommended investment selections. We integrate highly appreciated stock that would be too costly to sell and any sentimental investments into the asset allocation.

Those complexities complicate the rebalancing formula. SIPs avoids those automation complications by denying those services to the detriment of their clients.

Con: Revisits Useless Data

The final management service Schwab describes as “periodic evaluations to ensure that your asset allocation represents the right mix of risk and return.”

Reevaluating clients’ asset allocation is a great idea but only if the evaluation is based on progress toward their goals. Reviewing the asset allocation with “risk and return” preference in mind, however, is just as useless as the initial risk tolerance questionnaire. It may actually move clients in the wrong direction when it comes to meeting their goals.

Con: No Real Advisor

Robo-advisors, like SIPs, will never fully understand your goals and your needs. Automated support is better than not being invested. But better still is having a fiduciary who knows your particular case intimately and is legally bound to act in your best interest.

Investment management is critical, and it depends on a client’s personal situation. A robotic approach to rebalancing is good, but a personal approach is much better.

Screen captures from Schwab Intelligent Portfolios.

Follow David John Marotta:

President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.

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Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. She is the author of over 800 financial articles and is known for her expertise on tax planning.