Welcome to the 6th episode of the AMM Dividend Growth Podcast. I’m Glenn Busch a portfolio manager at American Money Management and the lead portfolio manager for the AMM Dividend Growth Strategy. Back in episode 3, I dived into our position in Charles Schwab. This episode is an update episode because a couple of things have happened in Schwab’s world after we published that episode. One is a new risk that and the other event made big headlines and caused some big stock moves in the discount broker world.
For show notes, links mentioned in this episode, and a for a transcript head to www.amminvest.com/episode6. That’s A for alpha M for Mike M for Mike I N V E S T dot com slash episode 6.
Before we get into the episode let’s do the disclaimer.
If you remember from episode 3 or from the 40th issue of the AMM Dividend Letter – link in the description – Schwab’s main focus is asset growth. Because Schwab generates the bulk of its revenue, around 57%, from the interest it earns on customer cash that it sweeps onto its balance sheet.
Schwab pays very little on the cash balances in customer’s accounts. For fiscal 2018 Schwab’s cost of funds, what it pays to use customer cash, was 0.27%. In 2018 JP Morgan’s cost of funds was 0.58%. Cash in Schwab accounts is viewed as strategic cash. Instead of shopping around for the highest interest, Schwab customers are willing to earn less on their cash for the immediate availability of the cash to invest in the next opportunity.
But Schwab wants to open new accounts and grow its asset base. Competitors can use Schwab’s low cash interest against them.
Wealthfront launched a high yield cash account and even though Wealthfront is not a bank its cash accounts have FDIC insurance up to 1 million dollars. The cash account started with an annual yield of 2.32%.
Wealthfront’s latest ADV filed back in August stated total assets of $11. Billion. A Few months later Wealthfront has over 20 billion dollars in assets. In an article by Investment News, 8 billion of the new assets came from its high yield cash account.
It’s a fair bet to say some of these new cash accounts will eventually open up Wealthfront investment advisor accounts.
Wealthfront is not a bank so it is paying this higher yield through its operations. They’re a private company so we don’t know how sustainable these rates are in regards to their operational costs. But I’m sure the company views the high yield cash account as a customer acquisition cost and the cost fits in with their estimate for the lifetime value of a new client.
These higher-yielding cash accounts are a threat to Schwab’s new account and asset growth. That 8 billion is 8 billion that Schwab doesn’t have.
It is also a threat to its profitability. If Schwab needs to offer higher interest to regain new account growth, it will sacrifice some net interest margin to do so. Couple that with the Fed cutting rates and the yields on 2-year treasuries coming down and Schwab’s net interest margin falls further.
Fidelity responded with their own high yield cash account for new retail accounts. So far Schwab hasn’t responded with higher cash account interest but we’ll see if they do.
The second event was Schwab’s announcement that commissions on all U.S. listed Stocks and ETFs will drop to zero. Option commissions are zero too but Schwab will still charge 65 cents per contract.
Schwab was down 10+% on the news, and the other discount brokers like TD Ameritrade, E-Trade, and Interactive Brokers were down just as much if not more.
If Schwab’s primary revenue source was commissions this is huge news. But as I pointed out in the 40th issue of the dividend letter, the bulk of Schwab’s revenue, around 57%, comes from the interest it earns on customer cash. Trading revenue is about 8%. Compare that to TD Ameritrade with around 30% percent of its revenue coming from trading revenue during the last quarter.
8 percent is better than nothing. Schwab’s trading revenue will not go completely to zero. It will still make money selling its order flow to UBS and collecting fees from other asset managers that want their mutual funds, ETFs, alternative investments on Schwab’s platform.
People notice commissions. Right or wrong it is the easiest way to compare brokers. Matt Levine puts it perfectly in his Money Stuff newsletter.
“…people are nonetheless going to choose brokers based on commission rates, so yours might as well be as low as possible. And then you make your money on the sweep accounts. You give people a good deal on the salient headline thing, and you make your profits where they aren’t looking; this is obvious stuff.”
Schwab is giving current customers and potential new customers a big discount on the primary metric they use to compare brokers.
Again, Schwab is doing this to protect and foster more asset growth. They will make far more money on cash sweeps and any investments made into its ETFs and mutual funds. Schwab also offers some of the cheapest index funds to attract more client assets into its investment products.
It also helps with independent RIA growth. The RIAs and financial advisors want to tell their clients that they are using the lowest cost but also the best tools for their account. Schwab offers one of the best RIA custodial platforms and now also offers the lowest commission rates. While RIA managed accounts tend to have lower cash balances then retail accounts. RIAs tend to leave at least 1-2% of client accounts in straight cash that Schwab can sweep onto their balance sheet to invest. RIAs will also use Schwab’s index ETFs because they are some of the lowest-cost ETFs out there.
Schwab will take an immediate hit to its earnings with the 0 percent commissions but it is playing the long game. Schwab is better positioned right now than its competitors for two big secular trends, ETFs and the growth of the independent RIA.
Schwab is also better positioned than its primary competitors to recoup the lost revenue through other means. This move may lead to further consolidation which will place Schwab in the driver seat. The 0 percent commissions may also lead to further industry changes like charging a basis point fee on all RIA assets rather than depending on net interest. Maybe a 20 basis points per account. Schwab earns about 18-20 bps on RIA custodial assets right now with expenses running around 9-10 basis points. But that whole topic is a topic for another day.
As we stand right now, we don’t see this new 0% commission rate being a long-term net negative for Schwab. We think it keeps them in the leadership position for RIA growth and for maintaining its current asset growth and its current account growth.
But like all our position we continue to monitor it. And if things change we can always change our opinion and move out of the position.
But right now Schwab is still a core holding in the AMM Dividend Growth Strategy.
If you enjoyed this episode please leave a rating and review on your favorite podcast player and please subscribe so you don’t miss future episodes. There is also a link in the description to sign up for the AMM Dividend letter and I’ve been compiling all our past dividend letters into small self-published books and there are links in the description to buy the first 3 volumes.
Until next time.