Charles Schwab Introduces Its Robo-Advisor: Is This The Next Big Thing In Investing?

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Charles Schwab (NYSE:SCHW) announced that it would be offering an automated online investment advisory service, Robo Advisor, at the end of October. This announcement comes in the wake of various online-investment advisers and digital investment advisers that have sprung up and led large brokerage firms such as Schwab, Ameritrade and Fidelity to respond. Schwab plans to introduce the Schwab Intelligent Portfolios by Q1 2015 to offer exchange trading funds to customers for comparatively low fees. The brokerage also intends to keep a lower minimum balance (as low as $5,000) as an eligibility criteria for this algorithm-based service.

We have a $25 price estimate for the company’s stock, which is about 10% below the current market price. Schwab’s stock price has risen by about 11% since it announced Robo Advisor in late October.

See our full analysis for Charles Schwab

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What is Robo-Advisory?

Until recently, portfolio management and financial advisory was done through human interaction. Robo Advisors, as the name suggests, offer automated portfolio management services with minimal human input. They use the same algorithm-based templates used in case of traditional advisory. Automated investment service firms offering this service, such as Betterment, Wealthfront and FutureAdvisor, have caught the eyes of venture capital firms and raised funds to try to become the next big thing in investing.

Robo-advisory has advantages over human-based methods similar to those of online banking or online shopping over traditional banks and stores. There is minimal human intervention, practically no time constraints and low minimums of investable assets for eligibility to advisory services. It has several advantages for the companies offering automated advisory, which include negligible employee costs, low administrative and capital expenditures, and a potential faster rate of gaining new customers – often first time investors.

The limitation of Robo Advisor is that its service is currently restricted to portfolio management, which basically just includes allocating stocks and investments to various asset classes based on a questionnaire or survey filled by the customer. Based on the answers to the questionnaire, the algorithm invests in a diversified portfolio of exchange traded funds (ETF) taking into account the risk appetite of the customer. However, as of now there is no provision to address other aspects of financial advisory, including tax planning and retirement planning.

How The New Automated Services Line Up Against The Big Players

Betterment (the operator of betterment.com) has over $800 million in assets under management from about 45,000 client accounts, accumulated over the last few years. [1] Similarly, Wealthfront has amassed over $1 billion in client assets, since it was launched in late 2011. [2] Betterment practices “goal-based investing”, which is different from conventional investing as it focuses on investment yields reaching personal financial goals of customers rather than the average market return on those investments. On the other hand, Wealthfront judges the risk-bearing ability of customers and accordingly prepares a portfolio suited to the customer needs.

FutureAdvisor is another such service provider which has just 20 employees, which it plans to take up to 40 by the end of this year. Assets under management at FutureAdvisor have grown from as low as $3 million last year to over $110 million in May this year. [3] According to FutureAdvisor’s founders, its core client base consists of tech savvy and young investors with relatively low assets under management. Somewhat like the Wealthfront platform, FutureAdvisor also uses an algorithm which assesses the risk that customers are willing to take. The company has witnessed a strong customer response, with its assets under management reaching $200 million by August this year. [4]

Charles Schwab’s Robo Advisor

Schwab announced that it will offer a Robo Advisor service in early 2015. Unlike its traditional business, Schwab Intelligent Portfolios will not charge any advisory fee, trading commission or account-service fee. [5] There will only be a fund-management fee of around 0.15-0.35% of assets under management. [6] The main idea behind introducing this service with virtually no fees is to retain customers that are looking for automated advisory but have been heading to other firms for this service and saving on advisory fees. Moreover, the brokerage firm intends to attract newer clients, particularly those belonging to a younger age group and lower assets under management compared to its core customer base of baby-boomers. Like Betterment and Wealthfront, Schwab Intelligent Portfolios will be restricted to risk profile-based asset allocation and will exclude other facets of financial planning. The automated services will rebalance portfolios in real time based on customer needs and not periodically (quarterly/annually) like the conventional services.

Schwab’s total client assets totaled $2.4 trillion at the end of September this year, with the brokerage generating revenues on an implied yield of under 0.11% on these assets. We forecast Schwab’s asset management and administration revenues to be around 13% higher y-o-y in 2014  at $2.6 billion for the full year, as we expect client assets to grow by about 10% y-o-y by the end of the year and a nearly flat yield.

According to an estimate by research firm My Private Banking, the assets managed by Robo Advisor services worldwide could be over $14 billion by the end of 2014, which is expected to rise to over $250 billion in the next five years, with over $200 billion worth of assets in the U.S. alone. [7] We currently forecast Schwab’s assets under management to grow at a CAGR of over 8% through the end of our forecast period. If Schwab’s assets under management grow at 10% annually by the end of this decade, it could imply a 5% upside to our price valuation for the company. You can modify the interactive chart below to gauge the effect a change in growth rate of client assets managed by Schwab would have on our price estimate for the brokerage.

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Notes:
  1. Can High Tech Money Management Create Happiness?, Forbes, September 2014 []
  2. Rise of the Robo Advisors?, Attain Capital Management Blog, June 2014 []
  3. Wealth Management Startup FutureAdvisor Raises $15.5 Million, Tech Crunch, May 2014 []
  4. Taking Stock of Automated Financial Advisers, Wall Street Journal, August 2014 []
  5. Schwab to Launch Robo-Advisory Service, Wall Street Journal, October 2014 []
  6. Schwab ready to unveil free ‘robo-broker’ service, Reuters, October 2014 []
  7. New Report Says Robo-Advisors Will Manage $255 Billion Within 5 Years, Business Insider, September 2014 []