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Charles Schwab offers free investment advice — but there's a big catch

Robo-advisory firms are all the rage in the investment world, as I wrote in a recent article. In that article, I focused on Betterment and Wealthfront, two startups that position themselves as automated online alternatives to conventional human investment advisers.

I argued that for nonwealthy customers, these companies simply didn't provide enough value to be worth the significant fees they charge (though high-income families may benefit from their tax loss harvesting services). A target date mutual fund essentially provides the same service, and the best target date funds cost half as much.

But that critique doesn't apply to another popular robo-adviser service offered by stock brokerage Charles Schwab, because its Intelligent Portfolio service has no fees at all!

Before you get too excited, you need to know that the Schwab plan has a big downside. Instead of charging customers directly, Schwab makes money off Intelligent Portfolio by steering customers into investments that don't always serve customers' interests.

Schwab forces clients to "invest" in cash

Conventional investment advice holds that investment portfolios should contain a mix of stocks and bonds. But Schwab requires clients to hold a significant portion of their portfolios in cash. The company's own example portfolios allocate between 6.9 and 15 percent of customer money to a cash account.

This is a bad investment strategy. Financial planners do encourage people to keep some money in cash for short-term emergencies. But the cash in a Schwab portfolio isn't really available for use in emergencies because Schwab requires customers to keep a minimum percentage of their portfolio in cash at all times. Taking money out of a Schwab Intelligent Portfolio account requires selling off some of your stock and bond funds — which is exactly what a cash emergency fund is supposed to help avoid.

Even worse, Schwab pays a very low interest rate on customers' cash. Online banks like Synchrony and Ally currently pay around 1 percent interest on deposits. Ultra-safe short-term bond funds can also be expected to earn around 1 percent. In contrast, Schwab's current rate (as of Monday) is a paltry 0.08 percent.

This mandatory cash allocation amounts to a hidden fee for using the Schwab account. If your portfolio is 15 percent cash, then the 0.92 percent gap between Schwab's 0.08 percent interest rate and the 1 percent rate you can get elsewhere amounts to a 0.138 percent hidden fee — not much different from the 0.15 percent fee Betterment charges for accounts over $100,000.

And if you're saving for retirement, it's probably better to put all your money in assets with expected returns of more than 1 percent, so the practical cost of this "cash drag" is likely to be even higher.

The conflict of interest at the heart of Schwab's business model

Of course, Schwab argues that the conventional wisdom is wrong, and holding some of your portfolio in cash makes sense, providing "ballast" in times of economic turmoil. You can read its argument for a cash allocation here. I didn't find it very convincing, but you might.

But the larger problem here is that there's an inherent tension between Schwab's claim to be acting as an "adviser" and the fact that its profits depend on steering customers to investments that make money for Schwab. You can debate whether holding 6 to 15 percent of your portfolio in cash in your portfolio is a good deal for the customer. But there's no doubt that it's a good deal for Schwab, which can invest the money in higher-yielding assets and pocket the difference.

The same critique applies to Schwab's non-cash recommendations. Like other robo-advisers, Schwab puts clients' money in exchange-traded mutual funds. But there's a big difference: Betterment and Wealthfront invest purely in third-party funds, and both companies say they never take a commission from the funds they recommend.

Schwab, by contrast, sometimes puts client money into funds operated by Schwab itself. Schwab also earns money for some of the non-Schwab funds it sells — though a Schwab spokesperson tells me that these payments are not a sales commission, but rather are for "record-keeping, shareholder services, and other administrative services" Schwab provides to third-party fund providers.

"We work hard to be open and transparent to the client," said Schwab executive Tobin McDaniel when I asked him about this on Monday.

He argues that Schwab has a rigorous process for choosing funds. He said Schwab looks for the lowest-cost option that is "large enough and liquid enough for us to trade," and he points out that low-cost Vanguard funds feature prominently in Schwab portfolios.

Still, when Schwab is choosing between its own funds and others supplied by third parties, it's hard to be confident that the best interests of customers is the company's only criteria.

Betterment and Wealthfront don't have this problem. Their business model is clear and transparent — they make their money by directly charging clients, they recommend only third-party funds, and they don't earn payments from third-party fund providers. That means they make exactly the same amount regardless of which investments they recommend.

It's still the case, as I wrote previously, that a target date fund is the best option for most retirement investors. But if you are interested in robo-advisers, it's worth picking a service with transparent pricing and no conflicts of interest. Schwab's "free" service could wind up costing you more in the long run.

Correction: I misplaced a decimal point and incorrectly quoted Schwab's interest rate as 0.8 percent instead of 0.08 percent.