Recently, Sensible Financial’s clients with Fidelity accounts received a note from our Investment Committee notifying them of changes to their Core Position at Fidelity. We received several questions about our note, which I will attempt to answer in this article.
While this article focuses on Fidelity accounts, it’s also relevant for Schwab accounts and, indeed, accounts at other brokerage firms as well.
What is a core position?
You can think of an account at a brokerage/custodian firm like Fidelity or Schwab as a container. In that container are securities you purchase, such as stocks, bonds, mutual funds, and ETFs. There can also be cash in that container. For instance, you might transfer money into that container and then use that cash to purchase securities. Cash also enters that container (hereinafter referred to as an account) if dividends or interest are paid by the securities you own.
Fidelity, Schwab, and other brokerage/custodian firms have set up accounts so that when there is cash in an account (not yet invested in securities), the money is “swept” into a vehicle that pays interest. This is sometimes called a brokerage sweep account, and the vehicle in which the cash is invested is often called the core position.
Firms structure core positions in a variety of ways:
- Money Market Mutual Fund: A money market fund (MMF) is a type of mutual fund that invests in short-term, high-quality fixed income securities and similar arrangements. While MMFs differ from each other based on their investments (such as Treasury securities only, Treasuries and other government securities, municipal securities, or commercial paper from banks and other companies), all are considered to be among the safest investments available. MMFs are not FDIC-insured, but since MMFs invest in very low-risk securities, many investors do not feel that FDIC insurance is necessary. In fact, many (or all, depending on the MMF) of the securities MMFs invest in are US Treasury securities, which are backed by the full faith and credit of the US government (like FDIC insurance). Annual fees for the large MMFs from firms such as Fidelity or Schwab are around 0.35%. As of this writing, MMFs are paying about 4% (net of fees), though that rate changes frequently.
- Bank Deposit Account: Some accounts are set up such that uninvested cash is swept to a bank account. The bank used is often a “program bank” that may be unrelated to the brokerage/custodian firm, but it could be an affiliated bank. Balances are typically FDIC-insured up to applicable limits. The interest rate on this type of core position tends to be lower than for MMFs (currently, Fidelity’s program of this type, not available for all accounts, pays a little more than 2%), and in many cases is close to zero (Schwab’s FDIC insured Bank Sweep currently pays 0.05%). Fees for bank accounts are not explicit – the bank makes money on the “spread” between what they pay in interest and the rate at which they can lend out that money.
- Non-Bank Interest Bearing Option: Fidelity’s FCASH is an example of this type of arrangement. In it, the brokerage/custodian firm holds the cash and pays interest on it. Fidelity may use the cash in its business operations or invest it in higher-yielding securities, profiting from the spread. The balance is an obligation of the brokerage/custodian firm. It is not FDIC-covered, but it would be SIPC-covered (see article on SIPC here) up to applicable limits. Like a bank deposit, fees are not explicit – the sponsor of the program (such as Fidelity) makes money on the spread. Fidelity’s FCASH currently pays 2.19%.
Competitive changes over time
Brokerage/custodian firms’ revenue sources have changed. Going back many years, trading commissions were a major revenue source. Customers buying stocks or bonds paid significant commissions. Some mutual fund companies also paid brokerage/custodian firms for selling their funds. Over time, competition has driven trading commissions to zero for most trades. Some mutual fund companies still do pay brokerage/custodian firms, but more and more dollars flow to funds that do not make such payments (such as most index funds).
In response, brokerage/custodian firms have looked for other ways to make money. One of those focuses on uninvested cash in brokerage accounts. Fidelity’s core position shift from a MMF (which pays ~0.35% annually) to FCASH (in which Fidelity can earn a spread of 2% or much more at current rates) is a prime example. Similarly, Schwab pays only 0.05% on uninvested cash, meaning it could be earning 4% or more on the spread.
What Sensible Financial is doing
Fidelity and Schwab are leading brokerage/custodian firms, by and large providing very good service for our clients. Though the low rate paid on uninvested cash is not what we would prefer, when taken in the context of the overall service offering, we are comfortable that these two firms provide good service and value for our clients.
However, Sensible Financial also invests our clients’ assets in a way that minimizes the negative effect of these lower interest rates on uninvested cash. For long-term portfolios (most of the assets we manage), the firm’s practice is to keep low cash balances in the portfolio’s accounts. When cash builds up in an account, we invest it in the long-term investment strategy selected by our clients (mainly mutual funds and ETFs). Nonetheless, there are usually small amounts of cash in the accounts, because:
- Dividends arrive frequently. It is not unusual to receive between five and ten dividend payments a month in an account, and it is not practical to trade every time a few dollars arrive. Though it is possible to automatically reinvest dividends in the mutual fund that paid the dividend, we generally prefer to receive dividends in cash and use the cash to rebalance the portfolio, which should reduce capital gains over time
- Clients have planned upcoming withdrawals
- Clients have requested that we withdraw our quarterly advisory fees from their accounts
As a result, there will usually be some cash in client portfolios. However, the amount of cash in long-term portfolios is relatively small, which means that the negative effect of the lower rate being paid on uninvested cash is modest. Though we do not have a precise calculation of the cost, a ballpark estimate for the lost interest for Fidelity customers (as compared to what they received before the recent change) is between $50 and $200 per year, depending on the size of the portfolio and other factors.
In addition to their long-term portfolios, some clients have asked Sensible Financial to manage their cash holdings. In these cash portfolios, the money is invested in high-yielding MMFs, rather than FCASH or other lower-yielding deposits. The recent change by Fidelity would have a minimal effect on those accounts.
Please contact your advisor with any questions you may have.
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