Scalper1 News
Summary This group of 6 ETFs offers 3 options from Schwab and 3 options from Vanguard. The ETFs that were selected each have a fairly similar match from the other ETF provider. I’m using modern portfolio theory to assess the impact on portfolio risk. The data favors Schwab at first, but after adding a bond ETF investors can get very similar levels of exposure through either option. My favorite two ETF combinations for international equity are combining either SCHC and SCHF or VSS and VEA. I would base the decision on free trading for frequent rebalancing. As I’ve been working through a comparison of low fee ETFs, it seemed prudent to do a comparison on a batch of ETFs between two of the lost cost leaders in the industry. Vanguard has a very long and proud track record of offering investors excellent diversification with extremely low fees. Schwab decided to compete in that arena and introduced a very respectable group of ETFs that also have very low expense ratios. In this piece I’m running a comparison on the international ETF options for Schwab and Vanguard. In an attempt to keep the comparison reasonable, I’ve selected the Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ), the Schwab Emerging Markets ETF (NYSEARCA: SCHE ), and the Schwab International Equity ETF (NYSEARCA: SCHF ) for Schwab and the Vanguard FTSE All-World ex-US Small-Cap ETF (NYSEARCA: VSS ), the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ), and the Vanguard FTSE Developed Markets ETF (NYSEARCA: VEA ) for Vanguard. SCHC and VSS invest in international small-cap companies. SCHE and VWO invest in emerging markets. SCHF and VEA invest in developed markets. The Core of the Portfolio To form the core I am using heavy allocations to SCHB and VTI. These two funds represent Schwab’s Broad Market ETF and Vanguards Total Market Index ETF. Each broad market ETF is being allocated 35% of the portfolio value and each international ETF is being allocated 5% of the portfolio value. A quick check for volatility can then be performed in the context of the portfolio by looking at which investments are adding the most risk to the portfolio. The similarity of returns can also be assessed by checking if each pair of international ETFs that I believe to be similar are actually showing high similarity in their returns so far this decade. The chart below shows the results for the sample portfolio. (click to enlarge) The highest annualized volatility measures go to VWO, VEA, and SCHE, but the more important factor is the risk contribution since volatility that is not correlated to the domestic stock market is substantially less relevant in determining how volatile the portfolio will be as a whole. When we look at the “Risk Contribution” column or the “Beta” column we can get a quick feel for which international ETFs are adding more risk than others. As it happens, VWO, VEA, and SCHE are again the three highest in each category. When I run these comparisons with portfolios that include more asset classes there is often a disconnect between the annualized volatility of the individual funds and their contribution to the overall risk profile. Quick Interpretation The notable differences are that VEA seems to be offering more volatility than SCHF and VWO seems to be more volatile than SCHE. When it comes to SCHC or VSS, the volatility has been almost precisely the same. The differences in the amount of volatility are not huge and may be within a reasonable margin of error. If investors were to compare historical returns to simply see how the funds have done, it is clear that SCHC outperformed VSS, but in the other two cases the vanguard funds with more volatility also had better returns. When We Add Bonds I ran the simulation again but this time I added in a 20% allocation to a very high duration bond fund, the PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ). Using ZROZ gives the portfolio a large dose of negative beta and provides a portfolio that when considered in the aggregate is substantially less risky than the portfolio with no bond exposure. The goal is to see how the risk contribution changes when we start pushing the portfolio to be closer to the efficient frontier by reducing volatility. To keep the comparison focused on the international ETFs, I simply dropped SCHB and VTI by 10% each. (click to enlarge) Now that the portfolio contains ZROZ, we see that SCHE is contributing more risk than VWO, though the other relationships remain unchanged. The portfolio as a whole, despite using the same time frame, has reduced the annualized volatility from 16.8% to 11.7%, The difference here is fairly dramatic as the portfolio went from being more volatile than the S&P 500 to being substantially less volatile. In this portfolio with bonds it appears that we have one fund for Vanguard winning in the risk comparison, VWO, one fund for Schwab winning, SCHF, and a tie between SCHC and VSS remains. What Does It All Mean? For investors that have free trading on either the Schwab or Vanguard funds, it looks like the best strategy is to use the group of ETFs that the investor can trade without commissions. Neither group is outperforming the other by enough to warrant paying the commissions. Rebalancing Because the annualized volatility on these international investments is so high, an investor should take care to consider a strategy for rebalancing their portfolio regularly to increase their allocations to whichever investments are out of favor with the market. Within Each Group When I’m looking at a comparison between VSS, VWO, and VEA, I’m seeing VSS as a very desirable option. VSS has an expense ratio of .19% which is slightly higher than I want to see on international investments, but it also has 3369 individual holdings within the portfolio and only 3.2% of the total assets are invested in the top 10 holdings. The internal diversification is exceptional. In my opinion, VSS is a world class option for including in diversified portfolios. Within the Schwab fund I’ve shown a slightly preference for SCHF in picking the ETFs for my own holdings, but I’m also attracted to using some SCHC and I’ve got a buy-limit order placed on SCHC to pick it if it falls far enough. With the market being so volatile right now, my cash is simply covering limit orders on a few of the ETFs that I have identified as desirable. That batch currently includes the Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ) and SCHF. I already own some of the first two ETFs, but don’t have any SCHC yet. I have not decided if I like SCHC as much as SCHF, but I do appreciate a little bit of extra diversification that can come from using both. If I had free trading on VSS, I would be tempted to use it also. Ideal Allocations The highest total international equity allocation that I would be comfortable holding is around 20% of the portfolio value. I think my ideal allocation level may be closer to 10% to 15% though. One factor that will influence me is the simplicity of rebalancing. When rebalancing is easier, I’m willing to use slightly higher international allocations because the higher volatility can be dealt with more effectively. Current Influences I’ve been a pretty huge bear on China and was calling for some major corrections in that market. On the other hand, while the domestic market felt a little frothy, I wasn’t expecting the drawdown we have seen in August. Because of my views on the performance of China and the correlation of markets during times of stress, I’m inclined to focus my international allocations on developed markets rather than emerging markets. That causes me to see SCHC, SCHF, VSS, and VEA as the more desirable options. On the other hand, if China has a very solid crash and emerging market funds fall hard, then I’d be comfortable working a small emerging markets position into the portfolio. I’m not convinced that those prices will fall far enough for me to decide that I want to add more emerging markets rather than developed markets. If investors want to use emerging markets rather than developed markets for the international portion of the portfolio, I would suggest using a lower limit than 20%. The emerging markets have more inherent risk and a heavy allocation to the sector simply produces too much risk. To find the optimal exposure level, I think investors can use any two of the international ETFs except for combining SCHE and VWO. Going all emerging markets with no developed markets simply does not make sense for risk adjusted returns on a portfolio. Disclosure: I am/we are long SCHF, SCHB, VTI. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis. Scalper1 News
Scalper1 News