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Summary SCHD offers investors less volatility than broad market ETFs. The holdings themselves are not extremely diversified, but the performance over the last several years shows the ETF maintains a lower correlation with other assets. I see some benefits to including a small position in SCHD while keeping the core in broad market ETFs. Lately I’ve been considering making some modifications to my portfolio strategy. As the market fell in August I had to recognize that I’m light on bonds. Of course, when the equity markets are falling and the bond markets are rallying it is precisely the worst possible time to start buying up the bond ETFs. Rather than focus on adding the bond ETFs right away, I’m working on revising my strategy. I’m looking for a portfolio that is easier to rebalance and shows less volatility with the market. One of the ETFs that I have been admiring for a long time is the Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ). After the market started selling off hard in August, I decided it was time to look for a position in SCHD and put in a limit order to start buying SCHD. As I transfer more funds into the accounts, I expect to have SCHD regularly listed as a top contender for getting more buy orders and a higher allocation. Largest Holdings The internal diversification within the portfolio is much weaker than using whole market ETFs or broad market ETFs. However, the portfolio also has a lower level of volatility despite that challenge. The top holdings are shown below: (click to enlarge) The portfolio pays off a decent dividend yield, currently that yield is nearing 3% which seems fairly attractive as long term bonds are rallying. If we head into another recession, I want to be buying high quality stocks at lower prices (and higher yields) when the recession starts, when we are in the middle, and when it ends. One of the reasons I waited this long to get in on SCHD is that I was hoping for better prices and those seem to be coming through. My limit-buy orders are not very far out of the money and may have hit by the time the article is published. Expense Ratio The expense ratio on SCHD is .07%. That is low enough that I am happy to work with SCHD in my portfolio. Building the Portfolio I put together a hypothetical portfolio using only ETF’s that fall under the “free to trade” category for Charles Schwab accounts. My bias towards these ETFs is simple, I have my solo 401k there and recently moved my IRA accounts there as well. When I’m building a list of ETFs to consider I want to focus on things I can trade freely so that I can keep making small transactions to buy more when the market falls. Within the hypothetical portfolio there are no expense ratios higher than .18%. Just like trading costs, I want to be frugal with expense ratios. The portfolio is fairly aggressive. Only 30% of the total is allocated to bonds and I would consider that the weakest area in the portfolio. I’d like to see more bond options (with very low expense ratios) show up on the “One Source” list for free trading. (click to enlarge) A quick rundown of the portfolio The Schwab U.S. Broad Market ETF (NYSEARCA: SCHB ) is a broad market index. The Schwab U.S. Large-Cap ETF (NYSEARCA: SCHX ) is focused on blended large cap exposure. The Schwab International Equity ETF (NYSEARCA: SCHF ) is developed international equity. The Schwab Emerging Markets ETF (NYSEARCA: SCHE ) is emerging market equity. The Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ) is developed small capitalization equity. The Schwab U.S. REIT ETF (NYSEARCA: SCHH ) is domestic equity REITs. The Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ) is a remarkably complete bond fund. The SPDR Barclays Long Term Treasury ETF (NYSEARCA: TLO ) is a long term treasury ETF. The PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (NYSEARCA: ZROZ ) is an extremely long term treasury ETF. Notice that the 3 international equity ETFs have only been weighted at 5% while the broad market index has been weighted at 25%. I find heavy exposure to international equity to bring more risk than expected returns so I try to keep my international exposure low. I prefer no more than 20% in international equity. Plenty of domestic companies already have enormous international operations so the benefit of international diversification is not as strong as it would be if the markets were isolated from each other. Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. When TLO and ZROZ post negative risk contribution it is because the negative correlation to most of the equity holdings results in the long term treasury ETFs reducing the total portfolio risk. In my opinion, this is the best argument for including them in the portfolio. Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio and with the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) One quick thing to take away from this is that mixing SCHB and SCHX does not add any material amount of diversification within the portfolio. Investors could simply pick whether they prefer a broad market ETF or a focus on larger capitalization companies. On the other hand, SCHD does some add some diversification to either SCHB or SCHX. The core of my portfolio is currently whole market ETFs and broad market ETFs (including SCHB). I don’t expect that core to change, but I’m seeing SCHD post a correlation of “only” .95 with SCHB and a lower correlation with SCHC and SCHF which helps it provide some diversification. Despite the ETF being heavily focused on providing dividends, SCHD still posts a very negative correlation with bond ETFs. However, the negative correlation is weaker for SCHD than it is for the other equity ETFs. Since I may be using heavy rebalancing and allocating more to bonds over the next few years, I don’t want to go overboard on moving SCHD into the portfolio. I’ll probably limit my holdings to a range of around 5% to 10%. Conclusion SCHD is a very strong ETF for most investors. After admiring it from afar for quite a while I decided to take the plunge and put in an order to buy some shares if they kept getting cheaper. One of those orders activated earlier in the week. I put in another order to buy more if it drops again. The ETF offers lower correlation with some of the other holdings I’m using for international exposure or considering adding to the portfolio soon. Even though the internal diversification is not as great as broad market funds, the volatility has been lower and I’m more comfortable holding SCHD going into a rough macroeconomic environment. Disclosure: I am/we are long SCHB, SCHD, SCHH. (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
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