Tag Archives: portfolio

SCHD: Lower Volatility Than SPY, Lower International Correlations And A New Place In My Account

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.

Comparing 6 Of The Top International Equity Options

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.

Messy Fund Managers Create An Illusion Of Skill

Mutual fund rating services divide mutual funds into categories based on their investment style. This helps investors compare the performance of one style to another and helps them compare the performance of individual funds in a particular style. While useful in many ways, this methodology can also create the illusion of superior performance when none exists. Among the most familiar investment style tools is the Morningstar Style Box, a nine-square grid that provides a graphical representation of a fund’s investment style. For stock funds, it classifies funds according to primary market capitalization (large, mid and small) and investment style (growth, core and value). Morningstar (NASDAQ: MORN ) tracks the performance of securities in the nine style boxes, creates style indices, and then compares fund performance to these indices. According to Morningstar magazine , the average actively managed US equity fund performance has fallen short of its comparable style box index in all nine categories over the past five years ending in June 2015. However, there are times when a majority of active managers appear to perform better than a style box index. Over the past three years, surviving large-cap value managers have fallen into this category by outperforming their benchmark index 62.7% of the time. See Figure 1 below. Outperformance by a majority of managers in a particular style is often followed by calls from the fund community to use active management in that style. There are those who begin to argue that the market is inefficient in certain areas. They say indexing doesn’t work in these styles and that active management works better. Don’t take these periods of active manager outperformance at face value. It is an illusion that is expected to fade over time. What’s actually occurring is the difference between pure style index returns and messy active manager returns. Style indices represent a pure selection of securities driven strictly by empirical measurements, while fund managers are often messy in their portfolio constructions. For example, the only securities you’ll find in a small-cap value index are small-cap value stocks. In a small-cap value fund , a manager may choose to extend into other style boxes by drifting outside of the pure style. (The fine print in the fund prospectus typically allows for this.) A fund with messy style drift often compares favorably to the style it is benchmarked against when the benchmark is lagging other styles. When enough fund managers in a category are messy in their stock selection, and the benchmark style performs poorly relative to adjacent styles, it creates a period when active style-drifting managers appear to be a better option for investors. This is a temporary illusion of superiority that is not expected to persist. Figure 1 compares the three-year performance of Morningstar Style Box returns to the percentage of managers outperforming their style index benchmark. The X-axis represents the three-year annualized Morningstar style index return and the Y-axis represents the percentage of managed funds that outperformed each style. Figure 1: Morningstar Style Box Performance and Percentage of Managers that Outperformed. Three years ending June 30, 2015. (click to enlarge) Source: Morningstar magazine, August/September 2015, chart and regression by R. Ferri Figure 1 graphically illustrates the relationship between style performance and the ability of active fund managers to outperform the style. Mid-cap Value ( MV ) earned 20.7% annually and outperformed all other styles; MV managers had a very difficult time outperforming this index and succeeded only about 9% of the time. In contrast, Large-cap Value (LV) earned 14.1% annually and was the worst-performing style index; LV managers had an easier time outperforming, winning about 63% of the time. The regression is close to 85%. This means the percentage of managers who outperformed in each style is highly correlated with the relative performance of the style index. The greater a style index outperforms adjacent styles, the fewer managers outperformed in that style and vice versa. This observation isn’t new in mutual fund analysis. William Bernstein wrote about the phenomenon in 2001 article, Dunn’s Law Review : The Life and Times of “Core and Explore,” in which he noted, “[T]he fortunes of indexing a particular asset class depend on its performance relative to other asset classes.” The concept was expanded by William Thatcher in a 2009 article, When Indexing Works and When It Doesn’t in U.S. Equities: The Purity Hypothesis . Both articles indicate an inverse relationship between a style’s relative performance to other styles and active management’s ability to outperform in style. This brings us to a couple of important questions. First, when do a majority of active managers outperform a poor-performing style? Second, can managers time styles and position their portfolios accordingly and make it worth investing in messy active funds? Tables 1, 2 and 3 help answer the first question: When do a majority of active managers outperform a poor performing style? The yellow box with the red numbers in each table represents the percentage of managers that outperformed that style over a three-year period ending in June 2015. The red box represents the performance of the Morningstar style index for that category. The green box represents the performance of surrounding Morningstar style indices. (click to enlarge) Table 1 indicates Large Cap Value (LV) managers had a great run over the three-year period ending June 2015. Almost 63% of active manager beat the Morningstar Large Value Index return of 14.1%. It’s easy to see why. The green areas in Table 1 represent the performance of adjacent styles indices: Large Core (18.3%), Mid Core (19.9%), and Mid Value (20.7%). All three had notably superior performance to Large Value. Any messy LV managers who invested outside of, but near the LV style index constituents would have added performance to their portfolio. Table 2 shows the opposite story for Mid Cap Value ( MV ) managers. Only 9.0% outperformed their style index. MV was the highest-performing style of the nine style boxes, so any messiness on the part of MV managers would have hurt their performance relative to the style index – and it did. Table 3 represents Small Cap Value (SV) managers, 33.6% of whom outperformed the Small Cap style index. Although the index performed satisfactorily at 17.0%, it underperformed the adjacent style indices, but not by as wide a margin as LV in Table 1. Accordingly, there was some benefit to active SV manages, but not enough to increase their win rate over 33.6%. This latest evidence substantiates what Bernstein and Thatcher have indicated in the past: It appears there is no truth to the cliché that the market is inefficient in one style and not another. It’s about style performance relative to adjacent styles, and how messy managers are about remaining within a style in their equity selection. Active fund managers look superior when their benchmark style performs poorly relative to adjacent styles, and they look bad when their benchmark style outperforms adjacent styles by a meaningful amount. Eventually, this all comes out in the wash. Active managers in every style have underperformed by about the same percentage. Please see The Power of Passive Investing for more analysis on this topic. The second question is easier to answer: Can active managers time styles and position their portfolios accordingly? They cannot. If they could, today’s Morningstar active versus passive results would show improvement since the time Bernstein wrote about it. But it has not. Managers do not appear to have persistent skill in timing investment styles. Mutual fund rating services help investors compare the performance of one style to another by creating style indices, and they help investors compare the performance of funds within a particular style. But raw data can create the illusion of superior performance when none exists. You’ll need to dig deeper into a manager’s performance to determine if he or she truly has ongoing skill or if it’s just an illusion. Disclosure: Author’s positions can be viewed here .