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Summary SCHC has incredible diversification within the holdings. The ETF needs to be combined with domestic equity ETFs and bond ETFs to be at its best. The expense ratio is higher than most of the ETFs I’m considering, but .18% is better than most international ETFs. I may need to sell off some VNQI and add some SCHC. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. I’m contemplating changing the way I structure my portfolio and I’m going to be analyzing several of the ETFs that I am considering. One of the options is the Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio The expense ratio is .18% which is one of the higher expense ratios out of the ETFs I’m consider, however it is vastly lower than many international options and is in a fairly small niche with targeting small-cap international equity. Most international equity funds would simply hold the international companies with larger market capitalizations. This ETF is nice because it allows investors a different exposure. Largest Holdings The internal diversification is out of this world. There are no holdings higher than 1% and only 1 that is higher than .45%. For getting diversification of holdings into the portfolio SCHC is a very impressive option. (click to enlarge) The diversification includes over 1600 companies which is more than I can recall for any of the international ETF options I’ve considered. Investors should be aware that during periods of financial stress in the international markets the correlation of returns is increased so SCHC may exhibit high correlation despite having very different holdings. I would treat that correlation as a market failure and just keep rebalancing the portfolio as necessary. Even if the high correlation in international investments is a market failure that does not reflect underlying value, remember that values can remain irrational for longer than some investors can remain solvent. Building the Portfolio I put together a hypothetical portfolio using only ETFs 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. Dividend Equity ETF (NYSEARCA: SCHD ) is a dividend index. The Schwab U.S. Broad Market ETF (NYSEARCA: SCHB ) is a broad market index. The Schwab U.S. Large-Cap ETF (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 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) Best Partners SCHC stands to benefit from being mixed with bond funds. The longer bond funds such as TLO and ZROZ exhibit the strongest negative correlation at -.42 and -.44 respectively. To reach a more optimal portfolio when using SCHC it would be wise for the investor to use a material allocation to bonds. Within the equity investments the lowest correlations are SCHH and SCHD. When I first looked at SCHC last year, I didn’t like it as much because the .18 expense ratio was higher than I wanted to pay on my ETF investments. I do have a strong desire for low expense ratios, but I think SCHC is investing in a smart area. Small capitalization was a great area for indexing in the U.S. market for a long time before investors caught on and widespread use of whole market indexes and broad market indexes allowed the average investor to gain effective small-cap exposure. While the international markets used in SCHC are reasonably developed, there may still be some outperformance in those markets. At the very least, there are 1600 companies that won’t get heavy exposure anywhere else in my portfolio. Conclusion I like SCHC now more than I did when I first looked at it. Perhaps it is simply seeing the market fall in August, but I’m placing a larger emphasis on designing my portfolio to be simple for rebalancing and to drive the portfolio volatility down. Currently all of my international equity exposure is through SCHF and the Vanguard Global ex-U.S. Real Estate ETF (NASDAQ: VNQI ). I’m contemplating selling off the VNQI and reallocating it to Schwab funds to make my portfolio easier to rebalance and to take advantage of lower expense ratios. I like the use of international REITs in VNQI, but I don’t like the expense ratio of .24%. I may initiate a small long position in SCHC in the near future. As of submission, I have a small limit buy order entered that is significantly below the market price. If shares take a sudden fall, I will be starting a small position. Disclosure: I am/we are long SCHB, SCHD, SCHF, SCHH, VNQI. (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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