Scalper1 News
Summary SCHZ has done an exceptional job of allocating the portfolio across different debt instruments. The maturities of the portfolio also offer a high degree of diversification. SCHZ is a great option for investors that want to use a larger allocation to bonds in their portfolio. Investors that only use a bond allocation for negative correlation to their equity investors may want to stick to long treasury securities. 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 working on building a new portfolio and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. One of the funds that I’m considering is the Schwab U.S. Aggregate Bond ETF (NYSEARCA: SCHZ ). 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 on SCHZ is only .05%. Since bond yields remain very low, it is especially important for bond funds to have very low expense ratios. A bond fund with weak yields on the securities and high expense ratios would offer investors a terrible investment. While the yields on SCHZ are limited as the portfolio holds a large amount of high quality debt in a market that is holding yields down, the low expense ratio remains a very attractive feature. Allocations The sector diversification within the ETF is very impressive for a bond fund. If an investor wanted to simply grab one bond portfolio, this would be an option for doing it all in a single purchase. My personal preference is to use more than one bond fund to make it easier to target different parts of the yield curve and create more diversification benefits for the portfolio, but I do think this is one of the better “one stop shopping” options. (click to enlarge) Maturity In addition to having a large degree of diversification within the type of debt instruments, the maturities of those instruments are also highly diversified to reduce volatility stemming from twists in the yield curve. (click to enlarge) 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. 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 (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. 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) Conclusion SCHZ offers investors a remarkable amount of diversification within the holdings. The diversification can be seen in the allocations to different types of debt instruments and to different maturities. The weakness in this otherwise exceptional fund is that including non-treasury debt makes it more susceptible to weak performance when the market becomes more timid. The exposure to credit risk is represented by the correlation for SCHZ to major indexes like SCHB and SCHD running in the -.23 to -.27 range. Those are good negative correlations that improve risk adjusted returns across the portfolio, but the negative correlation is much weaker than it is for ETFs that are focusing on treasury securities like TLO or ZROZ. On the other hand, if an investor wants a simple option for grabbing diversified bond exposure with lower volatility, SCHZ stands out as a very solid option that can fit nicely into a wide variety of portfolios. The question an investor must answer in buying into a bond ETF is “What is the purpose of this allocation”? If the desire is low volatility for the fund while the investor collects the interest income, then SCHZ should be a strong candidate. If the investor is simply trying to acquire negative correlations to other equity positions, then using longer treasury securities make more sense. In my opinion, investors assigning a higher portion of the portfolio to bonds will benefit more from SCHZ because the low volatility of the fund will be more important. Investors focused heavily on equity and only using bonds for negative correlations may want to focus on longer treasuries that use more volatility and negative correlation to counteract negative movements in equity markets. I’ve been contemplating buying some SCHZ for my portfolio; however I’m also running a portfolio that is heavily overweight on equities and light on bonds which pushes me towards using the treasury options for the stronger negative correlations. Disclosure: I am/we are long SCHB, SCHD, SCHF, 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
Scalper1 News