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Summary SCHF has excellent internal diversification and a low expense ratio. I’m holding SCHF already but I think I will add to the allocation. SCHF has only moderate correlations with domestic equities but shares their negative correlation with long term treasury ETFs. Holding SCHF as a major piece of the portfolio would be too risky, but it is great for being a small international allocation. 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 International Equity ETF (NYSEARCA: SCHF ). 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. Largest Holdings The diversification within SCHF isn’t too bad. By the 6th holding the allocations are less than 1% and there are over 1200 holdings in total. Put simply, SCHF is what I would look for as the centerpiece of an international allocation. The holdings are shown below: (click to enlarge) Expense Ratio The expense ratio on SCHF is only .08%. There is no way to complain about an expense ratio of .08% on international equity. Combined with it showing reasonable levels of volatility for an international equity investment in regression testing, I decided to use it as one of my international equity holdings. I’m already long SCHF, but there is a significant chance that I will be increasing my allocation since it is currently less than 2% of my portfolio. 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 (NYSEARCA: SCHX ) is focused on blended large cap exposure. 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) Holding SCHF SCHF is still a fairly volatile equity investment so investors should be planning on balancing their portfolio occasionally to ensure that their allocations don’t drift too far away from the intended allocations. I’m thinking that I will want to add some SCHC to my portfolio as well to round out my international exposure. While SCHF is holding larger and more stable international investments the portfolio for SCHC is even more diversified and focusing on holding smaller companies. In designing a long term portfolio strategy I see mixing SCHF and SCHC as a solid way to enhance my portfolio exposure and ensure that I am allocating more of my money to whichever ETF is out of favor. You may notice from the chart that ZROZ is excellent for diversification with SCHF. The correlation comes in at a negative .47 which is great for the diversification benefits. I could use TLO instead because it is less volatile than ZROZ, but my intent is to bring in high volatility on the allocation that will have a negative correlation to almost everything else in my portfolio. It may sound like risk seeking behavior to intentionally pick the more volatile investment but the high volatility combined with the low correlation means I can use a smaller allocation within the portfolio to achieve the desired level of diversification. When it comes to the bond allocations, I’m focused on the diversification benefits more than on their ability to generate income. Realistically, bonds just don’t pay a reasonable interest rate in the current macroeconomic environment. The logical reason to hold the bond ETF is to provide some stability at the portfolio level and ZROZ is doing that very well. I think my portfolio would stand to benefit from having a little more SCHF in my strategy and adding some long duration bonds. Conclusion I don’t see anything to dislike about SCHF. The expense ratio is low and the holdings are highly diversified. The ETF adds diversification benefits to the standard domestic equity exposure and it still maintains a very negative correlation with the same bond funds that I would want to use for their negative correlation with domestic equities. Simply put SCHF just fits well within the portfolio. In my opinion, an allocation greater than 20% would be dangerous to the health of the portfolio, but for an allocation between 5% and 10%, I think SCHF looks very nice. Disclosure: I am/we are long SCHF, 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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