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Summary SCHH is a great REIT ETF with a very low expense ratio. The holdings are little too heavy on SPG and the retail REIT sector in general. When considered within a portfolio the diversification benefits of SCHH are less important when the portfolio already has a large bond holding. Investors should treat SCHH as an optional replacement for a combination of equity and bonds. If I could make a modification to the SCHH portfolio, it would be to decrease retail REITs and increase residential REITs in lower income markets with higher capitalization rates. 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. REIT ETF (NYSEARCA: SCHH ). 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 SCHH has an expense ratio of .07%. The expense ratio is great for equity REIT ETF options. This is one of the holdings I’ve been adding to whenever I saw it dip. Largest Holdings I love what a REIT index does for diversifying a portfolio. However, when I look at the internal holdings of the ETF, I wish there was a little more diversification. Namely, I would like to see a cap on exposure to any individual REIT at about 5% to 6% of holdings. The holdings are shown below: (click to enlarge) Nothing against Simon Property Group, Inc. (NYSE: SPG ), I just don’t want to see 10% of my index fund invested in a single company. Types of REITs (click to enlarge) When we look at the type of REIT holdings by sector, I get the feeling that I would prefer to see retail REITs with a lower weights and residential REITs with a higher weight. I suppose that comes back to my issue with having over 10% of the portfolio in SPG. Drop that down and put the capital into a heavier weight on residential REITs and I’d be very happy with the overall portfolio composition. 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 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. 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) The Role of SCHH REIT ETFs can perform a couple roles within a portfolio. One major use of REITs is to boost the income yield from the portfolio, but SCHH doesn’t pay out as high of a dividend yield as some of the other equity REIT index funds. In my book, that makes it more useful for investors that are not concerned about distributions for decades. Since I’m holding the ETF in a tax advantaged account, I won’t have to worry about capital gains taxes either. Since SCHH is not offering a high current yield for investors, it is useful to look at the diversification benefits because SCHH runs between .70 and .60 on correlation with all of the other equity ETFs in the portfolio. The only real weakness for holding a large allocation in equity REITs is the correlation with bonds is not as favorable as it is for the other equity ETFs. If an investor wants to completely avoid using bond exposure in their portfolio, as I’ve been doing, then equity REIT indexes are absolutely critical in reducing the risk level. When the portfolio is including a substantial allocation to bonds it will reduce the optimal allocation for equity REITs. Conclusion SCHH may not offer a high dividend yield, but for long term investors looking to build an optimal portfolio it makes sense as a solid index fund with a very low expense ratio. When investors increase their allocation to equity REIT indexes it may be appropriate to fund the portfolio by selling both domestic equity and bond ETFs. If the investor sells out of their position in REITs, the most intelligent allocation strategy would be to split the proceeds between bonds and equity. With the domestic equity REIT space, SCHH is a very attractive ETF for having a very low expense ratio. The biggest thing I would like to see changed is moving some the retail REIT exposure to residential REIT exposure. If I were to get even more specific, I would love to see the residential REIT exposure focused on markets with higher capitalization rates and lower value properties that would be expected to do better in a recession. If I were adding individual equity REITs to my portfolio to compliment SCHH, I’d start with looking for ones that operated low income properties. 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
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