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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.

VAW Is A Great Idea, But The Portfolio Is Not Optimized For The Lowest Risk In The Sector

Summary VAW has a great expense ratio that makes it seem appealing at first glance. When I get into the holdings, I have to question their use of FCX rather than combining RIO or BHP with XOM to replicate mining and oil. With a weak dividend yield, high volatility, and high correlation to the S&P 500, I don’t see a long term holding. The ETF may be a solid option for making short term bets on the direction of the sector. The Vanguard Materials ETF (NYSEARCA: VAW ) offers investors a concentrated sector exposure. The holdings are fairly concentrated within the portfolio, but it is a Vanguard fund with a .12% expense ratio which makes it worthy of consideration Does VAW provide diversification benefits to a portfolio? Diversification benefits are primarily a factor of correlations and variance of returns. Looking back to January 2004 the correlation between VAW and the SPDR S&P 500 Trust ETF ( SPY) was 88% and the volatility for VAW was substantially higher at 25.4% compared to 19.4%. Due to the high correlation and high variance, it is not feasible to use VAW to reduce the risk at the portfolio level unless the starting level of risk was exceptionally high. If the core holding in the portfolio is representing the S&P 500 or the a broad market index, the position in VAW increases the total volatility. Yield & Taxes The distribution yield is 1.86%. That is not high enough to be considered for a dividend growth investor, but the volatility would have made this portfolio less desirable for those dividend growth investors and retirees anyway. Market to NAV The ETF is at a .01% discount to NAV currently. Premiums or discounts to NAV can change very quickly. Liquidity is not terrible, but an average volume around 60,000 shares is not as high as investors might be expecting for a Vanguard fund. Largest Holdings The chart below shows the top 10 holdings: (click to enlarge) The diversification within the ETF is not very strong if we are simply looking at the percentage of the portfolio in each company. On the other hand, if we look at the operations of the individual companies the picture changes materially. For instance, Freeport-McMoRan (NYSE: FCX ) is in my portfolio and regularly helps me lose money. I’m not too happy about that last sentence either, but the portfolio values don’t lie. Freeport-McMoRan is heavily invested in copper mining and oil drilling. The other companies offer investors very different exposure. While the fund is concentrated on the “Materials” sector, the individual companies are still fairly different. If the intent was to own a mining company, I’m a little surprised that Vanguard did not choose to hold shares in a more stable mining company such as BHP Billiton (NYSE: BHP ) or Rio Tinto (NYSE: RIO ) since they both have more diversified mining portfolios and lower cost operations. I assume they did not select Freeport-McMoRan for the oil exposure because they could have picked a much more stable like Exxon Mobile (NYSE: XOM ) if they were trying to include oil exposure. Volatility Comparison To show how much more volatile FCX is compared to using a combination of Rio Tinto and Exxon Mobil, I pulled the following chart from Investspy: (click to enlarge) For comparison sake I set the weight on FCX to 50% and the weights on RIO and XOM to 25% each. While Rio Tinto and Freeport-McMoRan had similar levels of volatility over the sample period, Rio-Tinto would have given the mining exposure with a smaller allocation so the oil exposure could be picked up by XOM. In this simple example FCX would have contributed 61.5% of the risk and XOM and RIO would have combined to contribute only 39.5%. This is a function of XOM simply being a much safer play for including oil exposure in the portfolio. If the oil exposure is not wanted, then the use of Freeport-McMoRan feels pretty strange. Conclusion VAW has a great expense ratio but it simply brings too much volatility for having such a high correlation with the S&P 500. When it comes to selecting companies for the portfolio, it seems like part of the risk stems from selecting companies that are riskier than necessary for creating the desired exposure. I’d rather see VAW modify the portfolio to get the “materials” sector exposure with as little volatility as possible. As it stands, VAW seems like a more useful ETF for making bets on sector movements than as a long term tool for generating wealth with the lowest level of risk possible for the expected returns. Disclosure: I am/we are long FCX. (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.

VDC: If You Can Trade It For Free, It Belongs In Your Portfolio

Summary VDC has a reasonable correlation with SPY and less volatility. The heavy focus on consumer staples resulted in the fund performing substantially better on risk-adjusted metrics. Using VDC as a portion of the equity portion of a portfolio would be appropriate for the majority of investors. I’m glad Schwab and Vanguard have been competing to offer the lowest cost funds, but I’d love to have VDC added to my “Free to trade” list. 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. The Vanguard Consumer Staples ETF (NYSEARCA: VDC ) ETF looks like an interesting option for risk reduction. 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 maximize risk-adjusted returns by minimizing risk without destroying the potential for returns by being too conservative or spending too much on trading costs or high expense ratios. Does VDC provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) as the basis for my analysis. I believe SPY, or another large cap U.S. fund with similar properties, represents the reasonable first step for many investors designing an ETF portfolio. Therefore, I start my diversification analysis by seeing how it works with SPY. I measured correlations using daily and monthly returns over five-year periods and two-year periods. Depending on the measurement periods and intervals, the correlation will generally run around 75% to 80%. The correlation is low enough that there is the potential for a reduction in risk. When I checked the volatility of the ETF over the last five years, the annualized volatility was 11.1%, which compares very favorably with the S&P 500 having an annualized volatility of 14.8%. On top of the low correlation and lower volatility, the max drawdown for the period was -11.2%. The worst drawdown for SPY in that range was -18.6%. By any risk measurement, VDC should be seen as a lower risk option for the portfolio. Returns were not destroyed either. VDC outperformed SPY during the holding period by 1% with gains of 115.1% compared to 114.1%. So far, VDC is looking fairly impressive. Yield & Taxes The yield is only 1.85%, which is not ideal for retiring investors seeking stronger yields from their portfolio, but the volatility numbers are excellent for investors that want lower levels of risk in their portfolio. Expense Ratio The ETF is posting .12% for an expense ratio (both gross and net). I want diversification, I want stability, and I don’t want to pay for them. I view expense ratios as a very important part of the long-term return picture because I want to hold most of my investments for a time period measured in decades. The .12% expense ratio is solid and it gives investors a good value on their investment. Largest Holdings The diversification within the ETF is not a selling point for me. The top position being over 10% is the antithesis of diversification, but Procter & Gamble (NYSE: PG ) do have quite a bit of diversification within the company, so the concentration of the position within one company is not as bad as it might seem at first. Coca-Cola (NYSE: KO ) and PepsiCo (NYSE: PEP ) being the next two provides me a little concern again because the portfolio is holding 15% of the value in these fairly similar companies. Despite that, they are both solid companies with global distribution and enormous product lines. Phillip Morris (NYSE: PM ) is selling products that are literally addictive and Wal-Mart (NYSE: WMT ) is a fairly large piece of the retail pie. Despite the concentration to a few of the companies at the top, the portfolio is still quite intelligent given that the ETF is being restricted to the “Consumer Staples” sector. Absent an enormous scandal at one of the large companies, the diversification within product lines should provide material protection from weakness in the economy. (click to enlarge) Conclusion This is simply a great ETF. If the ETF used a higher distribution yield to push more cash back into the hands of investors, it might be one of the best core holdings a retiring investor could find for reducing their risk on the equity side of the portfolio. Absent the high distribution yield, the fund is still a very solid choice for any long-term investor with a higher level of risk aversion. Even for those with only moderate levels of risk aversion, it would make sense to be a little overweight on consumer staples. The downside for investors that don’t have free trading on the ETF is that optimal use of the ETF would involve rebalancing the portfolio occasionally to ensure the weightings across the portfolio remain within a reasonable tolerance band. My estimates on reasonable allocations for a highly risk-averse investor would be running 20% to 30% of the equity portion of the portfolio. Note that this is specific to the equity portion; the investor would still need to determine their own bond to equity ratios and adjust accordingly. For the investor with a lower emphasis on reducing portfolio risk, the fund would still be a very reasonable allocation for 5% to 10% of the equity portfolio if the investor has free trading on it. The only real downside I see here for investors that are not taking distributions (so yield won’t matter) is that the fund is only going to be free to trade with certain brokerage companies. That’s a shame because this fund is such a solid holding under modern portfolio theory that it could be stuck into most real investor’s portfolios to improve the expected risk/return. If this fund were on my “free to trade” list, I’d be adding a small allocation to my portfolio. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (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.