SCHX: It’s Like SPY With Lower Expense Ratios
Summary I’m taking a look at SCHX as a candidate for inclusion in my ETF portfolio. SCHX looks incredible in my initial review. The ETF has slightly better diversification than SPY, but similar overall risk. I expect SCHX to be a core part of my new portfolio. I’m not assessing any tax impacts. Investors should check their own situation for tax exposure. 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. Large-Cap ETF (NYSEARCA: SCHX ). 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. What does SCHX do? SCHX attempts to track the total return of the Dow Jones U.S. Large-Cap Total Stock Market Index. At least 90% of funds are invested in companies that are part of the index. SCHX falls under the category of “Large Blend”. Does SCHX provide diversification benefits to a portfolio? Each investor may hold a different portfolio, but I use (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 start with an ANOVA table: (click to enlarge) The correlation is over 99%. In short, no benefits should be expected from combining the ETF with SPY. That’s fine; the holdings are largely the same as SPY. SCHX is a replacement ETF for SPY, not a complementary holding. Standard deviation of daily returns (dividend adjusted, measured since January 2012) The standard deviation is higher. For SCHX it is .7303%. For SPY, it is 0.7300% over the same period. SPY usually beats other ETFs in this regard, and the difference between the two is largely meaningless. Because the two funds have extremely high correlation and almost identical risk profiles, the most important part of the comparison will probably be the expense ratios. Allocation I believe a fund like SPY or SCHX should be a core holding in most portfolios. Therefore, I think a reasonable level of exposure ranges from 10% to 35%. The largest exposure I would want to consider would be around 50%. In my opinion, by the time exposure levels get that high, there are other investments that can be mixed in to lower the total risk of the portfolio without hurting the expected returns. Why I use standard deviation of daily returns I don’t believe historical returns have predictive power for future returns, but I do believe historical values for standard deviations of returns relative to other ETFs have some predictive power on future risks and correlations. Under standard deviation of daily returns, the S&P 500 is remarkably efficient in long-term growth relative to volatility. Yield & Taxes The distribution yield is 1.70%. The SEC yield is 1.78%. Based on the yields, I think the ETF is solid as a part of a portfolio for retirees. If I were retiring, I would want to lower my position in SPY or SCHX in favor of putting more of the portfolio into slightly higher yielding value companies. However, I still think an exposure around 10% would be both reasonable and prudent in many scenarios. It’s difficult to build a portfolio near the efficient frontier, in my opinion, without including an ETF that tracks large U.S. companies. Because I have a long ways to go to reach retirement, I want an exposure in the 15 to 30% range. I’m not a CPA or CFP, so I’m not assessing any tax impacts. Expense Ratio The ETF is posting .04% for an expense ratio. I want diversification, I want stability, and I don’t want to pay for them. The .04% expense ratio makes me happy as an investor. SPY appears to have around .09% for an expense ratio. The ratio for SPY is actually closer to .094%, but it is regularly rounded down when screening. Market to NAV The ETF is at a .06% premium to NAV currently. It is trading pretty close to NAV, but in the interest of risk-adjusted returns I really like to know that I’m buying it right on or just below NAV. Premiums or discounts to NAV can change very quickly so investors should check prior to putting in an order. Largest Holdings The portfolio has solid diversification. SPY is holding a very similar portfolio but with a slightly larger allocation to the top companies, such as 3.55% in Apple (NASDAQ: AAPL ). However, the additional diversification for SCHX can be partially set off by some of the companies near the top being less volatile or by the ETF having less trading volume. (click to enlarge) Conclusion I’m currently screening a large volume of ETFs for my own portfolio. The portfolio I’m building is through Schwab, so I’m able to trade SCHX with no commissions. I have a strong preference for researching ETFs that are free to trade in my account, so most of my research will be on ETFs that fall under the “ETF OneSource” program. SCHX is a very strong contender to be a core holding in the new portfolio. I wanted a replacement for SPY that I would be able to trade without commissions. Of course, I also wanted to see a lower expense ratio, and SCHX delivered that. When I transfer money into this new portfolio (probably in February), I expect that SCHX will be allocated 15 to 30% of my portfolio value. I am not compensated by Schwab in any way for writing about ETFs that fall under their program. I select several ETFs under their program because I am doing research for my own investing and want to avoid trading fees. 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. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.