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An Aggressive Allocation Strategy For Young Investors

Summary Using 5 ETFs investors can create a fairly efficient and aggressive equity portfolio. These ETFs are all listed as “commission free” for Schwab accounts and have low expense ratios. The strategy uses 25% international allocations and 75% domestic allocations. To create some bond sensitivity in a pure equity portfolio the allocation to domestic equity REITs is significantly higher. For this article I want to present a fairly aggressive allocation for young investors looking for a simple portfolio. This portfolio would be too aggressive for many older investors, and it even for younger investors that are unable to take the risk of going all in on equity. This portfolio holds precisely zero bonds, and investors would need to be aware of the higher volatility that this portfolio would experience. Holding a portfolio that is devoid of bonds is not a new strategy to me. My personal portfolio (counting investments under my wife’s name) is devoid of bonds with the exception of holding mREITs. The mortgage REITs are essentially a levered and option-embedded bond fund. My mREIT holdings are around 20% of my total portfolio. While the mREITs do represent bonds in a way, they are certainly not reducing the volatility of the portfolio the way that a simple treasury allocation would. The Five ETFs The five ETFs that I would suggest for this portfolio are: SCHE Schwab Emerging Markets ETF SCHC Schwab International Small-Cap Equity ETF SCHF Schwab International Equity ETF SCHH Schwab U.S. REIT ETF SCHD Schwab U.S. Dividend Equity ETF This allocation strategy results in 25% of the equity being invested internationally through the combination of three international funds with the rest of the portfolio being held in domestic investments. The equity REITs in SCHH get a heavier allocation than some investors would feel comfortable using because the equity REITs have some correlation with bonds. In effect, this is allowing the portfolio to import a small amount of bond sensitivity while still maintaining an aggressive all equity allocation. The weights I would use for this kind of portfolio are shown below: Rationale for Allocations – SCHH Since this aggressive strategy is not using bonds, it would be very reasonable to go overweight on either equity REITs or utilities since both have some very material correlation to bonds. Both of these sectors can be used as sources and compete for allocations from investors seeking income. Without bonds, I would want to overweight SCHH. This can be seen in my portfolio allocations as I have been keeping domestic equity REITs around 20 to 25% of my total portfolio. Rationale for Allocations – SCHE, SCHC, SCHF The rationale for the allocations among SCHE, SCHC, and SCHF is fairly simple. I like incorporating a small amount of SCHE for exposure to markets that otherwise would not be present in the portfolio. Currently, SCHE is the only one of these five ETFs that I do not own. By April I will probably have a small position in SCHE. The other four are already present in my portfolio. I feel the emerging markets are more dangerous than the developed markets, so I think SCHE positions should remain smaller than SCHC or SCHF. SCHC is the small-capitalization companies in the developed markets, and the fund keeps growing on me. I think these smaller capitalization companies in the international markets are going to be less efficiently priced than the larger capitalization companies. I expect this to give SCHC a little boost to performance. Even if I’m effectively buying those companies blindly, the position is diversified effectively. SCHF is giving more of what I consider the standard international allocation. The positions are in larger companies that are more established and may be more efficiently priced, however I’m starting to like international markets after several years of poor performance. Out of these three international funds I would expect SCHF to be the least volatile and it has a very low expense ratio for international investment at .08%. To be fair, this list is intentionally restricted to funds with very low expense ratios relative to peers in the space. Rationale for Allocations – SCHD I’ve used SCHD instead of a total or broad market ETF in this example which might surprise some investors. If I’m creating a hypothetical portfolio for a young investor, why wouldn’t I just use the whole market ETFs? The reason for using SCHD is the same reason that I put a heavy weight on equity REITs for the portfolio. This hypothetical portfolio is designed with zero allocation to bonds and SCHD has more defensive sector allocations than broad market ETFs. Perhaps most notable SCHD goes overweight on consumer staples which tend to withstand fierce selloffs in the market. If the portfolio were designed to incorporate more bonds, then I think the appeal of a broad market ETF would increase. Because I started with the assumption of a younger investors that wants to go without bonds, I opted to make the core equity holding a more defensive allocation. Hypothetical Use For an equity heavy strategy like this, dollar cost averaging would be very appealing. In this scenario I would favor rebalancing over just letting the positions sit. For a shorter time frame, I don’t think it would matter much but if the investor was simply going to let the portfolio run for longer than a decade, then I think some rebalancing would be favorable. Commissions Since trading commissions can eat into an investor’s return and my hypothetical young investor is stuck investing less than $10,000 per year, I picked only funds that would be commission free for investors using Schwab. In choosing a brokerage, I think one important consideration is which funds they offer as “commission free”. My only relationship with Schwab is having my personal accounts there. They got my business by offering an attractive list of commission free ETFs and knowing how to handle a solo 401K account. Volatility I ran a regression on this portfolio compared to the S&P 500 using returns since October of 2011. (click to enlarge) Investors should expect that this portfolio would underperform the S&P 500 over the last 4 years if they have been following global markets because international equity significantly underperformed domestic equity. Despite that under performance, it is worth noting that the combined portfolio had an annualized volatility of 12.8% compared to the S&P 500 having an annualized volatility of 13.5%. I believe this reflects an equity portfolio that is intelligent structured to reduce total volatility while offering the potential for significant returns. Conclusion A portfolio like this can be an option for a young investor with a strong enough risk tolerance to run a portfolio that is purely invested in equity. In my opinion, a strategy like this that is focused on ETFs should involve some plan for rebalancing.

This Small-Cap International ETF Is Really Growing On Me

Summary SCHC has incredible diversification within the holdings. The ETF needs to be combined with domestic equity ETFs and bond ETFs to be at its best. The expense ratio is higher than most of the ETFs I’m considering, but .18% is better than most international ETFs. I may need to sell off some VNQI and add some SCHC. 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 contemplating changing the way I structure my portfolio and I’m going to be analyzing several of the ETFs that I am considering. One of the options is the Schwab International Small-Cap Equity ETF (NYSEARCA: SCHC ). 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 is .18% which is one of the higher expense ratios out of the ETFs I’m consider, however it is vastly lower than many international options and is in a fairly small niche with targeting small-cap international equity. Most international equity funds would simply hold the international companies with larger market capitalizations. This ETF is nice because it allows investors a different exposure. Largest Holdings The internal diversification is out of this world. There are no holdings higher than 1% and only 1 that is higher than .45%. For getting diversification of holdings into the portfolio SCHC is a very impressive option. (click to enlarge) The diversification includes over 1600 companies which is more than I can recall for any of the international ETF options I’ve considered. Investors should be aware that during periods of financial stress in the international markets the correlation of returns is increased so SCHC may exhibit high correlation despite having very different holdings. I would treat that correlation as a market failure and just keep rebalancing the portfolio as necessary. Even if the high correlation in international investments is a market failure that does not reflect underlying value, remember that values can remain irrational for longer than some investors can remain solvent. 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 (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 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) Best Partners SCHC stands to benefit from being mixed with bond funds. The longer bond funds such as TLO and ZROZ exhibit the strongest negative correlation at -.42 and -.44 respectively. To reach a more optimal portfolio when using SCHC it would be wise for the investor to use a material allocation to bonds. Within the equity investments the lowest correlations are SCHH and SCHD. When I first looked at SCHC last year, I didn’t like it as much because the .18 expense ratio was higher than I wanted to pay on my ETF investments. I do have a strong desire for low expense ratios, but I think SCHC is investing in a smart area. Small capitalization was a great area for indexing in the U.S. market for a long time before investors caught on and widespread use of whole market indexes and broad market indexes allowed the average investor to gain effective small-cap exposure. While the international markets used in SCHC are reasonably developed, there may still be some outperformance in those markets. At the very least, there are 1600 companies that won’t get heavy exposure anywhere else in my portfolio. Conclusion I like SCHC now more than I did when I first looked at it. Perhaps it is simply seeing the market fall in August, but I’m placing a larger emphasis on designing my portfolio to be simple for rebalancing and to drive the portfolio volatility down. Currently all of my international equity exposure is through SCHF and the Vanguard Global ex-U.S. Real Estate ETF (NASDAQ: VNQI ). I’m contemplating selling off the VNQI and reallocating it to Schwab funds to make my portfolio easier to rebalance and to take advantage of lower expense ratios. I like the use of international REITs in VNQI, but I don’t like the expense ratio of .24%. I may initiate a small long position in SCHC in the near future. As of submission, I have a small limit buy order entered that is significantly below the market price. If shares take a sudden fall, I will be starting a small position. Disclosure: I am/we are long SCHB, SCHD, SCHF, SCHH, VNQI. (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.