Tag Archives: xhr-cb-time

My First Look At SCHM And It Falls Just A Little Short

Summary I’m taking a look at SCHM as a candidate for inclusion in my ETF portfolio. SCHM looks just a tad too risky for its high correlation. The ETF has great diversification in its investments, but the value still fluctuates slightly too much. If the risk was slightly lower, I would want to carve out a small space for it. 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. Mid-Cap ETF (NYSEARCA: SCHM ). 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 SCHM do? SCHM attempts to track the total return of the Dow Jones U.S. Mid-Cap Total Stock Market Index. At least 90% of funds are invested in companies that are part of the index. SCHM falls under the category of “Mid-Cap Blend”. Does SCHM 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. For investors curious about my personal choices, I will probably use (NYSEARCA: SCHX ) in place of SPY. I stick to using SPY in these articles because it is better known. I start with an ANOVA table: (click to enlarge) The correlation is about 94%. Diversification with SPY (or an alternative) will still provide some benefits. At 94%, the diversification benefits won’t be huge but I would still consider SCHM as an addition to a portfolio rather than replacing SPY as a core holding. Standard deviation of daily returns (dividend adjusted, measured since January 2012) The standard deviation is higher. For SCHM it is .8614%. For SPY, it is 0.7300% over the same period. SPY usually beats other ETFs in this regard. Because the correlation is fairly high and the volatility is higher, it will be more difficult for me to find a way to use SCHM for risk adjusted returns. Mixing it with SPY At a 50/50 weighting, the standard deviation of the portfolio is .7837%. Even with 95% in SPY and 5% in SCHM, the standard deviation of the portfolio is .7341%. The strong correlation makes it very difficult to get a level of diversification that is high enough to really offset the additional risk. 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 1.41%. The SEC yield is 1.33%. Based on the yields, I think the ETF isn’t a great pick for investors nearing retirement and they should consider leaning towards higher yield “value” funds. For a retiree, a position in SPY (or SCHX) still makes sense, but I just don’t see a good way to use SCHM unless it is a very small position. In my opinion, most readers aren’t interested in the case for putting one half of one percent into an ETF. It just wouldn’t be worth the hassle for individual retirees. I’m not a CPA or CFP, so I’m not assessing any tax impacts. Expense Ratio The ETF is posting .07% for an expense ratio. I want diversification, I want stability, and I don’t want to pay for them. That is cheaper than SPY, but more expensive than SCHB. All around, 07% is still a very solid ratio. Market to NAV The ETF is at a .02% premium to NAV currently. In my opinion, that’s not worth worrying about. It is practically trading right on top of NAV. However, premiums or discounts to NAV can change very quickly so investors should check prior to putting in an order. Largest Holdings The portfolio has spectacular diversification. Having less than .60% in any single stock is the kind of diversification I’m willing to pay the higher expense ratio for, but I think this sector of the market is offering a compelling level of risk adjusted returns on an aggregate basis. (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 SCHM 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. SCHM doesn’t look like a bad ETF. It isn’t a terrible investment by any means, but I don’t think it will fit in the portfolio I’m building. I’m still defining risk as the deviation of returns, and so long as the historical deviation is fairly accurate, I don’t think I can allocate enough of my portfolio to SCHM to make it worth having the additional position. Even without monetary trading costs or taxes to consider. When my portfolio gets so large that one percent is meaningful, I may reconsider using a small exposure to SCHM. If the correlation was only 83 to 80% or if the standard deviation of daily returns was in the .79% to .81% range I’d be much more likely to consider a 5% allocation to SCHM. If I saw the ETF trading at a .3% to .4% discount to NAV, I’d consider that fairly attractive, but I don’t expect such a discount to exist during open trading hours. 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.

SCHA Looks Like A Nice Complimentary Holding To Enhance A Diversified Portfolio

Summary I’m taking a look at SCHA as a candidate for inclusion in my ETF portfolio. The expense ratio relative to the diversification is fantastic. The moderate level of correlation to major funds helps SCHA find a place. I wouldn’t consider SCHA as a core holding, but I may choose it for 5% to 10% of the 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. Small-Cap ETF (NYSEARCA: SCHA ). 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 SCHA do? SCHA attempts to track the total return of the Dow Jones U.S. Small-Cap Total Stock Market Index. At least 90% of funds are invested in companies that are part of the index. SCHA falls under the category of “Small Blend”. Does SCHA 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 about 90%. This is a fairly moderate correlation. It’s low enough that we have a chance at lowering the risk level of a total portfolio so long as the standard deviation is not too high. Standard deviation of daily returns (dividend adjusted, measured since January 2012) The standard deviation isn’t great, but it is acceptable. For SCHA it is .9294%. For SPY, it is 0.7300% for the same period. SPY usually beats other ETFs in this regard, so that isn’t a major issue. Mixing it with SPY I also run comparisons on the standard deviation of daily returns for the portfolio assuming that the portfolio is combined with the S&P 500. For research, I assume daily rebalancing because it dramatically simplifies the math. With a 50/50 weighting in a portfolio holding only SPY and SCHA, the standard deviation of daily returns across the entire portfolio is 0.8094%. If we drop the position to 20% the standard deviation goes down to .7559%. In my opinion, that’s still too high. Once we drop it down to a 5% position the standard deviation is .7357%. If I include SCHA, I would probably seek to use an exposure level around 5%, but could potentially go as high as 10%. 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. Yield & Taxes The distribution yield is 1.43%. The SEC yield is 1.30%. In my opinion, these yields make the index less appealing for a retiring investor, but an argument could still be made for a position as large as 5% because of the correlation being down to almost 80%. I’m not a CPA or CFP, so I’m not assessing any tax impacts. If I were using SCHA, I would want it to be in a tax exempt account to remove any headaches associated with frequent rebalancing. Expense Ratio The ETF is posting .08% for an expense ratio. I want diversification, I want stability, and I don’t want to pay for them. The expense ratio on this fund is still within my comfort range. This expense ratio is lower than SPY, but higher than (NYSEARCA: SCHX ). SCHX is an alternative to SPY that I found more appealing. Market to NAV The ETF is at a .07% premium to NAV currently. I’m not thrilled about that, but it isn’t terrible. However, premiums or discounts to NAV can change very quickly so investors should check prior to putting in an order. Largest Holdings The portfolio is wonderfully diversified. The largest position is extremely short duration bonds at .67%. I suspect the ETF is using this as a method for storing dry powder rather than holding cash. That would be a fine solution in my book and I don’t mind seeing it in the portfolio as long as it is less than 1% of assets. I don’t want to be paying an expense ratio on a significant amount of funds that are not invested. For the real investments of the fund, the vast majority are under .30%. This is spectacular diversification and it is remarkable to find this with an expense ratio of only .08%. (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 SCHA 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. So far, I like SCHA for exposure to the smaller capitalization side of the market. The moderate correlation helps to mitigate the higher standard deviation of returns and makes this ETF look like a nice fit for a small portion of the portfolio. For me, that’s 5 to 10%. I’d be concerned about investors considering it a core asset and putting in 20% or more, but it looks like a nice piece for that small position in the portfolio. 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.

The Liquidity Curse

Is the liquidity premium turning into a discount? Traditionally, investors have been willing to pay a premium for stock liquidity. This premium appears to be turning into a discount. Could this phenomenon last? Historically, market participants have been willing to pay a premium for liquidity. In the equity market, in the hypothetical situation of two otherwise identical stocks, the one with the better trading liquidity would be expected to command a premium over the less liquid stock. In other words, everything else being equal, a stock that is easier to trade (one with better liquidity, i. e., more trading volume) would be expected to be awarded a higher valuation multiple than the less liquid alternative. Frequent readers are well aware that I am a strong fan of Warren Buffett. He has repeatedly noted how perverse it is that investors treat stocks so differently from real estate, simply because stocks are a much more liquid investment. Paraphrasing Mr. Buffett, he recently remarked how absurd it would be if a homeowner liquidated his or her home just because a neighboring home was sold at a discount versus its fair value. Homeowners do not track the theoretical value of their homes on a daily basis, and their investment psychology is not affected by the price fluctuations in their homes anywhere near to the extent that they are when they see the price swings in their stock holdings. Thus, Mr. Buffett often reminds us that, in the short term, the equity market functions as a voting machine, whereas in the long run, it is more like a weighing machine. That is one of the key reasons behind the success of long-term equity investing. In the long run, the stock market weighs the cash flow generating ability of the underlying equities, whereas in the short term, fads and popularity tend to determine the price at which a particular stock trades at specific point in time. The implied discrepancy is what often creates wonderful buying opportunities in very desirable equities for the long term. How could trading liquidity ever be a bad thing? In the short run , better stock liquidity can certainly work against a stock price. Particularly in severe market-wide corrections (or if a specific stock is heavily owned by leveraged traders), a liquid stock may suffer disproportionately in the short term as traders take advantage of the relatively high liquidity to raise cash. This is when particularly attractive entry points are often created for long-term investors, but also why I advocate that such investors never use margin debt to increase their exposure to stocks. Owning stocks on a leveraged basis does potentially expose market participants to a sort of ‘liquidity curse’. One may receive a margin call and be forced to liquidate a particular stock in a sudden market correction. But other than that, trading liquidity should always be considered a positive characteristic in a stock, in my view. Still, and perhaps because investors seem to be increasingly shunning volatility, it appears almost as if the historical liquidity premium may be turning into a discount, and that the liquidity curse may be becoming more widespread and more of a permanent feature across equities! Much has been written lately about the millennials. The so-called millennial generation does seem generally less open to equity investing than previous generations were at the time they were in the age range of millennials today. Having seen their parents go through the burst of the TMT bubble and the global financial crisis may have traumatized millennials enough to generally shun investing in publicly traded equities, at least for the time being. That said, investing in private equity seems much more currently popular. This is reflected both in the staggering valuations now prevalent in a number of late-stage venture investments, as well as in the growing popularity of ‘crowdfunding’. More investors than in the past, perhaps bolstered by young people including millennials, seem to be increasingly comfortable tying up their funds in illiquid investments. Equity is equity, and that which is not traded in the public markets is almost by definition riskier than publicly traded stocks, even everything else being equal. Thus, it would seem as if more people are choosing venture capital and private equity at the expense of the public markets, at least implicitly preferring trading illiquidity. One hypothesis I have for this phenomenon is that it is less traumatic for those investors not to know exactly how much a particular equity investment they own is worth at a particular point in time, just as is the case in real estate.