Key Points

  • Exchange-traded funds, or ETFs, are the basic building blocks of Schwab Intelligent Portfolios
  • ETFs provide a range of advantages for these portfolios over index mutual funds or actively managed mutual funds
  • The ETF evaluation and selection process for Schwab Intelligent Portfolios is designed to address a number of important factors that affect portfolio expenses and quality

ETF Selection

Charles Schwab Investment Advisory, the Schwab Intelligent Portfolios portfolio manager, applies a careful and consistent approach to ETF analysis and selection. We encourage you to learn more about the advantages of ETFs and how they are selected to construct diversified portfolios in the following whitepaper.

Background

Charles Schwab Investment Advisory, Inc. is responsible for selecting the low-cost, index tracking ETFs used in Schwab Intelligent Portfolios.

This white paper describes why ETFs are used as the investment vehicle of choice for Schwab Intelligent Portfolios, looks at challenges to ETF investing and explains why a thorough review of the ETF landscape is fundamental to investing success.

The paper then describes how the ETF marketplace is navigated to select and monitor the appropriate ETFs for Schwab Intelligent Portfolios.

ETF Advantages

During the process of selecting ETFs as the building blocks for Schwab Intelligent Portfolios, advantages that ETFs have over actively managed and index mutual funds for the purposes of constructing these portfolios were considered. These advantages include:

  • Transparency
  • Lower expense ratios
  • Greater tax efficiency

Transparency

When investors buy an ETF, they own a single security that is traded intraday and represents a basket of stocks, bonds or other securities. ETFs tend to offer greater transparency than mutual funds because ETFs pursue strategies that replicate market indexes where the methodology behind the selection and weighting of securities is publicly disclosed. And unlike actively managed mutual funds which are only required to report their holdings quarterly, usually with a lag of about a month, ETFs typically disclose exactly what is in their portfolios at the end of every trading day.

Another benefit of this transparency is more accurate pricing. Daily disclosure allows for institutional entities known as authorized participants or "APs," to transact directly with fund providers to independently value ETF portfolios throughout the trading day and create or redeem ETF shares. This is why many ETFs, unlike closed-end funds that trade on an exchange, tend to trade with only small premiums or discounts to the net asset value of their underlying holdings. This is also what allows investors to purchase ETFs in the secondary market at a price at or near the net asset value.

Lower Expense Ratios

Compared to mutual funds, ETFs tend to have lower expense ratios. As of Q1 2016, according to data from Morningstar Direct, the average net expense ratio for mutual funds was 1.11% compared to 0.57% for ETFs. Weighted by assets under management, the comparison is 0.68% for mutual funds vs. 0.27% for ETFs. Additionally, ETF investors do not pay load or 12b-1 fees, and all investors in an ETF pay the same net expense ratio (unlike mutual funds where larger investors may receive better pricing in higher-minimum share classes).

Greater Tax Efficiency

ETFs also tend to be more tax-efficient than mutual funds, even index mutual funds, for three reasons.

First, most ETF managers are tasked with tracking an index, not picking stocks and bonds that they believe will outperform. As a result, ETFs tend to have lower turnover than actively managed funds, leading to lower potential for capital gains distributions.

Second, when retail investors buy or sell shares of an ETF, they trade in the secondary market with other market participants; they do not transact directly with the ETF provider. As a result, ETF providers aren't forced to sell stocks or bonds when investors want out of their funds. Creation and redemption of ETF shares are frequently handled as in-kind, non-cash transactions between ETF providers and AP which also reduces the potential for capital gains.

Third, while an ETF provider may have to actually sell securities at certain times, such as in an index reconstitution or rebalancing, a unique feature of ETFs is that the ETF provider can prepare for these situations by giving the APs who redeem shares the lowest cost—basis shares of the underlying securities—that is, the securities that have the largest capital gains baked in. This leaves only higher cost—basis securities with lower capital gains available to be sold.

A 2015 report by Morningstar found that the majority of the tax efficiencies attributed to ETFs are due to their passive, index replicating investment styles. 

ETFs are much less likely to distribute capital gains and tend to have lower tax cost ratios, which is defined by Morningstar as "an annualized estimate of the tax-related headwinds facing investors and accounts for both regular income distributions as well as taxable capital gains."

Capital Gains Distributions Across Large-Blend Stock Funds
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Total Number of Mutual Funds 737 807 862 929 994 1053 1114 1199 1300 1385
Number Distributing Capital Gains 354 517 668 374 62 107 253 476 823 1008
% of Total Distributing Capital Gains 48 64.1 77.5 40.3 62.4 10.2 22.7 39.7 63.3 78.6
Total Number of ETFs 16 21 29 29 34 38 42 48 54 65
Number Distributing Capital Gains 0 0 1 0 1 1 1 3 4 5
% of Total Distributing Capital Gains 0 0 3.4 0 2.9 2.6 2.4 6.3 7.4 7.7

Source: Morningstar Direct

Challenges to Selecting ETFs

While many ETFs have all of the advantages described above, that isn't always the case. So it is important to take a thoughtful approach to ETF selection.

Here are three common challenges to selecting ETFs.

Challenge #1: Not all ETFs have low expenses.

Investors tend to pay more for ETFs that are narrowly focused on a specific country or industry or that track unconventional indexes. The fact that something is an ETF doesn't necessarily mean it's cheap to own. An approach to help overcome this challenge is to explicitly consider ETF expense ratios within the context of similar ETFs.

Challenge #2: Not all ETFs are easy and cheap to trade.

For ETFs that are traded frequently, bid-ask spreads tend to be quite small. However, less liquid ETFs tend to have much wider spreads. The ETFs in Schwab Intelligent Portfolios have historically avoided extreme bid-ask spreads, and they are monitored on a periodic basis for spread increases.

Challenge #3:  ETFs vary in how closely they reflect an asset class

As part of the approach to ETF selection for Schwab Intelligent Portfolios, the underlying asset allocation models are considered and ETFs that reflect the asset class benchmarks are selected.

Schwab Intelligent Portfolios ETF Selection Process

The overriding goal of the process is to select ETFs that closely align with the strategic asset allocation of each portfolio while ensuring low cost and meeting other qualitative standards.

One element of the process involves selecting ETFs that accurately reflect the intended exposures of the portfolios and have the smallest differences in net performance (excluding fees) compared to the asset class benchmarks.

In order to be considered for use in Schwab Intelligent Portfolios, ETFs must meet basic standards for structure, liquidity and economic viability (i.e., not likely to close due to insufficient investor demand), and tracking error.

From among those ETFs that meet the basic standards for structure, liquidity, and economic viability, the selection process favors those ETFs with the lowest expense ratios in each asset class and share prices below certain thresholds.

Since ETF shares cannot be purchased in fractional amounts, low share prices allow client accounts with low balances to generally include all ETFs, even if the portfolio's target allocation to an ETF is as little as 1%. ETFs that are below share price thresholds are selected as primary ETFs within the asset class. In general, the primary ETF is initially purchased for all portfolios barring restrictions while a secondary ETF is available for tax-loss harvesting and helping to avoid 'wash sales' when rebalancing.

When assessing whether an ETF accurately reflects a Schwab Intelligent Portfolios asset class, factors that are considered include the following (when applicable) as the ETF is compared to the asset class benchmarks:

  • Geographic exposure
  • Market cap
  • Industry/sector concentration
  • Yield, duration and/or credit quality
  • AMT-free vs. AMT-paying for municipal bonds
  • Currency hedging
  • Tracks a narrow index and/or an index with unconventional restrictions (e.g., the preferred securities category should include a broad array of sectors, including financials)
  • Legal structure consistent with the asset class (e.g., ETFs structured as C-corps with full exposure to master limited partnerships are preferred over '40 Act funds without full exposure).

At the present time, the following types of securities are ineligible for Schwab Intelligent Portfolios:

  • Exchange-traded notes (ETNs)
  • Limited Partnership ETFs

Cost of ETFs

Once an ETF has shown that it meets basic standards for structure and liquidity and economic viability (i.e., it is not likely to close), and its share price is low enough so that it can be included in the portfolio in a manner that accurately reflects the intended exposure within the Schwab Intelligent Portfolios asset allocation, ETFs selected have low costs. The total cost of owning an ETF is considered, but the focus is primarily on low operating expense ratios (OERs) because expense ratios are the most reliable component of total cost. Over a long-term holding period, differences in bid-ask spread are less material than differences in operating expense ratio (i.e., the ongoing cost of managing the ETF portfolio), which should be expected in portfolios that do not perform tactical trading.

While ETF providers have control over the OERs they charge for their funds, average bid-ask spreads depend on prices set by dealers in the secondary market and can be influenced by market-wide factors not related to any particular ETF. As a result, OERs tend to fluctuate less than bid-ask spreads. From Q1 2012 to Q4 2015, among ETFs that had at least $20 million in assets, the average standard deviation of bid-ask spread was 15 bps vs. 2 bps for OER (excluding funds where Morningstar changed the methodology for reporting OERs). Additionally, large Schwab Intelligent Portfolios trades are pooled for purposes of trade execution and may receive better spread pricing than what is available on smaller order sizes.

As holding period lengthens, OER differences remain influential while spread differences become less significant. Since investors only pay bid-ask spreads when they buy or sell, holding an ETF for longer than one year results in actual, realized spread costs that are only a fraction of what they are for shorter periods. On the contrary, OERs are annual fees that are equally present throughout the life of an ETF investment. Since Schwab Intelligent Portfolios does not offer tactical trading, it is expected that most Schwab Intelligent Portfolios ETFs will be held for periods longer than 1 year.

Cost Comparisons of Schwab Intelligent Portfolios' Primary ETFs

Compared to actively managed mutual funds and ETFs in similar Morningstar categories, the ETFs selected for primary slots within Schwab Intelligent Portfolios tend to be much lower.

Based on data as of December 2015, the average OER for Schwab Intelligent Portfolios ETFs in all asset classes is 0.27%. This compares to an average OER of 0.41% for all ETFs in similar Morningstar categories (a difference of 0.14%). Compared to actively managed mutual funds, the Schwab Intelligent Portfolios primary ETFs also tend to have much lower OERs. (However, investors should remember that ETF OER is not a complete measurement of total cost since it does not include bid-ask spread, and the comparison between ETFs and mutual funds is difficult as bid-ask spread is not a component of mutual fund total cost.)

ETF Monitoring

Once ETFs are selected for Schwab Intelligent Portfolios, they are monitored on a periodic basis to ensure that they remain an appropriate choice for the portfolios.

The information in this document is current as of January 2016 and is subject to change without notice.

Schwab Intelligent Portfolios charges no advisory fee. Schwab affiliates do earn revenue from the underlying assets in Schwab Intelligent Portfolios accounts. This revenue comes from managing Schwab ETFs and providing services relating to certain third party ETFs that can be selected for the portfolio, and from the cash feature on the accounts. Revenue may also be received from the market centers where ETF trade orders are routed for execution.

Diversification and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets.

Tax-loss harvesting is available for clients with invested assets of $50,000 or more in their Schwab Intelligent Portfolios™ account. Clients must enroll to receive this service.

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