An Introduction To SCHB: A Replacement Fund For SPY

| About: Schwab U.S. (SCHB)
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Summary

SCHB has the same top holdings, but with less concentration. However, the ETF has not demonstrated lower risk.

Both ETFs are trading very close to NAV, so neither is showing a superior entry point.

SCHB has a lower expense ratio than SPY.

The choice of SPY or SCHB should largely come down to which broker the investor is using.

In the interest of risk adjusted returns, I believe ETFs are one of the best tools available to investors. They provide substantial diversification benefits with relatively low expense ratios. Every investor should be focused on controlling their costs and increasing their diversification. In my opinion, many investors focus too much on trying to generate returns rather than trying to reduce risk. Because the investors don't pay adequate attention to their risk, it is very common for investors to take on more risk than required to achieve a given level of return.

The Schwab U.S. Broad Market ETF (NYSEARCA:SCHB)

SCHB offers investors an exposure to the broad U.S. market. At first glance, an investor might think that a broad market ETF would have some significant diversification advantage over the S&P 500 (NYSEARCA:SPY). That's where I start my analysis. I compare the daily standard deviation of returns using dividend adjusted close values. I attempt to get data for a few years, but some ETFs will have a longer history than others. Running a regression on the daily dividend adjusted returns for each provides me with an ANOVA table. I know stats can put people to sleep, so I'll keep this short:

The ANOVA table tells us that the correlation is over 99%. In other words, despite other stocks being included the two funds still trade in very close proximity to each other.

When I compared the standard deviation of daily returns, I found for SPY it was 0.97%, and for SCHB it was 1.00%. By combining that information I find that holding both ETFs provides virtually no diversification benefit (99% correlation) and that SCHB actually may have a slightly higher level of volatility. In my opinion, an investor should simply choose one or the other.

Expense Ratios

Because investors need to focus on controlling costs, they should always be very aware of the expense ratio of an ETF. For SCHB, the expense ratio is 0.04%. For SPY, it is 0.09%. In this case, the edge goes to SCHB. The edge for expense ratios goes to SCHB.

Note: SPY reports a gross expense ratio of about .11%, but due to a fee waiver it drops back down to .0945%. I'm not a huge fan of the fee being consistently rounded down to .09% in net expense ratios, but it was an intelligent move for the fund.

Distribution Yield

For the investor that wants steadier returns or that intends to use the yield for living expenses, a higher income level is nice. The distribution yield on SCHB is 1.69%, on SPY it is 1.78%. The edge goes to SPY.

Holdings

For both funds, the top holdings in order of market value are:

  • Apple Inc. (NASDAQ:AAPL)
  • Microsoft Corporation (NASDAQ:MSFT)
  • Exxon Mobil Corporation (NYSE:XOM)
  • Johnson & Johnson (NYSE:JNJ)
  • Berkshire Hathaway Inc (BRK.B)
  • Wells Fargo & Co. (NYSE:WFC)
  • General Electric Company (NYSE:GE)
  • The Procter & Gamble Company (NYSE:PG)
  • JPMorgan Chase & Co. (NYSE:JPM)
  • Chevron Corporation (NYSE:CVX)

Given that the correlation was 99%, it shouldn't be surprising that the ETFs are holding the same companies.

Market to NAV

I'm very cautious when I see any meaningful deviation from NAV in the trading price of an ETF. Paying a premium to establish the position is one way to prepare for poor returns. As of the last trade on December 19th, SPY is trading at a 0.01% premium to NAV. SCHB is trading right at NAV (within rounding error). I don't see .01% as a meaningful premium or discount, so I'm treating this as a tie.

Which ETF should investors use?

In my opinion, SCHB is a viable replacement for SPY in the portfolio. However, for many investors there are no substantial benefits to one over the other. I believe the lower expense ratio is very important, but the sample size was long enough (a few years) to suggest that SPY probably does actually have a slightly lower deviation of returns. If an investor was paying similar expenses for either fund, I would consider them relatively equal.

However, if investors are exposed to a trading fee that increases as the volume of shares increases then SPY makes more sense because the shares are trading at about 4 times the value of SCHB. For investors that are forced to pay per share, using SPY may reduce trading costs leading to a slight edge.

On the other hand, SCHB is covered under the "Schwab ETF OneSource" program so investors using Schwab would be able to completely eliminate commissions on trading SCHB. If the investor intends to rebalance frequently, this could be a significant advantage for SCHB.

Conclusion

So long as both are trading extremely close to NAV, I believe the cost structure of the transactions for the individual investor is the determining factor in which ETF would provide a better deal. The two ETFs provide very similar returns and very similar risks, though SCHB has a smaller concentration in the top companies. There could be a long term diversification advantage that wasn't present in the last few years, but I would be very hesitant to treat SCHB as being better diversified from a risk perspective.

There is one thing I definitely would not do: I wouldn't combine SCHB and SPY in any portfolio. There is simply no advantage to offset the trading costs.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has 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. The analyst holds a diversified portfolio including mutual funds or index funds which may include a small long exposure to the stock.