How To Get An Almost Free ETF Portfolio

April 29, 2014

The World’s Cheapest ETF Portfolio just got cheaper; here’s how to get an even better deal.

Charles Schwab has been doing great things for the ETF community. Its commitment to being the lowest-cost ETF provider in the world has put sustained downward pressure on ETF fees.

I know, because for the past six years, I’ve been monitoring The World’s Cheapest ETF Portfolio. It’s a broadly diversified portfolio holding the lowest-cost ETF in six different asset classes, including stocks, bonds, REITs and commodities.

When I started monitoring the portfolio, the all-in costs were just 0.16 percent per year, and the portfolio was made up mostly of Vanguard ETFs. Today, thanks to a series of fee cuts—including, most recently, Schwab cutting fees on the Schwab International Equity ETF (SCHF | B-96) from 0.09 to 0.08 percent per year—the portfolio’s costs have been cut in half to just 0.08 percent (0.083 percent if you’re being exact), and it’s Schwab almost all the way.

The World's Lowest-Cost ETF Portfolio
Asset Class Weight Fund Ticker Expense
Ratio
U.S. Equity 40% Schwab U.S. Broad Equity ETF SCHB 0.04%
Developed Markets Equity 30% Schwab International Equity ETF SCHF 0.08%
Emerging Markets Equity 5% Schwab Emerging Markets Equity SCHE 0.14%
Fixed Income 15% Schwab U.S. Aggregate Bond SCHZ 0.05%
REITs 5% Schwab U.S. REIT ETF SCHH 0.07%
Commodities 5% UBS Etracs DJ-UBS Commodity TR ETN DJCI 0.50%
Blended Expense Ratio 0.08%

 

The portfolio is an amazing bargain. For just $8.30/year for every $10,000 invested, you get exposure to nearly 4,000 stocks, 1,400 bonds and 19 commodities stretched across 40 different countries and a dozen different currencies. It’s one of the best deals in the history of investing.

But what if I told you that you could get a better deal? What if I told you that you could get a diversified ETF portfolio almost for free?

Lowest ‘Realized Cost’

Expense ratios are a critical factor when evaluating ETFs. But in the end, what really matters is not what you pay, but what you get.

Here’s what I mean.

 

Imagine two ETFs that track the same index and charge 0.10 percent per year in annual fees. At first glance, you might expect both to trail their benchmarks by the same 0.10 percent per year. You might not care which of the two funds you pick.

But what if I told you that, on average, one fund lagged its index by 0.20 percent per year, while the other missed by just 0.05 percent? You would choose the one that lagged by just 0.05 percent, 10 times out of 10.

That kind of performance variation happens all the time in ETFs. The reason is that managing an index fund is hard. Some ETFs track more difficult indexes than others; some use sampling strategies rather than fully replicating their index; some trade more than others; some engage in securities lending to earn extra income; and, frankly, some fund managers are just better than others.

We monitor how well funds track their indexes in our free ETF Analytics tool, using a statistic called “Median Tracking Difference.” It looks at how much an ETF has lagged its index over the average one-year period, examining all possible periods over the past two years. It’s an amazing statistic that tells amazing stories.

Take the Schwab U.S. Broad Market ETF (SCHB | A-100). The fund is the cheapest ETF in the United States, offering broad-based exposure to U.S. equities for a fee of just 0.04 percent per year. But that actually undersells just how good SCHB is!

SCHB has actually matched its index perfectly over the average given one-year period. Not only is it charging just 0.04 percent a year, it’s making that 0.04 percent up through smart management and securities-lending strategies. In other words, you’re getting broad-based equity exposure for free.

The Vanguard FTSE Developed Markets ETF (VEA | A-91) does even better. Not only does VEA have an ultra-low fee of just 0.09 percent per year, it has actually beaten its index by 0.15 percent per year on average over the period we studied.

If you take the broad-based ETF with the best median tracking difference in each asset class, based on the data we have, you end up with a portfolio with a blended median tracking difference of negative 0.03 percent per year (negative 0.027 percent if you’re being exact).

The World’s Lowest-Realized-Cost Portfolio
Asset Class Weight Fund Ticker Expense Ratio Median Tracking Difference
U.S. Equity 40% Schwab U.S. Broad Equity ETF SCHB 0.04% 0.00%
Developed Markets Equity 30% Vanguard FTSE Developed Markets VEA 0.09% 0.15%
Emerging Markets Equity 5% SPDR S&P Emerging Markets GMM 0.14% -0.40%
Fixed Income 15% iShares Core Total U.S. Bond AGG 0.08% -0.14%
REITs 5% Vanguard REIT VNQ 0.10% -0.05%
Commodities 5% UBS Etracs DJ-UBS Commodity TR ETN DJCI 0.50% -0.57%
SUM -0.03%

 

That is flat-out awesome. For just $2.70/year for each $10,000 invested, you’re getting 4,000 stocks, 1400 bonds, 40 countries and so on.

To put that in perspective, the average actively managed mutual fund charges 1.33 percent per year. You could own the World’s Lowest-Realized-Cost ETF Portfolio for 49 years for the same cost as holding that average actively managed mutual fund for the next 12 months.

There are reasons investors focus heavily on expenses. Expenses are fixed fees and are guaranteed to detract from your returns.

Tracking difference, by comparison, is variable, and can be impacted by changing events. Still, it’s the best available measure of what investors in each fund have experienced, and is fairly stable for mature ETFs. And as the portfolio above shows, you can use it to find one heck of a deal.


At the time this article was written, the author held a long position in VEA. Contact Matt Hougan at [email protected].

 

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