Schwab Intelligent Portfolios Guide to Asset Classes & ETFs

Introduction

A foundational belief that underlies Schwab Intelligent Portfolios® is that investors should be well diversified, both within and across asset classes. Within the program, any portfolio may contain up to 20 expanded asset classes, along with an FDIC-insured cash allocation. That begs the question, what is an asset class?

It's not an entirely precise concept. Generally speaking, an asset class is a group of investments such as stocks and bonds that can be further broken down by characteristics such as market capitalization and level of risk. Like so many definitions, though, the technical terms can only do so much. Examples bring the term to life far more powerfully.
 
This document is a guide to the asset classes that are present in at least one of the portfolios that comprise Schwab Intelligent Portfolios. In addition to describing the investments that are included in each asset class, we've highlighted the role each plays in a portfolio and when they tend to perform well and poorly.

This white paper also includes a list of the exchange-traded funds (ETFs) selected for each asset class within Schwab Intelligent Portfolios. ETFs are selected based on stringent criteria to ensure that all ETFs within the program—whether Schwab ETFs™ or third-party ETFs—deliver accurate asset class representation with low costs. These selection criteria include characteristics such as assets under management (AUM), ETF liquidity, how closely the ETF tracks its underlying index, operating expense ratio (OER), and other criteria.

Schwab Intelligent Portfolios are designed to be low cost and range in weighted average overall ETF OERs at the portfolio level from 0.04% to 0.18%.

These selection criteria help pare down more than 2,500 ETFs to the 51 included in the program that could potentially be part of your Schwab Intelligent Portfolios account. Most asset classes include two ETFs, a primary ETF and a secondary ETF. To enable tax-loss harvesting1 within asset classes, the primary and secondary ETFs selected for the program track different underlying indexes.2 Along with the name and ticker symbol for each of the 51 ETFs included in the program, this document provides details on why each ETF was selected for inclusion and why other ETFs were not selected.

Charles Schwab Investment Advisory, Inc. (CSIA) periodically reviews and updates the selected ETFs in our portfolios. All ETF data shown in this paper is as of March 31, 2021, to coincide with the last review process.

    Guide to Expanded Asset Classes

    Stocks

    • U.S. Large Company Stocks
    • U.S. Large Company Stocks–Fundamental
    • U.S. Small Company Stocks
    • U.S. Small Company Stocks–Fundamental
    • International Developed Large Company Stocks
    • International Developed Large Company Stocks–Fundamental
    • International Developed Small Company Stocks
    • International Developed Small Company Stocks–Fundamental
    • International Emerging Markets Stocks
    • International Emerging Markets Stocks–Fundamental
    • U.S. Exchange-Traded REITs
    • International Exchange-Traded REITs
    • U.S. High Dividend Stocks
    • International High Dividend Stocks

    Fixed Income

    • U.S. Treasuries
    • U.S. Investment Grade Corporate Bonds
    • U.S. Securitized Bonds
    • U.S.  Inflation Protected Bonds
    • U.S. Corporate High Yield Bonds
    • International Developed Country Bonds
    • International Emerging Markets Bonds
    • Preferred Securities
    • Bank Loans
    • Investment Grade Municipal Bonds
    • Investment Grade California Municipal Bonds 

    Commodities

    • Gold and Other Precious Metals

    Cash

    • FDIC-insured Cash

    ETF List (As of 3/31/2021)

    Stocks
    Fixed Income
    Commodities

    Stocks

    U.S. Large Company Stocks

    • What is it?
      Large company stocks—or "large caps"—are investments in the equity of larger U.S. companies, generally those with more than $10 billion in market capitalization, such as Exxon Mobil Corporation or Microsoft Corporation. Large company stocks are perceived to carry less risk than smaller company stocks since they generally have more assets and a longer track record of performance, but they may not provide as much growth potential.
    • What role does it play in a portfolio?
      Relative to some other asset classes, such as bonds, large cap stocks have higher expected long-term returns to compensate for the higher risk associated with them.
    • When does it perform well?
      There are many factors that influence the performance of U.S. large company stocks. In practice, many of these factors are exerting their influence on stock prices simultaneously and on each other. The U.S. Large Company Stocks tend to do well when inflation is low or moderate. These stocks also perform well when the U.S. economy is expected to grow and when interest rates are low. Valuation matters as well. When prices are low relative to, for example, earnings, subsequent price performance is more likely to be strong.
    • When does it perform poorly?
      These stocks perform poorly during economic slowdowns or expectations of such slowdowns and when interest rates are high. Unexpected inflation may also hurt these stocks. When prices are high relative to earnings, price performance can suffer.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF 
    • Name
      Schwab U.S. Large-Cap 
    • Ticker
      SCHX
    • Operating Expense Ratio
      0.03%
    • Secondary ETF
    • Name
      Vanguard S&P 500 
    • Ticker
      VOO
    • Operating Expense Ratio
      0.03%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: SCHX and VOO had two of the lowest operating expense ratios among more than 60 U.S. large company stock ETFs at the time of ETF selection. Both funds have historically produced returns that consistently tracked their underlying indices closely. In addition, SCHX and VOO each had sizable assets under management (well above $20 billion), and have traded with tight average bid-ask spreads historically. While both funds reach slightly into the mid-cap space to provide additional diversification and potential for growth, their portfolios have historically been dominated by very large U.S. companies.
    • Why other ETFs were not selected: SPDR® S&P 500 ETF (SPY) is the largest ETF in the Morningstar U.S. Fund Large Blend category (and the largest ETF period), and it has a history of trading with narrow bid-ask spreads. However, it has a higher expense ratio than our primary and secondary ETFs. Expense ratios are the most reliable component of total cost, and over a long-term holding period differences in bid-ask spread are less material than differences in operating expense ratio. CSIA also considers the potential impact to clients such as trading or other costs when selecting an ETF that would replace an existing ETF in the portfolios.

    U.S. Large Company Stocks—Fundamental

    • What is it?
      U.S. large company stocks—fundamental are investments of larger U.S. companies that are included in fundamental indexes, which screen and weight companies based on fundamental factors such as sales, cash flow and dividends. Most traditional stock indexes are constructed based on market-cap (e.g., S&P 500®, Russell 2000®, etc.), where companies with the largest market capitalizations have the largest weights. Including allocations to fundamentally weighted indexes adds diversification within a portfolio and may improve risk-adjusted returns over time. Due to their differences in construction, fundamentally weighted indexes tend to behave differently than market cap-weighted indexes in different market environments while retaining benefits of traditional indexing such as transparency and relatively low-cost implementation. For more information about Fundamental Indexing, please read "Fundamentally weighted ETFs add value while keeping investor costs low."
    • What role does it play in a portfolio?
      Investments in fundamentally weighted ETFs and traditional market-cap weighted ETFs can be used as a complement to each other because they differ in their performance under various market environments. The end result is a portfolio that we believe will result in better risk-adjusted results over time.
    • When does it perform well?
      Based on research conducted by Research Affiliates, LLC, FTSE Russell, and Schwab Center for Financial Research among others, fundamental index strategies have outperformed market-cap indexes over longer time periods. This is partly attributable to the fact that the fundamental strategies break the link of assigning a weighting with the price of the stock. A market-cap index provides the largest weighting to the largest companies regardless of valuation. As a result, market-cap indexes can be described as "overweighting over priced stocks and underweighting undervalued stocks."3 Since fundamental index strategies tend to overweight companies that appear cheap based on various financial metrics, they tend to outperform in environments that reward such "cheap" aka value stocks. As for their absolute level of performance, fundamental strategies are affected in much the same way and by the same factors as U.S. large company stocks.
    • When does it perform poorly?
      Fundamental index strategies may lag market-cap indexes in "boom" or "momentum" periods or when the biggest companies (as measured by market capitalization) dramatically outperform the smaller companies in an index.
    • ETF Selection

    ETF Table 2

    • Name 
    • Ticker 
    • Operating Expense Ratio 
    • Primary ETF
    • Name 
      Schwab Fundamental U.S. Large Company
    • Ticker 
      FNDX
    • Operating Expense Ratio 
      0.25%
    • Secondary ETF
    • Name 
      Invesco FTSE RAFI U.S. 1000
    • Ticker 
      PRF
    • Operating Expense Ratio 
      0.39%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: Based on Morningstar classifications, two ETF providers offered ETFs in this category at the time of ETF selection. While there are many indexing approaches that incorporate various fundamental factors, classifications for fundamental strategies within Schwab Intelligent Portfolios are based on Morningstar's classification for index selection and index weighting (among other data points). From among the eligible funds in this asset class, FNDX had the lowest operating expense ratio at the time of ETF selection while meeting all other criteria. Both FNDX and PRF had sizable assets under management and have historically traded with relatively narrow bid-ask spreads.

    • Why other ETFs were not selected: The category consists of just two ETFs.

    U.S. Small Company Stocks

    • What is it?
      U.S. small company stocks—or "small caps"—are investments in the equity of smaller U.S. companies, generally those that represent the bottom 10% of the market by cumulative market capitalization. Small company stocks may provide greater potential for growth than large company stocks. However, they are riskier because their size makes them more vulnerable to economic shocks, inexperienced management, competition and financial instability.
    • What role does it play in a portfolio?
      The U.S. small company stocks offer higher growth potential than many other asset classes because of the potential for such companies to grow rapidly. Small cap stocks have higher expected long-term returns relative to other asset classes to compensate for the higher risk associated with them. 
    • When does it perform well?
      U.S. small company stocks generally perform well when the economy is expanding or investors expect such expansion to occur. Small company stocks tend to be more closely tied to the strength of the U.S. economy than large company stocks because they typically generate most of their revenue within the U.S. while large multinational companies often generate a substantial portion of revenue in multiple geographies around the world. Valuation matters as well. When prices are low relative to, for example, earnings, subsequent price performance is more likely to be strong.
    • When does it perform poorly?
      During extreme equity market or economic stress, these stocks tend to perform poorly. When prices are high relative to earnings, price performance can suffer.
    • ETF Selection

    ETF Selection Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF 
    • Name
      Schwab U.S. Small-Cap 
    • Ticker
      SCHA
    • Operating Expense Ratio
      0.04% 
    • Secondary ETF 
    • Name
      Vanguard Small-Cap 
    • Ticker
      VB 
    • Operating Expense Ratio
      0.05% 

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: SCHA and VB had operating expense ratios that were among the lowest for U.S. small company stock ETFs at the time of ETF selection. Both of these ETFs have historically traded with tight bid-ask spreads. Diversification is particularly important in the small cap market segment, and SCHA and VB each hold more than 1,200 small cap stocks. Many of the ETFs in this category have fewer than 600 holdings, while a handful have fewer than 300 holdings.

    • Why other ETFs were not selected: Among other U.S. small company stock ETFs, iShares Russell 2000 (IWM) and iShares Core S&P Small-Cap (IJR) are both large, well-diversified ETFs that trade with tight bid-ask spreads. However, both had higher expense ratios at the time of ETF selection. CSIA also considers the potential impact to clients such as trading or other costs when selecting an ETF that would replace an existing ETF in the portfolios.

    U.S. Small Company Stocks—Fundamental

    • What is it?
      U.S. small company stocks—fundamental are investments in the equity of smaller U.S. companies that are included in fundamental indexes, which screen and weight companies based on fundamental factors such as sales, cash flow and dividends. Most traditional stock indexes are constructed based on market-cap (e.g., S&P 500®, Russell 2000®, etc.), where companies with the largest market capitalizations have the largest weights. Including allocations to fundamentally weighted indexes adds diversification within a portfolio and may improve risk-adjusted returns over time. Due to their differences in construction, fundamentally weighted indexes tend to behave differently than market cap-weighted indexes in different market environments while retaining benefits of traditional indexing such as transparency and relatively low-cost implementation. For more information about Fundamental Indexing, please read "Fundamentally weighted ETFs add value while keeping investor costs low."
    • What role does it play in a portfolio?
      Investments in fundamentally weighted ETFs and traditional market-cap weighted ETFs can be used as a complement to each other because they differ in their performance under various market environments. The end result is a portfolio that we believe will result in better risk-adjusted results over time.
    • When does it perform well?
      Based on research conducted by Research Affiliates, LLC, FTSE Russell, and Schwab Center for Financial Research among others, fundamental index strategies have outperformed market-cap indexes over longer time periods. This is partly attributable to the fact that the fundamental strategies break the link of assigning a weighting with the price of the stock. A market-cap index provides the largest weighting to the largest companies regardless of valuation. As a result, market-cap indexes can be described as "overweighting over priced stocks and underweighting undervalued stocks."4 Since fundamental index strategies tend to overweight companies that appear cheap based on various financial metrics, they tend to outperform in environments that reward such "cheap" aka value stocks.  As for their absolute level of performance, fundamental strategies are affected in much the same way and by the same factors as U.S. small company stocks.
    • When does it perform poorly?
      Fundamental strategies may lag market-cap indexes in "boom" or "momentum" periods or when the biggest companies (as measured by market capitalization) dramatically outperform the smaller companies in an index.
    • ETF Selection

    ETF Selection Table

    • Name 
    • Ticker 
    • Operating Expense Ratio 
    • Primary ETF 
    • Name 
      Schwab Fundamental U.S. Small Company 
    • Ticker 
      FNDA
    • Operating Expense Ratio 
      0.25% 
    • Secondary ETF
    • Name 
      Invesco FTSE RAFI U.S. 1500 
    • Ticker 
      PRFZ
    • Operating Expense Ratio 
      0.39% 

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: Based on Morningstar classifications, two ETF providers offered ETFs in this category at the time of ETF selection. While there are many indexing approaches that incorporate various fundamental factors, classifications for fundamental strategies within Schwab Intelligent Portfolios are based on Morningstar's classifications for index selection and index weighting (among other data points). At the time of ETF selection, there were only two ETFs classified within this category. Both FNDA and PRFZ had over $1 billion in assets under management and have historically traded with relatively narrow bid-ask spreads. FNDA was selected as the primary ETF because it had the lowest expense ratio at the time of ETF selection. PRFZ, which is slightly more expensive, was selected as the secondary. 

    • Why other ETFs were not selected: The category consists of just two ETFs.

    International Developed Large Company Stocks

    • What is it?
      International developed large company stocks are investments in the equity of larger foreign companies that have high market capitalizations and are domiciled in countries with mature economies. The stock markets in these developed countries benefit from strong investor protections, corporate governance and legal infrastructure. Investing in these stocks involves additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets.
    • What role does it play in a portfolio?
      While U.S. companies can have vast international operations and exposure, investing solely in U.S. stocks means excluding nearly three-fourths of the global economy and over half of the world's stock market value. International developed large company stocks provide some of the same benefits as U.S. large-company stocks – growth potential and more stable financial results than smaller foreign companies – but provide diversification benefits due to their exposure to non-U.S. markets. In addition, investing in companies located overseas offers the potential to benefit from currency diversification—foreign company returns are generally denominated in foreign currencies, so they provide some protection against a potential fall in the value of the U.S. dollar relative to those currencies.
    • When does it perform well?
      This asset class tends to perform well when international developed countries are growing more rapidly than the U.S. and when their currencies are appreciating against the U.S. dollar. Valuation matters as well. When prices are low relative to, for example, earnings, subsequent price performance is more likely to be strong.
    • When does it perform poorly?
      When the U.S. dollar is gaining against these currencies, this asset class tends to perform poorly relative to U.S. stocks. The relative performance can also be poor when non-U.S. economies are weakening or expected to weaken. When prices are high relative to earnings, price performance can suffer.
    • ETF Selection

    ETF Selection Table

    • Name 
    • Ticker 
    • Operating Expense Ratio 
    • Primary ETF 
    • Name 
      Schwab International Equity 
    • Ticker 
      SCHF 
    • Operating Expense Ratio 
      0.06% 
    • Secondary ETF 
    • Name 
      Vanguard FTSE Developed Markets 
    • Ticker 
      VEA
    • Operating Expense Ratio 
      0.05% 

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: SCHF and VEA provide diversified, low-cost exposure to developed market equities and had large amounts of assets, each with more than $20 billion in AUM at the time of ETF selection. These two ETFs had some of the lowest expense ratios in their category, and have historically traded with tight average bid-ask spreads.

    • Why other ETFs were not selected: The largest fund in this category by assets is iShares MSCI EAFE (EFA), which also trades with a narrow bid-ask spread. However, EFA's expense ratio was significantly higher at the time of ETF selection. Among other potential ETFs in this category, iShares Core MSCI EAFE (IEFA) also had a higher expense ratio. CSIA also considers the potential impact to clients such as trading or other costs when selecting an ETF which would replace an existing ETF in the portfolios.

    International Developed Large Company Stocks—Fundamental

    • What is it?
      International developed large company stocks – fundamental are investments in the equities of larger foreign companies that are included in fundamental indexes, which screen and weight companies based on fundamental factors such as sales, cash flow and dividends. Most traditional stock indexes are constructed based on market-cap (e.g., S&P 500®, Russell 2000®, etc.), where companies with the largest market capitalizations have the largest weights. Including allocations to fundamentally weighted indexes adds diversification within a portfolio and may improve risk-adjusted returns over time. Due to their differences in construction, fundamentally weighted indexes tend to behave differently than market cap-weighted indexes in different market environments while retaining benefits of traditional indexing such as transparency and relatively low-cost implementation. For more information about Fundamental Indexing, please read "Fundamentally weighted ETFs add value while keeping investor costs low."
    • What role does it play in a portfolio?
      Investments in fundamentally weighted ETFs and traditional market-cap weighted ETFs can be used as complements in an investment portfolio because they tend to perform differently in various market environments. Including both market cap-weighted and fundamentally weighted ETFs in a portfolio can enhance diversification and potentially improve risk-adjusted results over time.
    • When does it perform well?
      Based on research conducted by Research Affiliates, LLC, FTSE Russell, Schwab Center for Financial Research and others, fundamental index strategies have outperformed market-cap indexes over longer time periods. This is partly attributable to the fact that fundamental strategies break the link of assigning a weighting with the price of the stock. A market-cap index provides the largest weighting to the largest companies by market cap regardless of valuation. As a result, market-cap indexes can be described as "overweighting over priced stocks and underweighting undervalued stocks."5 Since fundamental index strategies tend to overweight companies that appear cheap based on various financial metrics, they tend to outperform in environments that reward such "cheap" aka value stocks. As for their absolute level of performance, fundamental strategies are affected in much the same way and by the same factors as other international developed large company stocks. 
    • When does it perform poorly?
      Fundamental index strategies may lag market-cap indexes in "boom" or "momentum" periods or when the biggest companies (as measured by market capitalization) dramatically outperform the smaller companies in an index.
    • ETF Selection

    ETF Selection table

    • Name 
    • Ticker 
    • Operating Expense Ratio 
    • Primary ETF 
    • Name 
      Schwab Fundamental International Large Company 
    • Ticker 
      FNDF 
    • Operating Expense Ratio 
      0.25% 
    • Secondary ETF 
    • Name 
      Invesco FTSE RAFI Developed Markets ex-U.S. 
    • Ticker 
      PXF 
    • Operating Expense Ratio 
      0.45% 

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: Based on Morningstar classifications, two ETF providers offered ETFs in this category at the time of ETF selection. While there are many indexing approaches that incorporate various fundamental factors, classifications for fundamental strategies within Schwab Intelligent Portfolios are based on Morningstar's classifications for index selection and index weighting (among other data points). Among the two ETFs in this category, FNDF was selected as the primary ETF because it had the lowest expense ratio at the time of ETF selection. PXF, which was slightly more expensive in terms of OER, was selected as the secondary ETF. Both FNDF and PXF had sizable assets under management and have historically traded with relatively narrow bid-ask spreads.

    • Why other ETFs were not selected: The category consists of just two ETFs.

    International Developed Small Company Stocks

    • What is it?
      International developed small company stocks are investments in the equity of smaller foreign companies that are domiciled in countries with mature economies and stock markets that benefit from strong investor protections, corporate governance and legal infrastructure. Investing in international developed small company stocks involves additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets.
    • What role does it play in a portfolio?
      Like U.S. small company stocks, these investments offer greater potential for growth than their large-cap counterparts. In addition, they provide diversification relative to U.S. markets because the revenues of these companies tend to be tightly tied to their home countries. By contrast, large multinational companies typically generate revenues in multiple geographies around the world.
    • When does it perform well?
      International developed small company stocks typically perform well during the earlier stages of a global economic recovery. A strong foreign currency relative to the dollar also enhances the returns of international developed small company stocks. Valuation matters as well. When prices are low relative to, for example, earnings, subsequent price performance is more likely to be strong.
    • When does it perform poorly?
      A struggling global economy adversely impacts the performance of these stocks. When prices are high relative to earnings, price performance can suffer.
    • ETF Selection

    ETF Selection table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Schwab International Small-Cap Equity
    • Ticker
      SCHC
    • Operating Expense Ratio
      0.11%
    • Secondary ETF
    • Name
      Vanguard FTSE All-World ex-U.S. Small Cap
    • Ticker
      VSS
    • Operating Expense Ratio
      0.11%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: Finding low-cost exposure to international small company stocks can be challenging. Among the funds in this category, expense ratios ranged from 0.11% to 0.58%. Among the eligible ETFs in the category, SCHC and VSS had the lowest expense ratios at the time of ETF selection. Each of our selected ETFs also had more than $3 billion in AUM at the time of ETF selection and has historically traded with relatively narrow bid-ask spreads.

    • Why other ETFs were not selected: iShares MSCI EAFE Small-Cap (SCZ) is the largest ETF in this category but had a significantly higher expense ratio at the time of ETF selection. SPDR® S&P International Small Cap ETF (GWX) also has a higher expense ratio.

    International Developed Small Company Stocks—Fundamental

    • What is it?
      International developed small company stocks - fundamental are investments in the equities of smaller foreign companies that are included in fundamental indexes, which screen and weight companies based on fundamental factors such as sales, cash flow and dividends. Most traditional stock indexes are constructed based on market-cap (e.g., S&P 500®, Russell 2000®, etc.), where companies with the largest market capitalizations have the largest weights. Including allocations to fundamentally weighted indexes adds diversification within a portfolio and may improve risk-adjusted returns over time. Due to their differences in construction, fundamentally weighted indexes tend to behave differently than market cap-weighted indexes in different market environments while retaining benefits of traditional indexing such as transparency and relatively low-cost implementation. For more information about Fundamental Indexing, please read "Fundamentally weighted ETFs add value while keeping investor costs low."
    • What role does it play in a portfolio?
      Investments in fundamentally weighted ETFs and traditional market-cap weighted ETFs can be used as complements in an investment portfolio because they tend to perform differently in various market environments. Including both market cap-weighted and fundamentally weighted ETFs in a portfolio can enhance diversification and potentially improve risk-adjusted results over time.
    • When does it perform well?
      Based on research conducted by Research Affiliates, LLC, FTSE Russell, Schwab Center for Financial Research and others, fundamental index strategies have outperformed market-cap indexes over longer time periods. This is partly attributable to the fact that fundamental strategies break the link of assigning a weighting with the price of the stock. A market-cap index provides the largest weighting to the largest companies by market cap regardless of valuation. As a result, market-cap indexes can be described as "overweighting over priced stocks and underweighting undervalued stocks."6 Since fundamental index strategies tend to overweight companies that appear cheap based on various financial metrics, they tend to outperform in environments that reward such "cheap" aka value stocks. As for their absolute level of performance, fundamental strategies are affected in much the same way and by the same factors as other international developed small company stocks.
    • When does it perform poorly?
      Fundamental index strategies may lag market-cap indexes in "boom" or "momentum" periods, or when the biggest companies (as measured by market capitalization) dramatically outperform the smaller companies in an index. 
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Schwab Fundamental International Small Company
    • Ticker
      FNDC
    • Operating Expense Ratio
      0.39%
    • Secondary ETF
    • Name
      Invesco FTSE RAFI Developed Markets ex-U.S. Small-Mid
    • Ticker
      PDN
    • Operating Expense Ratio
      0.49%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: Based on Morningstar classifications, two ETF providers offered ETFs in this category at the time of ETF selection. While there are many indexing approaches that incorporate various fundamental factors, classifications for fundamental strategies within Schwab Intelligent Portfolios are based on Morningstar’s classifications for index selection and index weighting (among other data points). Among the two ETFs in the category, FNDC was selected as the primary ETF because it had the lowest expense ratio at the time of ETF selection and has historically exhibited slightly higher liquidity.

    • Why other ETFs were not selected: The category consists of just two ETFs.

    International Emerging Market Stocks

    • What is it?
      Emerging market stocks are equity investments in foreign companies domiciled in countries with developing economies that have been experiencing rapid growth and industrialization. Emerging markets differ from their developed market counterparts in four main ways: (1) They have lower household incomes; (2) They are undergoing structural changes, such as modernization of infrastructure or moving from a dependence on agriculture to manufacturing; (3) Their economies are undergoing development and reform programs; (4) Their markets are less mature. Emerging markets are riskier than developed markets due to greater potential for political instability, currency fluctuations, an uncertain regulatory environment, volatility and higher investment costs.
    • What role does it play in a portfolio?
      Emerging markets offer a unique combination of benefits: (1) Higher growth potential than developed markets. For investors, this is important because corporate revenues have the potential to grow faster when economic growth is higher. (2) Diversification. By investing in emerging markets, diversification increases as emerging markets can perform differently than developed markets. (3) The potential to discover up-and-coming companies.
    • When does it perform well?
      Emerging market stocks generally perform well during periods of faster growth when commodities are trading at relatively high levels, local export markets are thriving due to a growing economy, and local governments implement policies more conducive to private sector growth. Valuation matters as well. When prices are low relative to, for example, earnings, subsequent price performance is more likely to be strong.
    • When does it perform poorly?
      Emerging market stocks typically struggle when the U.S. is in a recession or experiencing a slow-growth environment. Also, due to their relatively high dependence on commodity sales, they typically don’t perform well when commodities are experiencing declining prices. Periods of high geopolitical risk are also harmful for emerging market stocks. When stock prices are high relative to earnings, price performance can suffer.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Schwab Emerging Markets Equity
    • Ticker
      SCHE
    • Operating Expense Ratio
      0.11%
    • Secondary ETF
    • Name
      iShares Core MSCI Emerging Markets
    • Ticker
      IEMG
    • Operating Expense Ratio
      0.11%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: Nimble analysis is required to avoid potential pitfalls among emerging market equity ETFs. SCHE and IEMG both provide exposure to a diversified group of countries, unlike some funds which limit exposure to a single region or have a high concentration in one particular country. Furthermore, these are large ETFs with more than $5 billion in AUM each at the time of ETF selection. Each of these ETFs had low operating expense ratios at the time of ETF selection and have historically traded with relatively narrow bid-ask spreads (less than 0.05% in a category where spreads can be as high as 1%).

    • Why other ETFs were not selected: iShares MSCI Emerging Markets (EEM) is one of the largest ETFs in this category but had a significantly higher expense ratio at the time of ETF selection. CSIA also considers the potential impact to clients such as trading or other costs when selecting an ETF which would replace an existing ETF in the portfolios.

    International Emerging Market Stocks—Fundamental

    • What is it?
      International emerging market stocks—fundamental are investments in the equity of foreign companies that are based in countries experiencing rapid growth and industrialization, and are included in fundamental indexes, which screen and weight companies based on fundamental factors such as sales, cash flow and dividends. Most traditional stock indexes are constructed based on market-cap (e.g., S&P 500®, Russell 2000®, etc.), where companies with the largest market capitalizations have the largest weights. Including allocations to fundamentally weighted indexes adds diversification within a portfolio and may improve risk-adjusted returns over time. Due to their differences in construction, fundamentally weighted indexes tend to behave differently than market cap-weighted indexes in different market environments while retaining benefits of traditional indexing such as transparency and relatively low-cost implementation. For more information about Fundamental Indexing, please read "Fundamentally weighted ETFs add value while keeping investor costs low."
    • What role does it play in a portfolio?
      Investments in fundamentally weighted ETFs and traditional market-cap weighted ETFs can be used as complements in an investment portfolio because they tend to perform differently in various market environments. Including both market cap-weighted and fundamentally weighted ETFs in a portfolio can enhance diversification and potentially improve risk-adjusted results over time.
    • When does it perform well?
      Based on research conducted by Research Affiliates, LLC, FTSE Russell, Schwab Center for Financial Research and others, fundamental index strategies have outperformed market-cap indexes over longer time periods. This is partly attributable to the fact that fundamental strategies break the link of assigning a weighting with the price of the stock. A market-cap index provides the largest weighting to the largest companies by market cap regardless of valuation. As a result, market-cap indexes can be described as "overweighting over priced stocks and underweighting undervalued stocks."7 Since fundamental index strategies tend to overweight companies that appear cheap based on various financial metrics, they tend to outperform in environments that reward such "cheap" aka value stocks. As for their absolute level of performance, fundamental strategies are affected in much the same way and by the same factors as other emerging market stocks.
    • When does it perform poorly?
      Fundamental index strategies may lag market-cap indexes in "boom" or "momentum" periods or when the biggest companies (as measured by market capitalization) dramatically outperform the smaller companies in an index.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Schwab Fundamental Emerging Markets Large Company
    • Ticker
      FNDE
    • Operating Expense Ratio
      0.39%
    • Secondary ETF
    • Name
      Invesco FTSE RAFI Emerging Markets
    • Ticker
      PXH
    • Operating Expense Ratio
      0.50%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: Based on Morningstar classifications, two ETF providers offered ETFs in this category at the time of ETF selection. While there are many indexing approaches that incorporate various fundamental factors, classifications for fundamental strategies within Schwab Intelligent Portfolios are based on Morningstar's classifications for index selection and index weighting (among other data points). Among the two ETFs in this category, FNDE was selected as the primary ETF because it had the lowest expense ratio at the time of ETF selection. PXH, which had a slightly higher expense ratio, was selected as the secondary ETF. Both ETFs had more than $1 billion in assets under management at the time of ETF selection and have traded with reasonable average bid-ask spreads historically.

    • Why other ETFs were not selected: The category consists of just two ETFs.

    U.S. Exchange-Traded REITs

    • What is it?
      U..S exchange-traded REITs (Real Estate Investment Trusts) are investments in real estate investment trusts focused on real estate and/or mortgages or mortgage securities traded on US exchanges. REITs must pay 90% of their taxable income to shareholders every year.
    • What role does it play in a portfolio?
      Investors have long flocked to REITs (and real estate in general) because of their reputation as a hedge against inflation, as a way to increase diversification, and to generate income.
    • When does it perform well?
      Since dividends from REITs generally increase with inflation, REITs tend to do better than most other asset class in moderate or high inflation environments.
    • When does it perform poorly?
      REITs do poorly during recessions as occupancy rates and valuations may both fall in such environments. REITs also tend to do poorly during periods of rising interest rates when that rise isn’t accompanied by higher inflation.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Schwab U.S. REIT
    • Ticker
      SCHH
    • Operating Expense Ratio
      0.07%
    • Secondary ETF
    • Name
      iShares Core U.S. REIT
    • Ticker
      USRT
    • Operating Expense Ratio
      0.08%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: SCHH and USRT track market-cap weighted indexes of U.S. REITs, which are companies that own (and frequently manage) commercial and residential property. SCHH was selected as the primary ETF because it had the lowest expense ratio at the time of ETF selection. USRT also had a low expense ratio and was selected as the secondary ETF. Each of these ETFs are managed by firms with significant assets under management at the time of ETF selection.

    • Why other ETFs were not selected: Among other ETFs in this category, iShares Cohen & Steers REIT (ICF) and iShares U.S. Real Estate (IYR) had significantly higher expense ratios at the time of ETF selection.

    International Exchange-Traded REITs

    • What is it?
      International exchange-traded REITs are investments in real estate investment trusts focused on real estate and/or mortgage securities traded in foreign countries. Like most securities, REITs are exposed to potential downturns in specific sectors/regions of the real-estate markets and the broader economy and also contain additional risks due to potential leverage.
    • What role does it play in a portfolio?
      International real estate is appealing for a number of reasons: It has the potential to deliver strong performance, attractive yields and diversification relative to traditional investments. In addition, investing in companies located overseas offers the potential to benefit from currency diversification. Foreign company returns are denominated in foreign currencies, so they provide some protection against a potential fall in the value of the U.S. dollar relative to those currencies.
    • When does it perform well?
      As is the case with many other securities with exposure to real estate markets, international REITs typically perform well during declining interest rate environments and when banks are expanding their lending portfolios. They also tend to hold up well against inflationary pressures.
    • When does it perform poorly?
      As is the case with most asset classes, recessions generally don’t bode well for international exchange-traded REITs. Periods of sharply rising interest rates can also be difficult for this type of investment.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Xtrackers International Real Estate
    • Ticker
      HAUZ
    • Operating Expense Ratio
      0.10%
    • Secondary ETF
    • Name
      Vanguard Global ex-U.S. Real Estate
    • Ticker
      VNQI
    • Operating Expense Ratio
      0.12%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected:  Since U.S. REITs are a different asset class within Schwab Intelligent Portfolios, the ETFs selected here should target REITs from outside the U.S. HAUZ and VNQI provide well-rounded exposure to international REITs, and they have the lowest OERs in this category.

    • Why other ETFs were not selected: SPDR® Dow Jones International Real Estate ETF (RWX) (among the largest funds in this category) has historically traded with a narrow bid-ask spread, but it was not selected because it had a significantly higher expense ratio at the time of ETF selection. Among other ETFs in this category, iShares International Developed Property (WPS) and SPDR® Dow Jones Global Real Estate ETF (RWO) also had higher expense ratios. 

    U.S. High Dividend Stocks

    • What is it?
      U.S. high dividend stocks are investments in the equity of U.S. companies that tend to distribute higher-than-average dividends to shareholders.
    • What role does it play in a portfolio?
      These stocks typically are well-suited for investors seeking both growth and income from their investments because they deliver more predictable annual income than the average stock, may reduce volatility and could appreciate over time. Dividend-paying companies are generally perceived to be more stable than those that don’t pay dividends because they are returning excess capital to shareholders.
    • When does it perform well?
      High dividend paying stocks perform well in most markets.  They have exhibited particularly strong relative performance versus non-dividend paying equities during bear markets. Valuation matters as well. When prices are low relative to, for example, earnings, subsequent price performance is more likely to be strong.
    • When does it perform poorly?
      High dividend paying stocks may struggle to keep pace during more speculative bull market periods when stock price returns make up a larger portion of total returns, which include dividends plus stock price appreciation. Faster-growing companies that pay little or no dividends may see stronger stock price returns in this type of environment than companies that distribute earnings in the form of dividends rather than investing those earnings back into potential growth.

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Schwab U.S. Dividend Equity
    • Ticker
      SCHD
    • Operating Expense Ratio
      0.06%
    • Secondary ETF
    • Name
      Vanguard High Dividend Yield
    • Ticker
      VYM
    • Operating Expense Ratio
      0.06%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: Finding the right fit in the high dividend category can be challenging, since a high dividend payment may not be sustainable or may be the result of a falling stock price. However, screens that are too restrictive can result in low yield and sector deviations that are inconsistent with asset class goals.

    • At the time of ETF selection, SCHD held approximately 100 stocks with a history of fundamental strength and consistent dividend payments. SCHD was selected as the primary ETF because it had one of the lowest expense ratios at the time of ETF selection along with a history of trading with a narrow average bid-ask spread. VYM was selected as the secondary ETF as it provides a diversified portfolio of high dividend paying stocks, while still screening for dividend sustainability (stocks must be forecast to continue paying dividends for the next 12 months). Both ETFs have more than $20 billion in AUM and narrow bid-ask spreads.

    • Why other ETFs were not selected: Among other ETFs in this category, Vanguard Dividend Appreciation ETF (VIG) was not selected as the secondary due to more representative asset class coverage by VYM. VIG limits its portfolio to stocks that have increased their dividend for at least 10 years, resulting in a lower yield than either SCHD or VYM. SPDR® S&P Dividend ETF (SDY) and iShares Select Dividend (DVY) had higher expense ratios at the time of ETF selection.

    International High Dividend Stocks

    • What is it?
      International high dividend stocks are investments in the equity of foreign companies that tend to distribute higher-than-average dividends. Dividend-paying companies are generally perceived to be more stable than those that don’t pay dividends because they are returning excess capital to shareholders. As with most international assets, investing in international high dividend stocks involves additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets.
    • What role does it play in a portfolio?
      These stocks are well-suited for investors seeking both growth and income from their investments as well as international diversification. These investments offer the same potential benefits as domestic dividend generating securities, plus the added diversification benefits of international exposure.
    • When does it perform well?
      High dividend stocks generally perform competitively with other stocks in most market climates, but tend to outperform relative to other stocks during market downturns. Valuation matters as well. When prices are low relative to, for example, earnings, subsequent price performance is more likely to be strong.
    • When does it perform poorly?
      International developed high dividend stocks may perform poorly in higher return, more speculative markets where capital appreciation accounts for a higher percentage of total return.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Xtrackers MSCI EAFE High Dividend Yield Equity
    • Ticker
      HDEF
    • Operating Expense Ratio
      0.20%
    • Secondary ETF
    • Name
      Vanguard International High Dividend Yield
    • Ticker
      VYMI
    • Operating Expense Ratio
      0.28%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: In the international high dividend category, HDEF was selected as the primary ETF because it had the lowest expense ratio while meeting all other criteria at the time of ETF selection. VYMI was selected as the secondary ETF because it had the second-lowest expense ratio while meeting other selection criteria. Both ETFs screen companies for fundamental strength and have historically traded with reasonable bid-ask spreads, considering that international stocks can be less liquid than U.S. stocks.

    • Why other ETFs were not selected:  Among other ETFs in this category, SPDR S&P Global Dividend (WDIV) includes U.S. investments, and both iShares International Select Dividend (IDV) and Invesco International Dividend Achievers ETF (PID) had higher expense ratios at the time of ETF selection.

    Fixed Income

    U.S. Treasuries

    • What is it?
      Treasuries are debt securities of the U.S. government issued through the U.S. Department of the Treasury at various maturities, from one year or less to as long as 30 years. They generally pay interest on a semi-annual basis, and timely payment of principal and interest is backed by the full faith and credit of the U.S. government, making them among the highest credit-quality investments available. Treasuries are taxable at the federal level but exempt from state and local taxes. Yields on Treasury securities are usually lower than for most other bonds because investors are willing to accept less income in exchange for lower risk. While these bonds are generally considered free from credit risk, they do carry interest rate risk—all else being equal, their prices increase when interest rates fall and vice versa.
    • What role does it play in a portfolio?
      Since Treasuries are considered to be essentially free of credit risk, they provide a secure and predictable source of income, and can be a means of preserving capital. Money that investors want to keep safe from default and stock market risk is often invested in Treasuries. The market for Treasuries is large and liquid, which means that investors can easily buy and sell the securities when they want. By keeping a portion of the portfolio's assets safe, an allocation to Treasuries in an overall portfolio may allow an investor to take risk in some other part of the portfolio with more confidence. Finally, Treasuries provide diversification from stocks in a portfolio. They often move in the opposite direction of stocks, particularly when the economy is weakening and/or when stocks are falling.
    • When does it perform well?
      Treasuries tend to perform best when inflation is low and interest rates are falling, like all bonds. But they tend to outperform other types of bonds, on a relative basis, when market volatility is high and when the economy is weakening and stock prices are falling.  Investors often put money into Treasuries as a perceived safe haven during times of economic and/or geo-political turmoil due to the high level of safety and liquidity.
    • When does it perform poorly?
      Treasuries tend to perform poorly when inflation and interest rates are rising and market volatility is low. If investors perceive that the economic and financial environment is low risk, then Treasuries are seen as less attractive to hold than other types of investments, such as corporate bonds or stocks. The lower yields for Treasuries make them less attractive to investors when risk and market volatility are low.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Schwab Intermediate-Term U.S. Treasury
    • Ticker
      SCHR
    • Operating Expense Ratio
      0.05%
    • Secondary ETF
    • Name
      iShares 3-7 Year Treasury Bond
    • Ticker
      IEI
    • Operating Expense Ratio
      0.15%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: SCHR and IEI provide exposure to intermediate Treasuries and were among the lowest cost funds in this asset class at the time of ETF selection. Both SCHR and IEI had more than $3 billion in assets under management at the time of ETF selection and have historically traded with tight bid-ask spreads.

      Why other ETFs were not selected: Vanguard Total Bond Market (BND) and iShares Core U.S. Aggregate Bond (AGG) are among the largest fixed income ETFs; however, they were not selected because they invest not only in Treasuries but also in other types of securities such as securitized bonds and corporate bonds. PIMCO Active Bond (BOND) is another large fixed income ETF; however, it was not selected because it is an actively managed ETF and also covers a broader range of fixed income securities. Vanguard Intermediate-Term Treasury Index ETF (VGIT) and SPDR Portfolio Intermediate Term Treasury ETF (SPTI) were not selected because they track the same index as the primary ETF.

    U.S. Investment Grade Corporate Bonds

    • What is it?
      U.S. investment grade corporate bonds are investments in the debt of U.S. corporations with relatively high credit ratings provided by one or more of the major U.S. credit rating agencies. Investment grade corporate bonds are those rated BBB- or higher by Standard and Poor's, or Baa3 or higher by Moody's Investors Services. That high rating indicates that these bonds have relatively low default risk, and, as a result, the bonds generally pay a lower interest rate than debt issued by entities with below-investment-grade credit ratings. These bonds always pay higher interest than comparable bonds issued by the U.S. Government, all else being equal.
    • What role does it play in a portfolio?
      Investment grade corporate bonds can allow investors to earn higher yields (with more credit risk) than more conservative investments like U.S. Treasuries, with lower credit risk than that of sub-investment grade, or "high yield," corporate bonds. Credit risk is the risk that a borrower will fail to meet a contractual obligation, resulting in a loss of principal or interest. The higher yields that investment grade corporate bonds offer as compared to Treasuries can help enhance the overall return of a fixed income portfolio. Investment grade corporate bonds also offer diversification benefits. The investment grade corporate bond market is large, with hundreds of issuers and thousands of individual issues, allowing investors to diversify by issuer, industry, maturity and credit rating.

      Investment grade corporate bonds also offer diversification benefits due to relatively low correlation to stocks. Correlation is a statistical measure of how investments have historically moved in relation to one another. Investment grade corporate bonds tend to default less than high yield bonds. The relatively low default rate for investment grade bonds suggests that they can be considered part of an investor's "core" portfolio. Investment grade corporate bonds trade in the secondary market and their prices can fluctuate. They tend to be more liquid than sub-investment grade corporate bonds and less liquid than Treasuries, but the liquidity can vary depending on each issue. Some bonds trade more actively than others, and when selling you may receive less than your initial investment.
    • When does it perform well?
      Investment grade corporate bonds tend to perform well when the economy is growing and default rates are low and are expected to stay low. In addition to the higher yields that corporate bonds offer, investment grade corporate bonds can appreciate in price as well. The yield advantage that corporate bonds offer relative to Treasuries is called a credit spread; it can be thought of as compensation for the extra risks they have. If the economic outlook is strong or default rates are expected to remain low, investors may accept lower compensation, as the perceived risks of default may decline. When the credit spread falls, the price of corporate bonds generally rises relative to U.S. Treasury bonds.
    • When does it perform poorly?
      Investment grade corporate bonds tend to perform poorly if economic growth slows and defaults are expected to rise. Even though investment grade corporate bonds tend to default significantly less than high yield corporate bonds, investors may demand higher yields to compensate for the potential for a higher rate of corporate defaults. As a result, yields tend to rise relative to Treasuries, pushing prices lower. During periods of market distress, investment grade corporate bonds are generally less liquid than more conservative investments like U.S. Treasuries, which could exacerbate price volatility.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Vanguard Intermediate-Term Corporate Bond 
    • Ticker
      VCIT
    • Operating Expense Ratio
      0.05%
    • Secondary ETF
    • Name
      SPDR® Portfolio Intermediate Term Corporate Bond
    • Ticker
      SPIB
    • Operating Expense Ratio
      0.07%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: VCIT was selected as the primary ETF, and SPIB was selected for the secondary ETF. SPIB tracks a market weighted index of investment grade corporate bonds with maturities ranging from 1 to 10 years, while VCIT tracks a similar market weight index albeit with a smaller range of maturities (5-10 years). Both ETFs have large AUM and trade with narrow bid-ask spreads.

    • Why other ETFs were not selected: iShares iBoxx $ Investment Grade Corporate Bond (LQD) is one of the largest and most liquid corporate bond ETFs in the marketplace; however, it was not selected because it had a higher expense ratio at the time of ETF selection. CSIA also considers the potential impact to clients such as trading or other costs when selecting an ETF which would replace an existing ETF in the portfolios.

    U.S. Securitized Bonds

    • What is it?
      U.S. Securitized bonds are securities in which principal and interest payments are backed by cash flows from a particular asset or pool of assets.  Some of the most common assets used as collateral for these bonds include mortgages, automobile loans and credit card debt. Often these securities will be structured into various groups of assets, or tranches, based on the credit rating of the underlying debt. One type of securitized bond is a mortgage-backed security (MBS). Mortgage-backed securities are created by pooling mortgages purchased from their original lenders. As homeowners make their mortgage payments, those payments get passed on to MBS holders. As a result, mortgage-backed securities generally pay both interest and principal on a monthly basis. If the mortgages in the pool get paid off earlier than expected (from homeowner prepayments) then MBS investors would get their principal back more quickly. Some of the more common types of mortgage-backed securities are those guaranteed by the Government National Mortgage Association (Ginnie Mae) and those issued by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Ginnie Mae is backed by the full faith and credit of the U.S. government, while MBS issued by Fannie Mae and Freddie Mac are implicitly backed by the U.S. government. However, the U.S. government has no obligation to save either company from default. 
    • What role does it play in a portfolio?
      Securitized bonds can help investors earn higher yields than Treasuries, while still investing in high quality investments. And since they generally pay interest and principal on a monthly basis, they can help those investors looking for income. However, the monthly payment can vary, based on the payment speeds of the underlying assets, such as mortgage payments. The uncertainty of monthly payments is one reason why MBS generally pay higher yields than Treasuries. Mortgage-backed securities can also help boost the credit quality of a portfolio, especially those guaranteed by Ginnie Mae. MBS generally have many of the same risks of traditional bonds (such as interest rate risk, credit risk and liquidity risk), but they also come with two unique risks—prepayment risk and extension risk. Prepayment risk occurs when homeowners pay their mortgages back more quickly and then the principal of the MBS gets paid more quickly. Extension risk occurs when homeowners prepay at slower rates, leading to a return of principal that takes longer than initially anticipated. 
    • When does it perform well?
      Mortgage-backed securities generally perform well when interest rates are relatively stable or falling. Just like traditional bonds, the price and yields of MBS tend to move in opposite directions. However, because falling interest rates can lead to an increase in prepayments—due to homeowners refinancing their mortgages—the price of mortgage-backed securities might not rise as high as they would have in the absence of a prepayment option. In this case, price appreciation may be tempered, and because of an increase in prepayments, MBS investors are then left to reinvest at lower interest rates.
    • When does it perform poorly?
      MBS perform poorly when interest rates are rising. When interest rates rise, investors are less likely to prepay their mortgages, since they would likely have to refinance at a higher rate. This means that it can take longer to get your money back, meaning it will likely take longer to invest in those higher yields. And like Treasury bonds, higher MBS yields lead to lower prices. If long-term interest rates rise, mortgage-backed securities tend to perform poorly.
    • ETF Selection

    ETF Selection

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Vanguard Mortgage-Backed Securities
    • Ticker
      VMBS
    • Operating Expense Ratio
      0.05%
    • Secondary ETF
    • Name
      iShares MBS
    • Ticker
      MBB
    • Operating Expense Ratio
      0.06%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: VMBS and MBB had expense ratios among the lowest in the asset class while also meeting other criteria at the time of ETF selection. While VMBS and MBB track similar indexes of bonds issued by government agencies (e.g. Fannie Mae), VMBS's index excludes bonds that are not available for trading (in other words the index is "float-adjusted").

    • Why other ETFs were not selected: Other ETFs in the category had higher expense ratios at the time of ETF selection. CSIA considers the potential impact to clients such as trading or other costs when selecting an ETF which would replace an existing ETF in the portfolios.

    U.S. Inflation Protected Bonds

    • What is it?
      U.S. inflation protected bonds are securities issued by the U.S. Treasury that protect investors against inflation by adjusting the principal value based on changes in the U.S. Department of Labor's Consumer Price Index. Like traditional Treasury bonds, they are backed by the full faith and credit of the U.S. government. Inflation protected bonds pay interest on a semi-annual basis, based on a fixed rate at issuance. The actual coupon payment may vary, since that fixed coupon rate is based on principal that adjusts for inflation or deflation. Inflation protected bonds are issued several times a year, with initial maturities of 5, 10, and 30 years. However, due to the passage of time, these bonds can be bought in the secondary market with various maturities. The principal value rises with inflation, and falls with deflation. The coupon payment is always based on the adjusted principal, even if it falls below its initial par value due to deflation. However, at maturity, investors will always receive the greater of the adjusted par value or its initial par value. In other words, the initial principal amount of an inflation protected bond is protected from deflation, but the coupon payments are not.
    • What role does it play in a portfolio?
      In 1997, the U.S. Treasury introduced inflation protected bonds as a means of protecting against the corrosive impact of inflation. With these bonds, the principal value adjusts upward with inflation, and downward with deflation. Inflation protected bonds can be a good addition to a fixed income portfolio for investors to help protect against the impact of inflation on their fixed income holdings.
    • When does it perform well?
      U.S. inflation protected bonds generally perform well when inflation rises, since the principal and coupons would both rise as well. The bonds may also perform well when inflation expectations rise, as investor demand can push the prices higher relative to traditional U.S. Treasuries, as investors seek inflation protection. Inflation protected bonds are still bonds whose prices and yields move in opposite directions. If traditional Treasury bond yields are falling, inflation protected bonds' yields may follow suit, pushing prices higher.
    • When does it perform poorly?
      Inflation protected bonds generally perform poorly if inflation is declining, outright deflation takes hold, or inflation expectations decline. If expectations for future inflation are tame, investors may prefer traditional Treasury bonds, pushing inflation protected bond prices lower. Also, if Treasury yields rise without an accompanying rise in inflation, inflation protected bond prices would likely fall as well.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Schwab U.S. TIPS 
    • Ticker
      SCHP 
    • Operating Expense Ratio
      0.05%
    • Secondary ETF
    • Name
      SPDR Portfolio TIPS 
    • Ticker
      SPIP
    • Operating Expense Ratio
      0.12% 

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: SCHP and SPIP both hold Treasury inflation-protected securities (TIPS) issued by the U.S. Treasury and representing a broad range of durations. These two funds each had more than $1 billion in assets under management and both ETFs have a history of closely tracking their underlying indexes and trading with relatively narrow bid-ask spreads.

    • Why other ETFs were not selected: iShares TIPS Bond (TIP) is the largest ETF in the category but had a higher expense ratio at the time of ETF selection. Among other ETFs in this category, Vanguard Short-Term Inflation-Protected Securities ETF (VTIP) and iShares 0-5 Year TIPS Bond ETF (STIP) limit their holdings to short durations.

    U.S. Corporate High Yield Bonds

    • What is it?
      U.S. corporate high yield bonds—sometimes known as "junk bonds"—are investments in the debt of US corporations with lower credit ratings provided by the major U.S. credit rating agencies. High yield bonds have ratings of BB+ or below by Standard and Poor's and Ba1 or below by Moody's Investors Services. That low rating indicates that these companies have relatively high default risk, meaning that the issuer is much more likely to not be able to meet its debt payment obligation as compared to an investment grade bond. Because these bonds are riskier than those issued by entities with investment-grade credit ratings, they generally pay a higher interest rate than a comparable investment grade bond.
    • What role does it play in a portfolio?
      High yield corporate bonds generally offer higher yields than investment grade corporate bonds, so they offer the potential to enhance the total return of a portfolio even more. Like investment grade corporate bonds, high yield corporate bonds allow investors to diversify by issuer, industry, maturity, and credit rating, among others. However, the diversification benefits that high yield corporate bonds offer are different from investment grade corporate bonds. High yield bonds have therefore tended to behave like stocks in times of distress, and might not necessarily help protect the downside like U.S. Treasuries or investment grade corporates might.

      High yield corporate bonds enjoy a yield advantage—called a credit spread—over comparable U.S. Treasuries, and the advantage is more than investment grade corporate bonds, though high-yield bonds also come with a greater risk of default. The high yield bond market is smaller than that of the investment grade corporate bond market, and the deal size of high yield bonds is smaller than that of investment grade corporate bonds, on average. This reduces the overall liquidity and leads to greater volatility for high yield corporate bonds.
    • When does it perform well?
      High yield corporate bonds tend to perform well when the economy is strong and default rates are low and are expected to remain low. In addition to the higher yields that corporate bonds offer, high yield corporate bonds can experience price appreciation as well. The yield advantage that corporate bonds offer relative to Treasuries is called a credit spread; it can be thought of as compensation for the extra risks they have. If the economic outlook is strong or default rates are expected to remain low, investors may accept lower compensation, as the perceived risks of default may decline. When the credit spread falls, the price of corporate bonds generally rises relative to U.S. Treasury bonds.
    • When does it perform poorly?
      High yield corporate bonds tend to perform poorly if economic growth slows and defaults are expected to rise. High yield corporate bonds tend to be much less liquid than investment grade corporate bonds, and are much more prone to significant sell-offs. For example, the Bloomberg Barclays U.S. Corporate High Yield Index suffered a total return of -26.2% in 2008 as expectations of a surge in defaults materialized. According to Moody's Investors Services, the trailing 12-month speculative grade default rate rose as high as 14% in 2009. In contrast, the Bloomberg Barclays U.S. Corporate Bond Index, a proxy for investment grade corporate bonds, only suffered a loss of -4.94% in 2008.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Xtrackers USD High Yield Corporate Bond
    • Ticker
      HYLB
    • Operating Expense Ratio
      0.15% 
    • Secondary ETF
    • Name
      iShares Broad USD High Yield Corporate Bond 
    • Ticker
      USHY
    • Operating Expense Ratio
      0.15%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: HYLB and USHY had the lowest net expense ratios among eligible ETFs in this category at the time of ETF selection. Both HYLB and USHY contain high yield corporate bonds with a broad range of durations. Each of these ETFs had sizable assets under management at the time of ETF selection and a history of trading with reasonable bid-ask spreads.

    • Why other ETFs were not selected: iShares iBoxx $ High Yield Corporate Bond (HYG) and SPDR Bloomberg Barclays High Yield Bond ETF (JNK) are the largest ETFs in this category but had significantly higher expense ratios at the time of ETF selection. iShares Fallen Angels USD Bond ETF (FALN) and VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL) were not selected due to sector and duration profiles that differ significantly from our strategic benchmarks. CSIA also considers the potential impact to clients such as trading or other costs when selecting an ETF that would replace an existing ETF in the portfolios.

    International Developed Country Bonds

    • What is it?
      International developed country bonds are debt instruments issued by a government, agency, municipality or corporation domiciled in a highly developed country other than the U.S. They may be issued in the home currency of the country of origin or denominated in U.S. dollars or some other currency. International developed country government bonds typically carry investment grade credit ratings, but some may be rated below investment grade. Corporate bonds issued in developed market countries may be investment grade or sub-investment grade.
    • What role does it play in a portfolio?
      International developed market bonds share several characteristics of securities issued by the U.S. government and corporations, but also offer geographic diversification benefits and exposure to international markets that may be at a different stage of the business cycle than the U.S. at any given time. If the bonds are denominated in a foreign currency, there can be a benefit from diversification from the U.S. dollar if the dollar is declining.
    • When does it perform well?
      International developed market bonds tend to perform well when the U.S. dollar is declining against other major currencies and/or interest rates in the U.S. are low relative to other major countries. As with all bonds, performance is strongest when interest rates and inflation are falling. When foreign bond yields are higher than U.S. yields for comparably rated bonds of similar maturity, investors often buy foreign bonds to capture the more attractive yields. They have also historically performed well when the U.S. stock market is declining, as that often leads investors to shift out of U.S. securities and into other markets. 
    • When does it perform poorly?
      International developed market bonds tend to perform poorly when the U.S. dollar is rising and/or interest rates and inflation are rising. Country specific events can affect the performance of international bonds as well, such as rising government budget deficits or adverse political developments. Monetary policies also affect the performance of international developed country bonds, both in terms of the direction of interest rates and credibility. A country with a central bank that has a history of managing inflation well may pay less interest on its bonds than one where lax central bank policies have allowed inflation to be higher. International corporate bonds, much like U.S. corporate bonds, tend to perform poorly when the issuing company is experiencing poor growth in earnings or perhaps has increased its balance sheet leverage through high borrowing.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Vanguard Total International Bond
    • Ticker
      BNDX
    • Operating Expense Ratio
      0.08%
    • Secondary ETF
    • Name
      iShares Core International Aggregate Bond
    • Ticker
      IAGG
    • Operating Expense Ratio
      0.08%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: Both BNDX and IAGG offer currency-hedged exposure to international bonds issued by both governments and corporations in developed markets. By hedging currency exposure to the U.S. dollar, these funds aim to capture interest rate differentials (i.e. higher interest rates in foreign markets as compared to those in the U.S.) without exposing U.S. investors to volatile currency fluctuations. Additionally, both funds are broadly diversified by maturity and overwhelmingly investment grade. They also trade with bid-ask spreads within our acceptable range.

    • Why other ETFs were not selected: The category consists of just two ETFs that meet asset class objectives and other criteria.

    International Emerging Market Bonds

    • What is it?
      International emerging market bonds (EM bonds) are issued by a government, agency, municipality or corporation domiciled in a developing country. These investments typically offer higher yields to reflect the elevated risk of default, which can stem from underlying factors such as political instability, poor corporate governance and currency fluctuations. The asset class is relatively new compared with other sectors of the bond market. Indices that track EM bonds only date back to the 1990s when the market became liquid and actively traded. EM bonds may be denominated in local currency or in U.S. dollars or other major currencies. While some EM countries have taken on the characteristics of developed market economies, with more stable fiscal and monetary policies and sounder financial institutions, there remain wide differences among the countries categorized as emerging markets.
    • What role does it play in a portfolio?
      An allocation to EM bonds can provide investors with a source of higher income than developed market bonds might offer and the potential for capital appreciation. The potential upside, however, comes with more risk. Defaults among EM bonds have historically been higher than for developed market bonds. EM bonds tend to be more highly correlated with equities than with U.S. Treasuries or developed market international bonds. The correlation between U.S. dollar-denominated EM bonds, as measured by the Bloomberg Barclays Emerging Markets USD Aggregate Bond Index and the S&P 500 for the 20-years ending March 2021, was 0.53. EM bonds, if denominated in local currency, can provide another source of diversification in a portfolio. However, EM currencies also tend to be much more volatile than developed market currencies. Corporate bonds issued by companies in EM countries can offer access to fast-growing economies with higher yields than might be available in developed market corporate bonds.
    • When does it perform well?
      EM bonds tend to perform well when the U.S. dollar and other major currencies like the euro or Japanese yen decline because EM assets look more attractive by comparison. A growing global economy tends to benefit EM country bonds as well since exports generally represent a bigger proportion of EM economies. A low interest rate, low volatility environment has also tended to be positive for EM bonds because investors are attracted to the higher interest rates EM bonds offer.
    • When does it perform poorly?
      In addition to the factors that contribute to the poor performance of developed country bonds, EM bonds tend to perform poorly when investors are averse to taking risk or when global growth slows. Since many EM countries derive much of their growth from exports to developed countries, slower growth in trade globally tends to be a negative factor for the economies and currencies of EM countries.
    • ETF Selection

    ETF Selection Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      SPDR® Bloomberg Barclays Emerging Markets Local Bond
    • Ticker
      EBND
    • Operating Expense Ratio
      0.30% 
    • Secondary ETF
    • Name
      VanEck Vectors JP Morgan EM Local Currency Bond
    • Ticker
      EMLC
    • Operating Expense Ratio
      0.30% 

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: EBND and EMLC had expense ratios which are among the lowest in this asset class at the time of ETF selection. Both EBND and EMLC have a history of trading with reasonable bid-ask spreads (which can be difficult to do in the EM bond space).

    • Why other ETFs were not selected: In Morningstar's U.S. Fund Emerging-Markets Local Currency Bond category, there are also single-country and single region options (e.g. CBON and KCNY). We did not select any of these ETFs as they do not match our strategic benchmark and fail to meet the asset class objectives. CSIA also considers the potential impact to clients such as trading or other costs when selecting an ETF that would replace an existing ETF in the portfolios.

    Preferred Securities

    • What is it?
      Preferred securities are a "hybrid" investment, sharing characteristics of both stocks and bonds. In recent years, the term "preferred securities" has often been used as a blanket term to encompass anything from $25 par senior debt to traditional preferred stock. Like stocks, they are generally paid after a company's bonds in the event of a corporate liquidation. Like bonds, however, they generally make regular fixed payments and have a par value that can rise or fall as interest rates change. Preferred securities are senior to common stock – meaning their holders have priority over holders of common stock in the event of a claim on the company's assets – and some rank as high as senior unsecured bonds. This asset class is "preferred" because holders of such securities have claim on the company's earnings before dividend payments can be made on common stock. Preferred securities generally offer higher yields than traditional fixed income securities like bonds. Preferred securities often have very long maturities – usually 30 years or more – or no maturity date at all, meaning they are perpetual. However, most preferred securities have "call" features, allowing the issuing firm to retire them, at their par value, before maturity. Due to the perpetual nature of some preferred securities, there's no guaranteed return of principal. The prices of preferred securities can fluctuate, so investors needing to sell might receive less than their initial investment if they sell in the secondary market. Also, companies can suspend or cancel a preferred dividend payment at will, without facing the consequences of a default.
    • What role does it play in a portfolio?
      Preferred securities can help investors earn a higher yield and potentially enhance the overall total return of a portfolio. However, they do come with some unique risks. An issuer's preferred securities will usually have a lower credit rating than the firm's senior, unsecured bonds, due to the weaker guarantees of the income payments. Also, preferred securities tend to be issued by financial institutions, meaning it's difficult to have a preferred securities portfolio that is well diversified among various sectors. And there are significantly fewer preferred securities issuers than there are corporate bond issuers, so it's more difficult to be diversified by issuer as well.
    • When does it perform well?
      Preferred securities tend to do best when long-term bond yields are stable or falling, and the economic outlook is positive. Preferred securities have two key risks: interest rate risk and credit risk. If long-term interest rates are falling, the prices of preferred securities would likely rise. Preferred securities tend to have high durations, a measure of interest rate sensitivity, so their prices are very sensitive to a fall in interest rates. Also, preferred securities may perform well when investors demand less of a credit spread to hold them, which would push their prices higher relative to U.S. Treasuries.
    • When does it perform poorly?
      Preferred securities tend to do poorly when long-term interest rates are rising, due to their relatively high durations. Preferred securities also tend to do poorly when the perceived credit risk of the corporate market increases, as the risk rises that issuers could suspend the dividend or interest payments.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Global X U.S. Preferred
    • Ticker
      PFFD
    • Operating Expense Ratio
      0.23%
    • Secondary ETF
    • Name
      SPDR Wells Fargo Preferred Stock
    • Ticker
      PSK
    • Operating Expense Ratio
      0.45%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: PFFD and PSK were selected as the primary and secondary ETFs because each provides broad, diversified exposure to this asset category and has traded historically with a relatively narrow average bid-ask spread. Our primary ETF, PFFD is also the lowest cost ETF in this asset class.

      Why other ETFs were not selected: VanEck Vectors Preferred Securities ex Financials ETF (PFXF) excludes securities of financial institutions. These securities make-up as much as 75% of the preferred market, so PFXF did not provide the intended broad asset class coverage. Invesco Preferred ETF (PGX) and Invesco Financial Preferred ETF (PGF) had higher expense ratios at the time of ETF selection.

    Bank Loans

    • What is it?
      Bank loans are originated by banks and sold to institutional investors like mutual funds or ETFs. The loans are made to corporations, which use them to fund acquisitions and other strategic initiatives. The loans typically have floating rates, meaning they pay a set amount over a benchmark interest rate, often the 3-month London Interbank Offered Rate (Libor). Bank loans are generally rated below investment grade, meaning BB+ or below by Standard & Poor's or Ba1 or below by Moody's Investors Services. Bank loans are usually "secured," which means that they are backed by a pledge of the issuer's assets, such as inventories or receivables. And they are generally senior to most other corporate debt; so in default, they would get paid before the issuer's other corporate bonds. Due to bank loans' senior and secured status, they generally have higher recovery rates in the case of a default. Since bank loans are rated below investment grade, they generally carry higher yields than investment grade corporate bonds.
    • What role does it play in a portfolio?
      Under certain conditions, these types of loans and notes can be attractive to investors who think short-term interest rates may rise. Since they are rated below investment grade, they should be considered an aggressive investment relative to other types of fixed income. The coupons are tied to short-term interest rates. If long-term interest rates rise, the coupons on bank loans would likely be unaffected. Also, most bank loans have a "Libor floor," which is the minimum rate for Libor on which the coupon will be based. This means that Libor would need to rise to that level before the coupons started to adjust higher.
    • When does it perform well?
      Bank loans tend to perform well when short-term interest rates—specifically 3-month Libor—are rising and default rates remain low. In this scenario, investors can benefit from higher coupons payments, with less risk of prices falling due to defaults. Bank loans also perform well when market volatility is lower, since they tend to suffer from low liquidity.
    • When does it perform poorly?
      Bank loans can perform poorly when short-term interest rates are falling. In this scenario, the coupon payments would decline, likely reducing the total return. Bank loans tend to perform poorly when the economy is expected to slow and defaults rates are rising or expected to rise. Despite their "senior, secured" status, bank loans are still aggressive investments.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Invesco Senior Loan 
    • Ticker
      BKLN 
    • Operating Expense Ratio
      0.65% 
    • Secondary ETF
    • Name
      N/A
    • Ticker
      N/A
    • Operating Expense Ratio
      N/A

    Source: Morningstar Direct, as of 3/31/2021.

    • Why this ETF was selected: BKLN is currently the only ETF in this asset class that meets our eligibility criteria. BKLN has large assets under management and has historically traded at a relatively narrow bid-ask spread.

    • Why other ETFs were not selected: No other ETFs in this asset class met our eligibility criteria.

    Investment Grade Municipal Bonds

    • What is it?
      Investment grade municipal bonds are investments in bonds issued by municipalities—cities, states, counties—as well as enterprises that serve a public purpose, such as universities, hospitals and utilities. These investments generally have high credit ratings from various rating agencies. The coupon payments made by these bonds are typically exempt from federal and state income tax (if issued by a municipality located within the resident's state). However, other taxes may apply.  For example, tax-exempt income may be subject to the Alternative Minimum Tax (AMT), capital appreciation from bond funds and discounted bonds may be subject to state or local taxes, and capital gains are not exempt from federal income tax. Despite the high-profile credit problems of some municipalities, almost all U.S. cities have been able to cut spending or increase revenue to support payments even during tough economic times, and so historically, defaults for investment-grade municipal bonds have been exceedingly rare. In fact, between 1970 and 2017, less than 100 municipal issuers rated by Moody's defaulted.
    • What role does it play in a portfolio?
      Investment grade municipal bonds combine strong historic creditworthiness and tax advantages. Interest income earned on most municipal bonds is not subject to federal taxes, an advantage compared to corporate and Treasury bonds for investors in higher tax brackets or investing in taxable accounts. Like other bonds, they often move in the opposite direction of stocks, so they can provide diversification benefits as well as income.
    • When does it perform well?
      Like most bonds, investment grade municipal bonds tend to perform best when interest rates are falling and inflation is low. Money used to pay municipal bonds tends to be tied to tax revenues or usage fees, so they often perform well when the economy is improving and tax receipts or usage is high. Municipal bonds tend to perform similarly to Treasury and corporate bonds, based on changes in market interest rates. Other factors, however, can cause differences in performance including higher or lower demand for the tax advantages. Already issued municipal bonds often tend to trade infrequently compared to many other fixed income markets. Therefore, municipal bonds may also do well compared to other fixed income investments when the amount of newly issued municipal bonds is low because the scarce supply can drive prices up.
    • When does it perform poorly?
      When interest rates are rising or inflation is high, investment grade municipal bonds tend to perform poorly. They also tend to perform poorly when, among other things, municipal credit conditions are deteriorating (often driven by lower tax revenues or higher municipal expenses). The municipal bond market is also more prone to headline risk—or the risk that investors will sell their investments due to a single negative event that is not actually impacting the rest of the market—compared to other markets. Because municipal bonds pay interest that is generally exempt from federal taxes, lower federal tax rates make municipal bonds less attractive compared with other taxable fixed income investments because it reduces the benefit of the tax exemption. While the municipal bond market has a lot of debt outstanding, the size of this market is much smaller than others such as U.S. Treasuries. This smaller size increases the potential liquidity risk, which can drive down prices when selling into an illiquid market.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      Vanguard Tax-Exempt Bond
    • Ticker
      VTEB
    • Operating Expense Ratio
      0.06%
    • Secondary ETF
    • Name
      SPDR® Nuveen Bloomberg Barclays Municipal Bond ETF
    • Ticker
      TFI
    • Operating Expense Ratio
      0.23%

    Source: Morningstar Direct, as of 3/31/2021.

    • Why these ETFs were selected: Among the eligible ETFs in this category, VTEB is the ETF with the lowest expense ratio that met all other criteria at the time of ETF selection. TFI has the second lowest expense ratio among ETFs that provide exposure to broad duration munis and tracks an index that is not identical to the primary ETF.

    • Why other ETFs were not selected: iShares National Muni Bond ETF (MUB) is the largest ETF in this category but tracks an index that is identical to the primary ETF and therefore not suitable for tax loss harvesting. VanEck Vectors AMT-Free Intermediate Muni ETF (ITM) and Invesco National AMT-Free Muni Bond ETF (PZA) had higher expense ratios at the time of ETF selection. 

    Investment Grade California Municipal Bonds

    • What is it?
      Investment grade California municipal bonds are investments in bonds issued by municipalities and enterprises in the State of California. These investments generally have high credit ratings from various rating agencies. The coupon payments made by these bonds are exempt from federal and California state income tax for California residents.  However, other taxes may apply. For example, tax-exempt income may be subject to the Alternative Minimum Tax (AMT), capital appreciation from bond funds and discounted bonds may be subject to state or local taxes, and capital gains are not exempt from federal income tax. Despite the high-profile credit problems of some municipalities, most U.S. cities have been able to cut spending or increase revenue to support payments even during tough economic times, and so historically, defaults for investment-grade municipal bonds have been exceedingly rare. 
    • What role does it play in a portfolio?
      Investment grade municipal bonds combine strong historical creditworthiness and tax advantages, with an additional tax advantage for California residents. Like most other bonds, they tend to have lower correlations with stocks, so they can also provide diversification benefits.
    • When does it perform well?
      Like most municipal bonds, investment grade California municipal bonds tend to perform best when interest rates are falling and inflation is low. Money used to pay municipal bonds tends to be tied to tax revenues or usage fees, so they often perform well when the economy is improving and tax receipts or usage is high. Already issued municipal bonds often tend to trade infrequently compared to many other fixed income markets. Therefore, municipal bonds in general may also tend to perform well compared to other fixed income investments when the amount of newly issued municipal bonds is low because the scarce supply can drive prices up.
    • When does it perform poorly?
      When interest rates are rising or inflation is high, investment grade California municipal bonds tend to perform poorly. They also tend to perform poorly when the local economy is deteriorating. This can impact tax revenue or usage fees, which are generally tied to the source of repayments for municipal bonds. Compared with other markets, the municipal bond market is also more prone to headline risk—or the risk that investors will sell their investments due to a single negative event that is not actually impacting the rest of the market. While California has a large amount of debt outstanding, the size of its market is much smaller than others such as U.S. Treasuries. This smaller size increases potential liquidity risk, which can drive down prices when selling into an illiquid market.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      iShares California Muni Bond
    • Ticker
      CMF
    • Operating Expense Ratio
      0.25%
    • Secondary ETF
    • Name
      Invesco California AMT-Free Municipal Bond
    • Ticker
      PWZ
    • Operating Expense Ratio
      0.28%

    Source: Morningstar Direct, as of 3/31/2021.

    Why these ETFs were selected: These are the only two ETFs meeting all selection criteria that provide dedicated exposure to California municipal bonds. PWZ and CMF have both traded historically with reasonable bid-ask spreads. Both funds are AMT-free.

    Why other ETFs were not selected: There were no other ETFs meeting all selection criteria in this category at the time of ETF selection.

    Commodities

    Gold and Other Precious Metals

    • What is it?
      Precious metals include gold, silver, platinum, and other precious metals.
    • What role does it play in a portfolio?
      This asset class adds diversification to a portfolio and is typically considered defensive because of its tendency to perform well when financial assets (e.g., stocks and bonds) perform poorly.
    • When does it perform well?
      Precious metals tend to perform well when expectations for future inflation are increasing, the U.S. dollar is falling, geopolitical unrest is rising, or there are widespread concerns about the stability of the financial system.
    • When does it perform poorly?
      Precious metals tend to perform poorly when expectations for future inflation are decreasing, the U.S. dollar is rising, geopolitical unrest is falling, or concerns about financial system stability are declining.
    • ETF Selection

    ETF Table

    • Name
    • Ticker
    • Operating Expense Ratio
    • Primary ETF
    • Name
      iShares Gold Trust
    • Ticker
      IAU
    • Operating Expense Ratio
      0.25%
    • Secondary ETF
    • Name
      Aberdeen Standard Physical Precious Metals Basket Shares
    • Ticker
      GLTR
    • Operating Expense Ratio
      0.60%

    Source: Morningstar Direct, as of 3/31/2021.

    Why these ETFs were selected: Commodities exposure within Schwab Intelligent Portfolios is limited to gold and other precious metals because ETFs that focus on other commodities tend to be structured as exchange traded notes (ETNs) and/or issue K-1 reports, making them ineligible for the program. In the precious metals category, IAU was selected as the primary ETF because it has an expense ratio that is among the lowest in the asset class while meeting all the other criteria at the time of ETF selection. GLTR was selected as the secondary ETF because it does not focus on the exact same assets, which is necessary for tax loss harvesting purposes. IAU's portfolio consists entirely of gold bars held in vaults around the world, while GLTR's portfolio also includes silver, platinum and palladium.

    Why other ETFs were not selected: CSIA considers the potential impact to clients such as trading or other costs when selecting an ETF which would replace an existing ETF in the portfolios.

    FDIC-insured Cash

    • What is it?
      The FDIC-insured cash allocation8 in Schwab Intelligent Portfolios is invested in the Schwab Intelligent Portfolios Sweep Program, which is sponsored by Charles Schwab & Co., Inc. By enrolling in Schwab Intelligent Portfolios, clients consent to having the free credit balances in their brokerage accounts swept to deposit accounts at Schwab Bank. These deposit accounts will earn interest at a rate that will be greater of (i) the rate determined by reference to a third party index for retail deposits at the $100,000 level based on a survey as calculated by RateWatch; or (ii) the rate paid on cash balances of $1,000,000 or more in Schwab’s bank sweep program for brokerage accounts. See the current interest rate by going to schwab.com/intelligent-cashrate.
    • What role does it play in a portfolio?
      Cash investments play an important role within a well-diversified investment portfolio and serve several purposes, including greater stability, diversification and potential inflation protection. Schwab Intelligent Portfolios includes cash as an investment to help provide a stable foundation within an overall asset allocation that includes other asset classes such as equities, bonds and commodities. Cash allocations are determined according to an investor’s risk profile, with the most risk-averse or short-term portfolios holding the highest levels of cash and the least risk-averse or longer-term ones holding the lowest levels of cash. A meaningful cash allocation provides stability to help mitigate downside risk. Lower portfolio risk can help moderate downturns and keep investors focused on their longer-term goals rather than overreacting to short-term market movement.
    • When does it perform well?
      Cash tends to do well relative to other asset classes during periods of rising interest rates because its duration is so short. Cash is also a member of the "defensive asset" club. The price movements of defensive assets generally have low or negative correlations with those of equity securities. Defensive asset classes tend to perform well when there is downward pressure on equities. What makes cash unique among other defensive assets is that it has the lowest price volatility of the group. Other defensive assets (e.g., gold) have a great deal of price volatility associated with them.
    • When does it perform poorly?
      Cash may underperform in a very low interest rate environment where the central bank is keeping short-term interest rates low to stimulate economic growth, such as in the aftermath of the U.S. financial crisis. Since cash is very liquid, the rate paid to investors is generally low compared to the yield on other securities.