Your Complete Schwab ETF Guide

Charles Schwab (SCHW 0.34%) introduced ETFs, or exchange-traded funds, in 2009. In the time since, it's become a market leader, offering industry-leading low expense ratios and setting the trend for commission-free ETF trading.

Schwab has 22 ETFs, fewer than competitors such as Vanguard. Dedicated ETF issuers such as Blackrock iShares and Invesco Powershares have hundreds of different ETF products. So Schwab's ETF selection is relatively manageable, comparatively speaking, and easy to get your arms around.

Here's your complete guide to Schwab ETFs.

Image source: Getty Images.

What's an ETF?

An ETF, or exchange-traded fund, is a securitized basket of stocks, bonds, or various other investable assets. Investors can buy shares of an ETF and gain exposure to a proportional share of the underlying portfolio. It allows investors to quickly and simply diversify their portfolio with a single security.

ETFs are very similar to mutual funds, but as the name implies, they're traded on an exchange just like stocks and bonds. Mutual funds, by comparison, are bought and redeemed through the issuing company. ETFs are bought and sold through brokers that match up buyers and sellers. ETFs, therefore, trade throughout the day, while mutual funds trade once a day, after the market closes.

Most ETFs track a market index. An index is a group of securities. The index makers use a weighted average of the prices of each security to develop a level. Investors can use an index's level to describe the current market.

The level isn't the same as a price. Buying an index would require you to buy each individual stock in that index according to the index's specified weight. That could add up to a lot of commission fees. ETFs can use their scale to cut costs and make it easy for investors to keep up with the market returns.

ETFs also have a share creation and redemption mechanism that makes them incredibly tax efficient. Instead of sending money to the ETF issuer and having the issuer create more shares, like a mutual fund, ETF issuers require broker/dealers to put together the exact portfolio of stocks, bonds, and other securities the ETF holds. When a broker/dealer wants to redeem shares of the ETF, the issuer exchanges all of the individual securities in the portfolio for shares. That way, the issuer isn't facing buying and selling decisions every day, and it avoids most capital gains taxes.

Note the expense ratio

There are some fees to watch for when investing in ETFs. The most important is the expense ratio -- the percentage of holdings the issuer charges. Schwab ETFs have some of the lowest expense ratios in the industry.

Expense ratios can eat into your investment returns, but you probably won't even notice them with Schwab. If you have $10,000 invested in the Schwab U.S. Broad Market ETF, which has an expense ratio of 0.03%, you'd pay about $3 per year. Other ETFs can have expense ratios over 1%, which you'll definitely notice on your brokerage statement.

Pay attention to expense ratios, or your returns could suffer. Even if an ETF can produce a better gross return (before fees), a high expense ratio could leave investors with lower net returns (after fees). For example, if the Schwab U.S. Broad Market ETF had a gross return of 8% on average over the course of five years, investors would see a return close to 7.97%. An ETF that's able to produce higher average returns, say 8.25%, but has a higher expense ratio, say 0.3%, would net investors 7.95%. While the difference may seem negligible, also consider the fact that returns aren't guaranteed, but expenses are.

Another expense worth paying attention to is the commission fee -- the amount you pay each time you buy or sell shares of an ETF (or any other security). If you're buying or selling a Schwab ETF on Schwab's brokerage platform, you won't pay any commissions. If you're on another platform, you probably will.

Most brokers, including Schwab, offer a list of commission-free ETFs that includes ETFs issued by the brokerage company and some third-party ETFs. So when deciding between two ETFs, be sure to check what you'll pay in commissions, especially if you'll be making regular repeat purchases.

The two ways Schwab categorizes its equity ETFs

Schwab offers two types of equity ETFs: market-cap ETFs and Fundamental Index ETFs.

Market-cap ETFs, as the name implies, benchmark indexes to their portfolio holdings based on market capitalization. Examples include the Schwab 1000 Index and Dow Jones U.S. Small-Cap Total Stock Market Index. The former aims to track the 1,000 largest companies traded on the U.S. stock market. The latter aims to track 1,750 stocks near the bottom of the list of companies sorted by market capitalization -- the total market value of a company's outstanding shares of stock.

Schwab's Fundamental Index ETFs track various Russell RAFI indexes. The Russell RAFI index series selects stocks based on certain fundamental variables, such as adjusted sales -- which is the company's revenue adjusted for any anomalous items. Schwab describes the Fundamental Index ETFs as a "cost-effective alternative to active management." Active management is used to describe mutual funds that have a portfolio manager actively buying and selling stocks in an effort to meet or exceed a benchmark index.

Market-cap ETFs will generally have lower fees and fewer changes in the portfolio holdings, , and they'll generally produce returns in line with the benchmark index they track. Fundamental Index ETFs require rebalancing the portfolio on a regular basis, and the rules-based portfolio rules means more turnover -- i.e., change in the portfolio holdings. They do, however, provide potential alpha -- a measure of returns in excess of a portfolio's perceived risk -- for investors looking to best market returns. (That's no guarantee that they will outperform the market capitalization index, though.)

Market-capitalization Schwab ETFs

Schwab offers several straightforward market-capitalization ETFs that offer easy ways to invest in large-cap, mid-cap, and small-cap companies trading on the U.S. stock market, or the entire U.S. stock market in general. 

Large-cap companies are generally considered any company with a market capitalization above $10 billion. Mid-cap companies have a market cap between $2 billion and $10 billion, and small-cap companies are worth less than $2 billion. Of course, there are daily fluctuations in market capitalization, so the cut-offs aren't so strict.

Here are Schwab's market-cap-based ETFs:

Data source: Schwab.

All of these ETFs have extremely low expense ratios. The Schwab U.S. Broad Market ETF expense ratio of 0.03% led the way to that level, with few other competitors able to follow. The popular Vanguard Total Stock Market ETF (VTI 1.09%), which tracks a similar index, has an expense ratio of 0.04%.

Investors simply looking to invest in U.S. stocks based on market cap will do well with Schwab's ETFs. They're simple and straightforward, and you'd be hard pressed to find an issuer with better expense ratios.

Investment-strategy ETFs

Schwab offers a limited number of strategy ETFs for investors looking for a specific style of investment.

Data source: Schwab

Investors interested in a particular investment strategy may be left wanting by Schwab's ETF choices. The company offers just three different investment strategies, and I hope large-cap stocks suit your needs.

Growth stocks have shown strong revenue and earnings growth over the past few years. These stocks are often more expensive than value stocks, which represent companies whose stock trades at a relative discount to their earnings. Value stocks are generally more mature and growing earnings at a much slower pace than growth stocks.

Stocks found in a dividend-focused index like the Dow Jones U.S. Dividend 100 Index include high-yield dividend payers. These stocks also often represent more mature, slower-growing companies, but the stocks don't necessarily trade at a discount to their earnings results.

Investors interested in small-cap value stocks or dividend growth stocks won't find what they're looking for from an ETF from Schwab. Schwab keeps things incredibly simple, and that allows it to maintain very low expense ratios.

Sector ETFs

If you're looking to invest in a specific sector of the stock market, you'll probably have to look beyond Schwab's ETFs. The only sector it offers an ETF for is real estate.

Data source: Schwab

For investors interested in U.S. real estate investment trusts, a type of company that pools money to invest in real estate, the Schwab U.S. REIT ETF is a very good option. It has a significantly lower expense ratio than peers such as the SPDR Dow Jones REIT ETF (RWR 0.55%), which tracks the same index but charges a 0.25% expense ratio. Other ETFs tracking similar indexes still charge more.

But people looking to invest in sectors besides real estate won't find anything from Schwab.

International ETFs

Schwab has a few options for investors interested in international markets.

Data source: Schwab.

Again, Schwab keeps things simple. Investors won't find ways to invest in specific countries or regions. But for investors seeking simple international exposure, Schwab's international ETFs can get the job done.

Fixed-income ETFs

Schwab offers access to some government bonds, as well as one general bond ETF.

Data source: Schwab

The Aggregate Bond ETF includes Treasury securities, government agency bonds, mortgage-backed bonds, corporate bonds, and some foreign bonds that are publicly available for sale in the United States. It tracks a very broad-based index, and it will give investors a general exposure to the U.S. bond market. For someone who doesn't know much about investing in bonds, the Aggregate Bond ETF from Schwab covers all the bases to balance a portfolio's need for bond exposure.

Investors who want more specific bond funds are stuck with TIPS -- Treasury Inflation-Protected Securities -- or short- and intermediate-term treasuries. The value of TIPS is tied to inflation, as measured by the Consumer Price Index.

Schwab's short-term Treasury bond ETF mostly holds bonds with maturities between one and three years. That is, the Treasury will pay back the full principal of the bond note within just a few years. The intermediate-term ETF holds bonds with longer maturities, between three and 10 years. Note that bonds with longer maturities generally carry higher interest rates because there's an increased risk the issuer will default. If the U.S. Treasury defaults, however, you might have bigger things to worry about than your bond portfolio.

Fundamental Index ETFs

Schwab introduced Fundamental Index ETFs in 2013 to track the Russell RAFI Index Series. The Russell RAFI indexes use mathematical formulas based around three fundamental metrics -- adjusted sales, retained operating cash flow, and dividends plus buybacks -- to determine which stocks to include and which ones to exclude. Adjusted sales is a measure of revenue, excluding one-time items or changes in accounting standards. Retained operating cash flow is a measure of how much cash the company keeps every year. Dividends are how much the company pays to shareholders, and buybacks are the amount the company spends buying shares of its own company on the open market. Both are ways to return excess earnings to shareholders.

Schwab offers three domestic Fundamental Index ETFs and three international ETFs.

Data source: Schwab.

The Fundamental Index ETFs have considerably higher expense ratios than their market cap-based counterparts. In addition, the rebalancing and greater portfolio turnover can result in greater tax liabilities for shareholders.

At the same time, it's not clear the Russell RAFI methodology is capable of producing better returns. The Schwab U.S. Broad Market ETF has outperformed the Schwab Fundamental U.S. Broad Market Index ETF over the past five years. On the other hand, the small-cap and emerging-market versions of Schwab's Fundamental Index ETF have outperformed their market-cap ETF counterparts.

Image source: Getty Images.

Schwab has the basics covered

Schwab has a core group of basic ETFs that will allow most investors to meet their needs of investing in broad-based index funds that cover the U.S. stock market, the international stock market, and the U.S. bond market. Keeping things simple allows it to keep its expenses low, and it consistently beats the competition with single-digit basis-point expense ratios.

Schwab's Fundamental Index ETFs offer a way for investors to experiment with smart-beta, which uses advanced algorithms to expand on regular index investing, but it's not clear whether they're worth the higher expenses and potential taxes.

Investors interested in moving beyond the basics should consider Schwab ETFOneSource, which offers a variety of ETFs that trade commission-free on Schwab's brokerage platform.

Using Schwab ETFOneSource to expand beyond the basics

Schwab issues just 22 ETFs, so investors could be left looking to a different issuer to invest in their interested market strategy or sector. Investors using Schwab as their brokerage account should look to the ETFOneSource options first. Schwab won't charge any commissions on these ETFs, and investors can find ETFs covering strategies such as small-cap value stocks and sectors such as utilities.

Investors can find a lot of interesting ETFs on Schwab's OneSource, but pay attention to expense ratios, which will be considerably higher than Schwab's own ETFs. The more specialized the ETF, the higher the expense ratio. It's worth doing further research to see if it's worth paying a commission on an ETF with a lower expense ratio.

How to buy Schwab ETFs

Schwab offers plenty to get started building a simple ETF portfolio, with its own issued ETFs and the ETF OneSource commission-free ETFs. If investors can't find a suitable commission-free option, Schwab's brokerage commissions are relatively low, so paying for a couple of trades won't break the bank.

Buying shares of an ETF is just like buying shares of a stock. After funding your account, you're ready to buy shares.

On Schwab's website, or your broker of choice, simply type in the ETF ticker and the number of shares you'd like to buy. If it's a commission-free ETF, you'll pay only for your shares. Otherwise, you'll have to make sure you have enough cash in your account to cover the share price and the added commission fee.

You should see your order go through immediately, and when your broker fills your order, the shares of your ETF will be in your account. It's as simple as that.