Equity index products are plentiful, but cheap muni funds are scant.
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By Christine Benz | 09-14-15 | 06:00 AM | Email Article

There's much to like about investment supermarkets like Schwab's. They allow investors to graze among individual stocks and bonds, as well as mutual funds and exchange-traded funds. Supermarket investors can build portfolios composed of investment products from many different firms, but yet receive a single statement and trade on a single platform. By offering distribution, supermarkets have also arguably allowed small investment managers to gather assets (which can bring down total costs) even though they have little distribution muscle of their own. 

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

Yet, just as the big brand-name cereal makers have to pay for eye-level placement on your grocery store shelves, mutual funds, too, have to pay for placement in a fund supermarket. To gain access to a supermarket, mutual funds have to pay, and those fees usually show up in the form of a 12b-1 fee. 

Those extra fees for distribution aren't a deal breaker in the realm of stock funds, but they're more impactful for bond funds, especially given that returns for the asset class are apt to be muted over the next decade. If an intermediate-term bond fund returns a gross 3% over the next decade, a 0.75% expense ratio will eat up a fourth of that return, whereas a fund with a 0.30% expense ratio would cede just 10% of its return to costs. 

In my article about bucket retirement portfolio for Schwab supermarket investors in tax-deferred accounts, I noted that some of Morningstar's favorite low-expense bond funds were unavailable on a no-transaction-fee basis--Fidelity, Vanguard, T. Rowe Price, and Dodge & Cox, for example. The same challenge exists for investors looking to use Schwab's supermarket for their taxable accounts: Inexpensive municipal-bond options that are available without a load or transaction fee are few and far between. Using Schwab's screener, I identified just a handful of municipal-bond funds with expense ratios of less than 0.50% and no load or no transaction fee when purchased on Schwab's platform. (That list also included some state-specific muni funds that wouldn't be appropriate for this exercise.) 

For this series of taxable model portfolios, I stuck with the NTF platform and included bond funds whose expense ratios are higher than I would consider ideal. Schwab's core equity-index ETFs and funds are solid and cheap, which helps the portfolios on the total-cost front. But rather than purchase pricey bond funds that are available on a no-transaction-fee basis, buy-and-hold investors could sensibly pay a transaction fee to obtain access to lower-cost funds such as those from Fidelity. 

Bucket Basics
As with all of the portfolios, I used a "bucket" strategy. The basic idea of bucketing, as envisioned by financial-planning guru Harold Evensky, is to hold a cash component to cover near-term living expenses alongside a long-term total-return-oriented portfolio. The cash buffer should enable the retiree to better handle the fluctuations that will inevitably accompany the long-term portfolio. The retiree then periodically refills the cash bucket as she spends it, using income distributions from the long-term holdings, rebalancing proceeds, or both. 

I used Morningstar's Lifetime Allocation Indexes to guide the asset-class exposures for these tax-efficient Schwab portfolios. However, it's worth noting that retirees should customize their own asset allocations based on the extent to which they're spending from their portfolios. Say, for example, a retiree expects to spend 3% of her portfolio per year. Her bucket one (cash) would hold 6% of her portfolio (two years' worth of living expenses), her bucket two might hold another 24% of her portfolio (3% of her portfolio times eight years), and the remainder of her assets would go into bucket three. 

To help populate the portfolios with specific funds, I cross-referenced the output from my Schwab screens with  Morningstar's medalist ratings

Aggressive Bucket Portfolio
Anticipated Time Horizon: 25 or more years 

Bucket 1: Years 1-2
8%: Cash (certificates of deposit, money market accounts, and so forth; percentages will vary based on amount of assets and spending rate) 

Note that the percentage of a retiree's portfolio that goes into bucket one should be determined by his or her anticipated spending from that taxable portfolio. A retiree who is taking less from her taxable portfolio than the 4% per year spending I've assumed here (4% times two years), perhaps because required minimum distributions from her IRA fulfill most of her living expenses, would necessarily have a lower percentage of that portfolio in bucket one. Of course, cash yields are extremely modest right now, so it's important not to stake too much in bucket one; the long-term opportunity costs are too great. Online savings accounts will tend to provide the highest yields today. 

Bucket 2: Years 3-10
10%:  Wells Fargo Advantage Short-Term Municipal Bond
22%:  BlackRock National Municipal  

Wells Fargo Advantage Short-Term Municipal Bond serves as the portfolio's next-line reserves, to be tapped if bucket one is running dry and income distributions and/or rebalancing proceeds from buckets two and three are insufficient to refill it. A few other medalist short-term funds are available on the Schwab no-transaction-fee, no-load platform, but this Bronze-rated fund offered the best combination of seasoned management, risk controls, and not-egregious fees. Note that longtime manager Lyle Fitterer and his team have usually favored a more credit-sensitive profile rather than taking on duration risk. 

For the longer-term portion of bucket two, I've employed the Bronze-rated BlackRock National Municipal, which draws upon the firm's deep resources and experience managing municipal-bond money. (Senior analyst Beth Foos notes that the firm currently runs about $100 billion in muni assets.) Foos notes that the fund's modest use of leverage has the potential to heighten volatility, but she points out that over time the fund has been no more volatile than its typical muni-national intermediate-term category peer. 

Bucket 3: Years 11 and Beyond
45%:  Schwab U.S. Broad Market ETF
15%:  Schwab International Equity ETF  

Putting together a tax-friendly equity portfolio at Schwab is a lay-up. Not only does the firm field a lineup of very low-cost traditional index funds, but Schwab investors can also buy and sell a broad swath of ETFs on a no-commission basis, both its internally managed funds as well as from firms like S&P and WisdomTree. I used Schwab ETFs for these portfolios, but investors could readily use Schwab's traditional mutual funds instead. (In fact, the traditional index funds have slightly lower tax-cost ratios than the ETFs, but it's debatable whether that advantage will hold going forward.) 

For U.S. equity exposure, I employed Schwab U.S. Broad Market, which tracks the Dow Jones U.S. Broad Stock Market Index and levies an ultraskinny 4-basis-point expense ratio. But investors could obtain similar exposure in a traditional index fund via the Silver-rated  Schwab Total Stock Market Index , which charges just 9 basis points. (I also love the index fund's $100 minimum, which makes it accessible to investors at all income levels and life stages.) I also like      Schwab U.S. Dividend Equity ETF , but its emphasis on dividends contributes to higher tax costs than the total-market trackers. 

On the international-equity side, I used Schwab International Equity ETF, which tracks the FTSE Developed ex US Index. Here again, the traditional mutual fund,     Schwab International Index , an MSCI EAFE tracker, would be a fine alternative, albeit with slightly higher costs. Note that both the fund and the ETF lack exposure to emerging markets; my assumption was that investors could obtain that exposure via their tax-deferred accounts rather than bolting on an additional tiny emerging-markets position for this portfolio. But  Schwab Emerging Markets ETF is certainly a fine option for investors who would like to make sure that their taxable portfolios include emerging markets. 

Moderate Bucket Portfolio
Anticipated Time Horizon: 20 or more years

This portfolio contains the same holdings as the aggressive Schwab portfolio, differing only in its allocations to them. Because it's geared toward retirees with shorter time horizons, it includes larger positions in cash and high-quality short- and intermediate-term bonds and smaller positions in equities. 

Bucket 1: Years 1-2
10%: Cash (certificates of deposit, money market accounts, and so forth; percentages will vary based on amount of assets and spending rate) 

Bucket 2: Years 3-10
15%: Wells Fargo Advantage Short-Term Municipal Bond
25%: BlackRock National Municipal 

Bucket 3: Years 11 and Beyond
40%: Schwab U.S. Broad Market ETF
10%: Schwab International Equity ETF 

Conservative Bucket Portfolio
Anticipated Time Horizon: 15 years 

In contrast with the aggressive and moderate portfolios, both of which emphasize growth to varying extents, this portfolio is geared toward older retirees with shorter time horizons/life expectancies. As such, its focus is on preserving purchasing power and funding living expenses; capital appreciation is secondary. Because its growth prospects are relatively low, it would not be appropriate for younger retirees unless they are extremely risk-averse and--more importantly--have more than enough money to last throughout their retirement years. 

Bucket 1: Years 1-2
12%: Cash (certificates of deposit, money market accounts, and so forth; percentages will vary based on amount of assets and spending rate) 

Bucket 2: Years 3-10
20%: Wells Fargo Advantage Short-Term Municipal Bond
28%: BlackRock National Municipal 

Bucket 3: Years 11 and Beyond
30%: Schwab U.S. Broad Market ETF
10%: Schwab International Equity ETF

Securities mentioned in this article

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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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