We combine Gold-rated active funds with Schwab's low-cost index products.
By Christine Benz | 09-16-15 | 06:00 AM | Email Article

Over the past few decades, grocery stores have increasingly aimed to serve as one-stop shops for busy consumers. The trend started with supermarkets bolting on pharmacies and selling toiletries; banks, coffee bars, and restaurants came next. In-grocery bars seem to be the latest fad, with retailers hoping that consumers might be more likely to open their pocketbooks for pricey cheeses and takeaway foods if their cupholders contain a frosty craft beer or glass of wine.

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.

Over the same time frame, many financial firms have aimed to serve as one-stop shops, too, allowing investors to buy and sell their own house brand of mutual funds, stocks and bonds, as well as mutual funds offered by third parties.

 Charles Schwab popularized the investment-supermarket concept in the early 1990s, capitalizing on no-load mutual funds' explosion in assets and the then-raging bull market. Investors relished the convenience of being able to trade funds from a broad gamut of investment firms, from Oakmark to  Janus to American Century, without having to maintain separate accounts with each of these firms.

More than 20 years and two major bear markets later, investor preferences have changed. The dot-com bust quelled many individuals' appetites for buying and selling stocks, and investors' interest in actively managed products has also waned. Sensible, ultradiversified products like target-date vehicles and index funds have been gaining assets at the expense of almost everything else.

Against that backdrop, the Schwab OneSource mutual fund supermarket may look less relevant today than it once did. While investors were once clamoring to buy funds run by boutique investment managers on a single brokerage platform like Schwab's, that's much less the case today.

That said, Schwab hasn't ignored the winds of change. Over the past decade, the firm has built out its lineup of very low-cost, low-minimum index funds and exchange-traded funds. The presence of those ultra-low-cost choices makes the firm much easier to recommend as a one-stop investment shop than would otherwise be the case. While Schwab isn't quite as compelling a destination for retired investors with fixed-income-heavy portfolios--for reasons discussed here--it's a solid choice for investors who are accumulating assets for retirement.

Previously, I created in-retirement portfolios employing funds on Schwab's platform, including tax-deferred (IRA) and taxable (tax-efficient) models. This time around, I'll focus on model Schwab portfolios for accumulators: working people who have longer time horizons. I've created three Schwab Supermarket Retirement-Saver portfolios: Aggressive, Moderate, and Conservative. These portfolios are geared toward investors in tax-deferred accounts like IRAs and 401(k)s, meaning that they're not assembled with any consideration for tax efficiency.

Morningstar's Lifetime Allocation Indexes helped inform these portfolios' positionings. I employed many of the same holdings in these portfolios that I used with my in-retirement Schwab portfolios, relying heavily on  Morningstar's medalist ratings to help identify the best options on Schwab's OneSource platform. (Schwab OneSource funds can be purchased without a load or transaction fee.)

Aggressive Schwab Supermarket Retirement-Saver Portfolio
Anticipated Time Horizon to Retirement: 40 years

20%:  Oakmark Fund
10%:  Harbor Capital Appreciation
15%:  Schwab Total Stock Market Index
10%:  Diamond Hill Small-Mid Cap
30%:  Harbor International
5%:  Harding Loevner Emerging Markets
5%:  Metropolitan West Total Return Bond
5%:  Credit Suisse Commodity Return

This portfolio uses the allocations of Morningstar's Lifetime Allocation 2055 Aggressive Index to guide its weightings. Given that it's geared toward someone with a 40-year time horizon, it features an aggressive 90% equity stake. Its U.S. equity portfolio is anchored by two of Morningstar's highest-conviction actively managed large-cap funds. Oakmark Fund provides value to blend exposure, while Harbor Capital Appreciation supplies high-octane growth stocks. Both receive Gold ratings currently.

As with the in-retirement Schwab portfolio, the Schwab saver portfolio includes Diamond Hill Small-Mid Cap. I'm a big fan of so-called "smid" funds like this one because they allow investors to gain exposure to both small- and mid-cap stocks in a single shot; moreover, their managers don't have to spend too much time thinking about market-capitalization bands when running the portfolio. That can reduce trading and tax costs. I augmented those active funds with Schwab Total Stock Market to help smooth out the active fund's sector exposure, provide additional exposure to small- and mid-caps, and to lower the portfolio's overall costs. Index-centric investors could use the index fund alone to supply their portfolios' U.S. equity exposure.

As with the Schwab tax-deferred "bucket" portfolio, I used Harbor International to supply core foreign-stock exposure, albeit with a value flavor. Because that fund is currently light on emerging markets (less than 5% of assets, according to Morningstar's data, a well-below-market weighting), I augmented it with a small position in Harding Loevner Emerging Markets. Here again, investors could reasonably supplant the active funds with a core international equity fund like         Schwab International Index .

The portfolio includes smaller positions in bond and commodities-tracking investments to provide a bit of extra diversification. MetWest Total Return Bond provides well-diversified core bond exposure, while Credit Suisse Commodity Return is in place to provide additional diversification and inflation protection.

Moderate Schwab Supermarket Retirement-Saver Portfolio
Anticipated Time Horizon to Retirement: 20 years

20%: Oakmark Fund
10%: Harbor Capital Appreciation
15%: Schwab Total Stock Market Index
10%: Diamond Hill Small-Mid Cap
20%: Harbor International
5%: Harding Loevner Emerging Markets
15%: Metropolitan West Total Return Bond
5%: Credit Suisse Commodity Return

The Moderate Schwab Supermarket Saver portfolio employs the same basket of funds that I used with the Aggressive Saver portfolio, and the allocations aren't terribly different, either. Given that a person in his or her 40s has a 20-year time horizon until retirement, it's only reasonable that the bulk of the portfolio remains in stocks, which should enhance its return potential.

That said, there are a couple of noteworthy differences between the Aggressive and Moderate portfolios. First, the Moderate portfolio's equity allocation is a touch lower--80% versus 90% for the Aggressive portfolio. Much of that differential owes to the Moderate portfolio's lighter international-equity allocation; the domestic-equity stakes in both portfolios are virtually identical in size.

The bond piece of the Moderate portfolio is also higher than the Aggressive portfolio's. Note that Morningstar's Lifetime Allocation Index for 2035 retirees with moderate time horizons contains tiny stakes in both Treasury Inflation-Protected Securities and foreign bonds. However, the MetWest fund has the latitude to invest a portion of its portfolio into those areas, so I used that fund to provide all-in-one bond exposure.

Conservative Schwab Supermarket Retirement-Saver Portfolio
Anticipated Time Horizon to Retirement: 5 years

15%: Oakmark Fund
5%: Harbor Capital Appreciation
10%: Schwab Total Stock Market Index
7%: Diamond Hill Small-Mid Cap
12%: Harbor International 
3%: Harding Loevner Emerging Markets
30%: Metropolitan West Total Return Bond
7%: USAA Short-Term Bond
6%:  BlackRock Inflation Protected Bond
5%: Credit Suisse Commodity Return

As with the previous two portfolios, I used Morningstar's Lifetime Allocation Indexes to help set the baseline allocations--in this case, the 2020 Lifetime Allocation Index for investors with moderate risk capacities. (I stuck with the moderate index for this portfolio because the conservative index's positioning is simply too meek for most investors, in my view.)

Yet, even as it's notably more conservative than the Aggressive and Moderate Schwab Saver portfolios, the Conservative portfolio maintains a 50% weighting in stocks; the goal of that hefty allocation is to improve the portfolio's long-term return potential and preserve purchasing power.

The portfolio's bond position is substantially larger than the Moderate portfolio's. With a short period until retirement, investors at this life stage should consider diversifying within their bond allocations and queuing up assets to provide in-retirement living expenses. Pre-retirees might, therefore, consider steering part of their fixed-income sleeves to a short-term bond fund that could be readily converted into cash. After all, having sufficient short-term assets in the portfolio can help mitigate sequencing risk--the chance that a retiree could encounter a lousy market right out of the box. I also added a position in a TIPS fund, BlackRock Inflation-Protected Bond, to add inflation insulation to the enlarging fixed-income position.

How to Use
As with the bucket in-retirement portfolios, my key goal here is to depict sound asset-allocation and portfolio-management principles rather than to shoot out the lights with performance. That means that investors with very long time horizons and/or very high risk capacities could use it to help size up their own portfolios' asset allocations and suballocations. Alternatively, investors can use the portfolio as a source of ideas in building out their own portfolios. As with the bucket portfolios, I'll employ a strategic (that is, long-term and hands-off) approach to asset allocation; I'll make changes to the holdings only when individual holdings encounter fundamental problems or changes. 

I also developed the portfolios without consideration for tax efficiency--that is, I assumed they would be held inside of a tax-sheltered wrapper of some kind, such as an IRA. Investors who intend to hold their portfolios inside of a taxable account would want to put a greater emphasis on tax efficiency, emphasizing index funds and ETFs on the equity side and municipal bonds for their fixed-income exposure.

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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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