An ETF, or exchange-traded fund, is a basket of securities that gives you exposure to a particular asset class, industry, commodity, or region. We like them because they offer similar diversification as an index mutual fund but unlike index mutual funds, ETFs can be traded at any time during the day. ETFs also offer exposure to a greater breadth of markets, are more transparent in terms of their underlying holdings, and tend to be more tax efficient and low cost.
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Selecting Exchange-Traded Funds for Schwab Intelligent Portfolios™
ETFs were initially designed to provide broad, low-cost market exposure by mimicking the performance of an index. Most indexes were "market-cap weighted," which means that the bigger a company's market capitalization (its share price multiplied by the number of outstanding shares) the larger its weight in the index.

Fundamentally weighted ETFs weight stocks based on factors like sales, cash flow, and dividends. A market-cap index and a fundamentally weighted index focused on the same asset group will typically own similar stocks—but in different proportions.
Fundamentally weighted and market-cap weighted ETFs both track indexes, but their performance can vary widely.

Given their unique construction, fundamentally weighted ETFs can complement traditional ETFs in a portfolio. While traditional market-cap ETFs often provide low cost diversification, fundamentally weighted ETFs provide a value tilt in the portfolio construction. To help ensure that our portfolios are truly diversified, Schwab Intelligent Portfolios invests in both types of ETFs with the goal of helping to reduce volatility and provide better risk-adjusted results over time.

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Fundamental Indexing Has Proved Its Value in 2016
Both Schwab ETFs™ and third-party ETFs are filtered through a carefully selected set of stringent criteria. This ensures that all ETFs chosen for Schwab Intelligent Portfolios deliver both diversity and cost efficiency.

These selection criteria help pare down more than 1,800 ETFs to the 53 that could potentially be part of your Schwab Intelligent Portfolios account. So, let's examine those criteria and see how that works.

Eschewing risk. First of all, any nonstandard ETFs are eliminated--that is, ETFs that are inverse and leveraged, actively managed, that invest only in one country, or those that have less than three months' of history, among other factors. This helps avoid exposing the portfolios to some riskier ETFs that could compromise your target profile.

Size matters. Next, all ETFs without sufficient assets under management are stripped out, because ETFs without sufficient assets are at greater risk of closing. And although an ETF that liquidates ultimately distributes the proceeds to shareholders, it's preferable to avoid the potential tax complexities that could arise.

Looking for minimal spreads. Also screened out are ETFs with wide bid-ask spreads—that is, those with a significant difference between the highest price a buyer is willing to pay for shares (the bid), and the lowest price a seller is willing to take for them (the ask). When the spread between the bid and the ask is too wide, investors risk paying too much to buy, or receiving too little on a sale. As returns are compounded, those differences can add up over time.

Monitoring consistency. Schwab Intelligent Portfolios ETFs must closely track their underlying indexes, because a significant tracking error can cause an ETF to drift from its intended role in your portfolio. So any funds that don't track their indexes particularly well are ruled out. This measure is not whether the fund outperforms the benchmark, but rather the degree to which it approximates its index.

Low OERs are key. Finally, the selection process focuses on ETFs with low operating expense ratios (OERs). OERs are the percentage of fund assets that the ETF managers spend each year to keep the funds running. A typical ETF charges a little over 0.44% of your investment per year, but some OERs can be astoundingly low. Schwab Intelligent Portfolios include those that have the lowest OER while also meeting the size, tracking, and bid-ask spread criteria. (Source: "How to Choose an Exchange-Traded Fund (ETF)," The Wall Street Journal How-To Guide.)

After the ETFs are chosen, Charles Schwab Investment Advisory, Inc. (CSIA) monitors their performance quarterly. CSIA also reviews the ETF selection annually to make sure the ETFs available for Schwab Intelligent Portfolios continue to meet the criteria described above, and can provide consistency and diversity.

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Selecting ETFs for Schwab Intelligent Portfolios™