Custom Models Disclosure

Advisors who use Betterment’s Custom Models (“Custom Models”) should consider the following information before using any of the features, and for communicating this information, as necessary, to their clients.

A. Overview

Betterment’s Custom Model feature provides Advisors with a menu of investment products in Betterment’s interface to construct custom model portfolios for their clients. Investment products may, but will not necessarily, include exchange-traded funds (“ETFs”), mutual funds, other similar equity related index funds, stocks, bonds, money market funds, U.S. treasury funds, cash sweep accounts, other liquid cash and cash-like vehicles, and model portfolios composed of other investment products. If an Advisor would like to include any additional investment products that are not already supported in Betterment’s interface, the Advisor may request Betterment review such additional products, but Betterment is not obligated to support any Product for inclusion in a Custom Model other than those available in the Interface.

B. Constructing a Custom Model

Advisors can construct a Custom Model from one or more "components." A component can be a security group composed of one or more individual investment products, or it can be a portfolio strategy (i.e., a Betterment-constructed portfolio, a third-party model portfolio, or another Custom Model the Advisor has constructed). The Advisor is responsible for selecting each component and assigning it a percentage weight totaling 100% across the Custom Model. Within an underlying portfolio strategy, the securities keep the relative weights its manager set, scaled by the weight the Advisor assigns to that portfolio strategy as a component. Betterment supports a set number of asset allocations per Custom Model. Advisors can request that Betterment support additional asset allocations, but Betterment is not required to support them, to make any particular investment product or model portfolio available as a component, or to continue making available any component it currently offers.

Advisors who construct Custom Models for their clients are responsible for determining the primary, secondary and/or tertiary tickers (e.g., an IRA secondary ticker, or a sell-only substitute (as described below)) for each security group that is a component in athe Custom Model. Security groups are groupings of securities that include a primary ticker, and may include secondary and/or secondary IRA tickers designed to help avoid wash sales and allow for tax-loss harvesting opportunities. A “sell-only” substitute is a ticker assigned to a security group within a Custom Model that contributes to a security group’s weight and may be sold during rebalancing if the security group is overweight. Advisors, on their client’s behalf, can transfer the ticker into the client’s account and define it as a sell-only substitute. After defining a ticker as a sell-only substitute in a Custom Model and transferring positions in that ticker from another custodian into the client's Betterment account, Betterment’s portfolio management system will then incorporate and manage the position in the portfolio. Sell-only substitutes behave differently with rebalancing, as described below in “Rebalancing and Smart Transitions”. Advisors cannot designate primary, secondary or IRA secondary (or otherwise known as tertiary) tickers, or sell-only substitutes, for the security groups within certain underlying portfolio strategies (i.e., third-party model portfolios and Betterment-constructed portfolios), as those designations are determined by the manager of the portfolio.

Advisors should be aware that a Custom Model cannot include the same security in more than one component, and Betterment's interface will prevent an Advisor from constructing or assigning a Custom Model in which components hold one or more overlapping securities. The Advisor is responsible for resolving any such overlap (for example, by selecting a different component or by substituting a different security in a Custom Model that the Advisor constructed) before the Custom Model can be used.

Advisors can also elect to include a cash allocation in a Custom Model in taxable accounts, health savings accounts, and individual retirement accounts (IRAs) and can set the target cash allocation at their discretion; when there are fees, withdrawals, or other portfolio management actions in a client's account, this cash will be used first, reducing the need to sell securities to cover smaller transactions. Cash can only be included as a distinct component of a Custom Model, and cannot be included within any component. An Advisor can therefore designate a cash allocation when constructing a Custom Model, but cannot use as a component a portfolio or model that itself includes a cash allocation (and to the extent Advisor wishes to designate a Betterment-constructed portfolio or a third-party model portfolio available via the model marketplace as a component within a Custom Model, those components exclude the cash allocation).

A Custom Model that includes any element that is not itself eligible for use in a 401(k) account is not eligible for use in a 401(k) account, or in a tax-coordinated portfolio that includes a 401(k) account. This includes, without limitation, a Custom Model that includes a cash allocation and a Custom Model that includes a portfolio strategy that is not available for use in 401(k) accounts. Advisors are responsible for confirming that a Custom Model is eligible for the account types in which the Advisor intends to use it.

Advisors are also responsible for providing expected return and volatility assumptions (collectively, “capital markets assumptions”) for each asset allocation level (i.e., risk level) that the Advisor includes in a Custom Model. Betterment may provide default capital market assumptions at the asset allocation level. In that case, Advisors may use Betterment’s default capital market assumptions or may elect to provide Betterment with its own capital market assumptions. Betterment calculates a Custom Model's capital markets assumptions from Betterment's own assumptions for the securities each component holds. An Advisor can substitute its own assumptions for the Custom Model as a whole, but not for a single component. If a component is itself a Custom Model with Advisor-supplied assumptions, Betterment does not carry those component assumptions over into the overarching Custom Model (which may include other components). Advisors are responsible for verifying the accuracy and reasonableness of all Capital Markets Assumptions with respect to any Custom Model, including any default Capital Market Assumptions provided by Betterment, and Betterment does not evaluate or otherwise provide Advisors with feedback regarding whether the Capital Market Assumptions and resulting Client projections are accurate or reasonable. 

A model portfolio used as a component will follow updates provided by its manager: when the manager publishes an update, Betterment will automatically create a new version of the Custom Model and migrate client accounts assigned to it to that new version, and Advisors are responsible for the resulting trading activity, including any resulting taxes. If an update would cause components to hold overlapping securities, Betterment will not migrate client accounts; those accounts will remain invested in accordance with the most recent version of the Custom Model without overlapping securities until the Advisor resolves the conflict through the Betterment interface.

Advisors can modify Custom Models through Betterment’s interface, including by making adjustments to security groups, asset allocations, capital market assumptions, and Advisor-designated drift thresholds. Modifications to Custom Models can cause trading in all client accounts assigned to the Custom Model. To the extent an Advisor is modifying a Custom Model, the Advisor is responsible for specifying a migration strategy for each impacted client account. Advisors should review information about Betterment’s portfolio migration strategies before submitting a client’s portfolio change. Advisors are responsible for any modifications to Custom Models, and Betterment is not responsible for any resulting client account trading activity, including resulting taxes and transaction fees.

C. Betterment’s Portfolio Management Tools

Advisors should be aware of how Custom Models interact with other Betterment portfolio management features, including rebalancing, tax loss harvesting, tax coordination, and smart transitions, as well as the other features and limitations described in the Custom Model agreement. Betterment’s auto-adjust feature is generally not compatible with Custom Models.

i. Rebalancing and Smart Transitions

Custom Models are compatible with Betterment’s rebalancing features, as described in Betterment’s rebalancing disclosure, and smart transition features, as described in Betterment’s smart transitions disclosure. Betterment’s rebalancing functions differently with a Custom Model and Advisors should explain these limitations to Clients.

Unless an Advisor disables rebalancing or elects to use any of Betterment’s tax smart transition features, Custom Models with balances above the minimum required threshold will automatically be eligible for rebalancing following Betterment’s or the Advisor’s existing drift thresholds for the particular client and Betterment’s tax minimization-based rebalancing algorithms. For Advisor-built Custom Models in which every component is a security group, Advisors can set customized drift thresholds for rebalancing for a particular client’s goal, and Betterment evaluates drift at the security group level (except as described in the paragraph directly below). As noted above, security groups contain a primary ticker, and may include secondary and/or IRA secondary tickers designed to help avoid wash sales and allow for tax-loss harvesting opportunities, as well as sell-only substitutes. 

Where a Custom Model includes a portfolio strategy as one or more components, Betterment evaluates drift at the component level rather than the security group level, comparing each component's actual weight to the weight the Advisor assigned it. Drift of a component (which may include a portfolio strategy component) above the default drift tolerance (as disclosed in Bettermen’s Form ADV) makes the Custom Model eligible for rebalancing, subject to certain calibrations to avoid frequent small rebalance transactions and to seek tax efficient outcomes, such as reducing wash sales and minimizing short-term capital gains. When rebalancing a Custom Model with portfolio strategy components, Betterment will prioritize buying and selling to reduce drift at the component level, rather than at the asset class and security group levels. Because drift is measured on the component's overall weight, holdings within a model portfolio used as a component of a broader Custom Model can move away from that portfolio's target allocation without making the Custom Model eligible for rebalancing.

A Custom Model that includes one or more model portfolios as components may experience greater portfolio turnover than a Custom Model in which every component is a security group. Each model portfolio follows its own manager's update schedule, and Betterment migrates client accounts to a new version of the Custom Model each time one of those managers publishes an update, so a Custom Model may be updated more frequently than any one of its components would be on its own. Such portfolio turnover may lead to increased trading costs and tax consequences, including taxes on short-term capital gains.

Advisors should also be aware that Betterment’s rebalancing feature will work differently with a sell-only substitute. If a security group becomes overweight and portfolio drift exceeds the designated threshold, Betterment’s rebalancing feature will aim to sell shares from the overweight group to help manage overall risk. When determining which shares of the security group should be sold, all primary, secondary, and sell-only substitute positions are evaluated. Rebalancing is also calibrated to avoid frequent small rebalance transactions and to seek tax-efficient outcomes, such as reducing wash sales and minimizing short-term capital gains.

• Betterment’s rebalancing algorithm decides which holdings to sell within the security group by picking the lots that will minimize the tax cost of the rebalance. Primary, secondary and sell-only substitute tickers are all evaluated by the rebalancing algorithm.
• For example, rebalancing may prioritize selling the primary or secondary security of an overweight security group, rather than the sell-only substitute, particularly if the sale of the sell-only substitute would have a higher tax impact relative to the other holdings in the security group (even if the sale of the sell-only substitute would result in realizing long-term capital gains). While this behavior seeks to minimize the tax impact of rebalancing transactions, it can result in the Advisor’s client’s portfolio retaining the sell-only substitute rather than selling out of the sell-only substitute.
• Rebalancing will not buy additional shares of a sell-only substitute if its security group becomes underweight relative to the target allocation in the Custom Model.

For more information about rebalancing and Custom Model trading behavior, please review Betterment’s rebalancing disclosures and smart transitions disclosures.

ii. Tax Loss Harvesting (“TLH”)

Advisor-constructed Custom Models are compatible with Betterment’s TLH feature, as described in Betterment’s Tax Loss Harvesting disclosure, but Advisors should understand that TLH functions differently in a Custom Model and should explain these limitations to Clients.

If an Advisor elects to enable TLH for a client’s account with a Custom Model, the Advisor should understand that the number of harvesting opportunities and effectiveness of TLH depend on the number of secondary and IRA secondary tickers that have been assigned to security groups in the Custom Model, including within its components. Constructing a Custom Model with fewer secondary and IRA secondary ticker assignments in security groups may reduce opportunities to harvest tax losses. The secondary and IRA secondary ticker assignments within an underlying Betterment-constructed or third-party portfolio are determined by the manager of that portfolio and cannot be modified by the Advisor. A component whose security groups do not have secondary or tertiary tickers assigned will not be eligible for TLH.

Further, Advisors should understand that Betterment’s TLH feature may be less effective for a Custom Model relative to the Betterment Core portfolio and may identify fewer harvesting opportunities for a Custom Model that contains Mutual Funds relative to those that contain exclusively ETFs. In particular, if a Custom Model security group contains a mutual fund as its primary ticker, the security group containing the mutual fund cannot have secondary or IRA secondary tickers of any type defined, and therefore will not be eligible for TLH. Similarly, if a security group contains a mutual fund as a sell-only substitute, that security group is not eligible for TLH. Advisors are not able to elect mutual funds as secondary or IRA secondary tickers for any security group.

Advisors should also understand how the inclusion of a sell-only substitute or mutual fund in a Custom Model impacts the operation of TLH. Betterment’s TLH feature does not consider sell-only substitutes when evaluating shares of a security group to be sold in a tax loss harvest. This means that Betterment’s TLH feature does not harvest unrealized losses for sell-only substitutes, and that there may be fewer opportunities to harvest losses in a Custom Model that contains a sell-only substitute relative to other portfolio strategies that Betterment supports. However, if a ticker is designated as a sell-only substitute in a particular Custom Model, and the client holds the same ticker designated as a primary or secondary security in another portfolio of the same legal account type (e.g., if that ticker is the primary ticker in a Betterment-constructed portfolio that the client uses in a different goal), Betterment’s TLH feature will evaluate that ticker to sell for potential harvests. 

Electing different portfolio strategies for multiple Betterment goals (including electing multiple Custom Model strategies or a Custom Model strategy and a Betterment or third-party model portfolio strategy) may cause TLH to identify fewer opportunities to harvest losses than it might if you elect the same portfolio strategy for all of your Betterment goals. This is because there could be overlapping tickers in certain asset classes of the portfolio strategies you elected. TLH does not harvest losses in any asset classes with overlap (excluding sell-only substitutes of the asset class) to minimize the risk of wash sales and/or permanently disallowed losses.

Betterment has calibrated TLH in a way that Betterment believes optimizes its effectiveness given expected future returns and volatility. Betterment does not alter that calibration to optimize the effectiveness of TLH for any particular Custom Model, and other calibrations could result in more frequent harvests or better results depending on the tickers in a particular Custom Model and actual market conditions.

See Betterment’s Tax Loss Harvesting disclosures for further detail.

iii. Tax Coordination

If an Advisor or Client elects to use a Custom Model in conjunction with Betterment’s asset location feature (“Tax Coordination”), the Advisor understands that Betterment will supply, for each ticker, its qualified dividend income, non-qualified dividend income, expected returns, and expense ratio for purposes of implementing automated asset location software strategies. Betterment is unable to incorporate any of an Advisor’s capital markets assumptions into its Tax Coordination feature, which may result in inconsistencies between Tax Coordination and the other features and experiences that rely on the Advisor’s capital markets assumptions.

Advisors should also be aware that Custom Models that incorporate “target date” mutual funds are not eligible for Tax Coordination if the client’s goal includes a taxable component. In addition, a Custom Model is not eligible for Tax Coordination if any of its components is ineligible for an account type in the client's goal, as described above, or is not available in all of the tax treatments represented in the client's tax-coordinated portfolio. For example, a Custom Model that includes a cash allocation is not eligible if the client's goal includes a 401(k) account.   

See Betterment’s Tax Coordination disclosures for further detail.

iv. In-Kind Transfers

Subject to the terms and conditions of Betterment’s Automated Customer Account Transfer Service (“ACATS”) disclosure, Betterment supports in-kind transfers to goals using Custom Models.