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ETFs

Investment Selection: Building Portfolios, Fund by Fund

Building and managing an investment portfolio is a bit like building a piece of furniture. Here are the tools we used.

Rukun Vaidya

By Rukun Vaidya
Head of Trading, Betterment  |  Published: September 26, 2014

Good investment selection integrates portfolio objectives and associated fund costs to maximize long-term performance.

We pay particular attention to the tax efficiency of every fund selected.

Building and managing an investment portfolio is a bit like building a piece of furniture. If you are creating something extremely simple, you don’t need more than a small set of basic-purpose tools. Constructing something better calls for selecting the right wood, the right tools, and the right technique. Similarly, building the best portfolios calls for selecting the best investment vehicles.

Unfortunately, as with woodworking, knowing exactly which tools to buy and the small differences between them is a daunting task for the inexperienced. It’s hard for investors to make the right choices when presented with a huge, diverse marketplace of offerings. At Betterment, the investment team has already done that work—hand-picking a portfolio of funds which carry lower costs and maximize potential returns.

expense-ratios-03In order to have maximal diversification (e.g. Modern Portfolio Theory), a portfolio must contain an optimal mix of different asset classes. As we have written about before, diversification can add significant investor alpha to returns.

However, diversification alone is not enough. Investment selection must follow as well. Investors cannot control markets—but what they can control are their fixed costs, such as expense ratios and tax efficiency. These factors are central in determining investment vehicle type and can have a significant impact on returns.

As stewards of entrusted capital, our primary goal is to build our customers the best portfolios for their goals. Just like a good carpenter, we’re always trying to pick the best tools for the job.

For a more in-depth discussion on this, please read the full white paper on our investment selection process. Below you can read a summary of the methodology we use to select investments in your portfolio.

Our selection process

At Betterment, we use a portfolio made up entirely of ETFs—all selected for their low cost and high liquidity. Here are just a few reasons:

  • There is a wide availability of funds that passively track broad-market benchmarks across both equities and fixed income.
  • ETFs transact throughout market hours. That means you can gain or reduce exposure on your schedule, trading just as if it’s a stock of a company.
  • ETFs generally carry lower costs and are not subject to mutual fund-like pass-through charges (front and back loads, administrative fees, etc.)
  • Their structure makes it impractical for administrators to engage in price, share class, or investor-level discrimination. In addition, unlike mutual funds, their management and marketing are not exposed to misaligned incentives in the form of sales or brokerage kickbacks to advisors recommending certain vehicles.
  • Their structure leads to minimal mutual fund-style distributions and results in an inherently lower tax burden. An ETF investor will never accrue capital gains due to the fund selling assets to generate liquidity. Every investor controls their own tax profile.
  • The growth in assets and participants across the ETF market has increased liquidity and lowered transaction costs for everyone.

Next, we calculated the total cost for managing a portfolio of selected funds. Here are some of the factors considered in the selection of each fund:

  • Expense ratio.
  • Liquidity as measured through the bid-ask spread—narrow spreads lead to lower costs to manage a portfolio. We naturally favor more liquid funds.
  • Tracking error: How well does the ETF replicate its benchmark? The lower this error, the more dependable the fund as a long-term portfolio component.
  • Market impact: Will Betterment’s participation on our customers’ behalf have an undue effect on market price? We only select funds showing robust trading volume with a large existing asset base.

Investable ETFs Sized by Total Assets

Explore ETFs by exclusion criteria

The results

Systematic rules-based investment selection yields a typical Betterment portfolio that has an average annual expense ratio of just 15 basis points, or 0.15%, compared to an industry average ETF expense of 43 basis points, or 0.43%.² That’s an annual savings of 0.28% of your invested capital. It may not seem like much but evaluated after only five years, that’s 1.4% you’re keeping as returns rather than paying in expenses.

Our most recent analysis is presented below for our whole portfolio, consisting of 12 asset classes, represented by both a primary and secondary ETF. The dual tickers can be used to improve tax efficiency for all customers and enables us to offer additional Betterment features like our automated Tax Loss Harvesting+.

¹http://www.icifactbook.org/pdf/14_fb_table01.pdf

²For a 70% stock portfolio composed only of primary securities, the average underlying expense ratio is 0.136%. If each asset class consisted of a 50/50 split between primary and alternate, that cost would be 0.152%—a difference of less than two basis points. You can read more how we calculated these costs in this white paper.

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