Contributing Authors
Lisa Huang
Lisa Huang
Director of Quantitative Investing
Dan Egan
Joshua Rubin
Corporate Counsel
Jamie Cartwright
Jamie Cartwright
Content Manager

When it comes to investing in the market, a portfolio strategy should be well aligned with your personal goals and disposition to bear market risks. If you are seeking to outperform a conventional, market-cap portfolio strategy, despite the potential to experience underperformance, our analysis shows there may be a more effective strategy for you.

Today, we’re introducing a smart beta portfolio, sourced from Goldman Sachs Asset Management, to help meet the preference of our customers who are willing to take on additional risks to potentially outperform a market capitalization strategy.

This smart beta portfolio strategy reflects the same underlying principles that have always guided the core Betterment portfolio strategy—investing in a globally diversified portfolio of stocks and bonds. The difference is that the smart beta portfolio strategy seeks higher returns by moving away from market capitalization weightings in and across equity asset classes.

What is a smart beta portfolio strategy?

Industry insiders often describe portfolio strategies as either passive or active. Most index funds and exchange-traded funds (ETFs) are categorized as “passive” because they track the returns of the underlying market based on asset class. By contrast, many mutual funds or hedge fund strategies are considered “active” because an advisor or fund manager is actively buying and selling specific securities to attempt to beat their benchmark index. The result is a dichotomy in which a portfolio gets labeled as passive or active, and investors infer possible performance and risk based on that label.

In reality, portfolio strategies reside within a plane where passive and active are just two cardinal directions. Smart beta funds, like the ones we’ve selected for this portfolio, seek to achieve their performance by falling somewhere in between extreme passive and active, using a set of characteristics, called “factors,” with an objective of outperformance while managing risk. The portfolio strategy also incorporates other passive funds to achieve appropriate diversification.

This alternative approach is also the reason for the name “smart beta.” An analyst comparing conventional portfolio strategies usually operates by assessing beta, which measures the sensitivity of the security to the overall market. In developing a smart beta approach, the performance of the overall market is seen as just one of many factors that affects returns. By identifying a range of factors that persistently drive returns, we seek market-beating performance while managing reasonable risk.

When we develop and select new portfolio strategies at Betterment, we operate using five core principles of investing:

  • Personalized planning
  • A balance of cost and value
  • Diversification
  • Tax optimization
  • Behavioral discipline

The Goldman Sachs Smart Beta portfolio strategy aligns with all five of these principles, but the strategy configures cost, value, and diversification in a different way than Betterment’s core portfolio. In order to pursue higher overall returns, the smart beta strategy adds additional systematic risk factors that are summarized in the next section.

Additionally, the strategy seeks to achieve global diversification across stocks and bonds while overweighting specific exposures to securities included in Betterment’s core portfolio, such as real estate investment trusts (REITs). Meanwhile, with the smart beta portfolio, we’re able to continue delivering all of Betterment’s tax-efficiency features, such as tax loss harvesting (Tax Loss Harvesting+™) and asset location (Tax-Coordinated Portfolio™).

Investing in smart beta strategies has traditionally been more expensive than a pure market cap-weighted portfolio. The Goldman Sachs Smart Beta portfolio strategy has a far lower cost than the industry average, with aggregate annual ETF expense ratios ranging from 0.11% to 0.24%, depending on the portfolio’s allocation between stocks and bonds. This is slightly more expensive than the core Betterment portfolio strategy, which has aggregate annual ETF expense ratios of only 0.07% to 0.16%, depending on the portfolio’s allocation.
Note: Expense ratios data are from Xignite as of August 30, 2017

Because a smart beta portfolio incorporates the use of additional systematic risk factors, we typically only recommend this portfolio for investors who have a high risk tolerance and plans to save for the long term.

Which “factors” drive the Goldman Sachs Smart Beta portfolio strategy?

Factors are the variables that drive performance and risk in a smart beta portfolio strategy. If you think of risk as the currency you spend to achieve potential returns, factors are what determine the underlying value of that currency.

As analysts, we can dissect a portfolio’s return into a linear combination of factors. In academic literature and practitioner research (VanguardResearch AffiliatesAQR), factors have been shown to drive historical returns. These analyses form the backbone of our advice for using the smart beta portfolio strategy.

Factors reflect economically intuitive reasons and behavioral biases of investors in aggregate, all of which have been well studied in academic literature. Most of the equity ETFs used in this portfolio are Goldman Sachs ActiveBetaTM, which are Goldman Sach’s factor-based smart beta equity funds. The factors used in these funds are equal weighted and include the following:

Factor investing smart beta1. Good Value

When a company has solid earnings (after-tax net income), but has a relatively low price (i.e., there’s a relatively low demand by the universe of investors), its stock is considered to have good value. Allocating to stocks based on this factor gives investors exposure to companies that have high growth potential but have been overlooked by other investors.

2. High Quality

High-quality companies demonstrate sustainable profitability over time. By investing based on this factor, the portfolio includes exposure to companies with strong fundamentals (e.g., strong and stable revenue and earnings) and potential for consistent returns.

3. Low Volatility

Stocks with low volatility tend to avoid extreme swings up or down in price. What may seem counterintuitive is that these stocks also tend to have higher returns than high volatility stocks. This is recognized as a persistent anomaly among academic researchers because the higher the volatility of the asset, the higher its return should be (according to standard financial theory). Low-volatility stocks are often overlooked by investors, as they usually don’t increase in value substantially when the overall market is trending higher. In contrast, investors seem to have a systematic preference for high-volatility stocks based on the data and, as a result, the demand increases these stocks’ prices and therefore reduce their future returns.

There are some interesting hypotheses behind this preference. One suggests that investors treat high-volatility stocks as lotteries and are therefore willing to accept lower expected returns by paying a premium to gamble on these stocks.

4. Strong Momentum

Stocks with strong momentum have recently been trending strongly upward in price. It is well documented that stocks tend to trend for some time, and investing in these types of stocks allows you to take advantage of these trends. It’s important to define the momentum factor with precision since securities can also exhibit reversion to the mean—meaning that “what goes up must come down.”

How can these factors lead to future outperformance?

In specific terms, the factors that drive the smart beta portfolio strategy—while having varying performance year-to-year relative to their market cap benchmark—tend to outperform their respective benchmarks when combined, with a high degree of persistence. You can see an example of this in the chart of yearly factor returns for US large cap stocks below. You’ll see that although the ranking of the four factor indexes varies over time, the ranking of the equally weighted index returns is relatively stable and performs better than the S&P 500 most of the years.

Hypothetical Performance Ranking of Smart Beta Indices vs. S&P 500
Smart Beta factor comparison

This chart is for illustrative purposes only, and the factor returns it references are not necessarily the same factor returns in the Goldman Sachs Smart Beta portfolio strategy. The chart above compares annual returns (data from Bloomberg) for the period from January 2000 to August 2017 and is used to illustrate the points discussed in this article. For each year, we have ranked the annual performance of each factor alongside an equal weighting of all four factors, using the S&P 500 as a comparison. The returns for Momentum, Quality, Value and Low volatility are calculated from the S&P 500 Momentum Index, S&P 500 Value Index, S&P 500 Quality Index and S&P Low-volatility Index, respectively. “Equal weighting of all four factors” was calculated by Betterment by giving each factor corresponding to each index listed above an equal weight to yield the hypothetical performance figures. This calculation was not provided by Goldman Sachs Asset Management. This analysis is for illustrative purposes only and does not reflect or predict future performance. Moreover, this analysis does not include fees, liquidity, and other costs associated with actually holding a portfolio based on these exact indexes that would lower returns of the portfolio.

Why invest in a smart beta portfolio?

As we’ve explained above, we generally only advise using Betterment’s choice smart beta strategy if you wish to attempt to outperform a market-cap portfolio strategy in the long term despite potential periods of underperformance.

For investors who fall into such a scenario, our analysis, supported by academic and practitioner literature, shows that the four factors above can persistently drive higher returns than a portfolio that uses market weighting as its only factor. While each factor weighted in the smart beta portfolio strategy has specific associated risks, some of these risks have low or negative correlation, which allow for the portfolio design to offset constituent risks and control the overall portfolio risk.

Of course, these risks and correlations are based on historical analysis, and no advisor could guarantee their outlook for the future. An investor who elects the Goldman Sachs Smart Beta portfolio strategy should understand that the potential losses of this strategy can be greater than those of market benchmarks. In the year of the dot-com collapse of 2000, for example, when the S&P 500 dropped by 10%, the S&P 500 Momentum Index lost 21% (see chart above).

Given the systematic risks involved, we believe the evidence that shows that smart beta factors can lead to higher expected returns relative to market cap benchmarks, and thus, we are proud to offer the portfolio for customers with long investing horizons and a high degree of comfort with the risks involved.

To get started, create a new goal account and select the Goldman Sachs Smart Beta portfolio strategy. Or, if you’re not yet a Betterment customer, click here to open an account with our smart beta portfolio strategy.

Factors, as applied in investing, can mean different things. In the context of asset allocation, factors are drivers of return within broader asset classes used as a lens to uncover return potential and minimize risk. The Goldman Sachs Smart Beta portfolios examine market capitalization, rates, emerging markets, credit, equity style, commodities and momentum to seek to avoid taking unnecessary risk while pursuing the best opportunities to drive portfolio returns.