ETFs are a great innovation—with lower expenses and greater flexibility than traditional mutual funds—but those very qualities can actually lead to lower performance for investors who choose ETFs over more traditional alternatives, research shows.dark side ETF investing

A 2012 study led by Professor Utpal Bhattacharya of the Indiana University Kelley School of Business found that investors were actually worse off for having adopted ETFs than people who stuck to more traditional vehicles like mutual funds or individual stocks. The reason? ETFs encourage market timing—thus “individual investors do not improve their portfolio performance when they use these products,” the authors say.

Fortunately, the Betterment platform minimizes the downside to give you the full upside of ETF investing. With sophisticated technology, Betterment allows you to harness the tax, liquidity and cost advantages of ETFs to give you the best risk-adjusted returns net of tax, time and behavior.

The rapid growth of ETFs

The first ETF, or Exchange Traded Fund, came into existence in Canada in 1990 and was quickly followed in 1993 by the famous SPDR (“Spider”) ETF designed to track the S&P 500 index. Hailed as a great innovation in investing, ETFs have grown to account for around $1.7 trillion in assets in the U.S. alone—nearly the size of the entire hedge fund industry.

This growth is continuing to  accelerate while at the same time the much larger mutual fund industry has been in decline, as the chart below demonstrates.


While similar in spirit to index-tracking mutual funds, ETFs offer some advantages over their more traditional counterparts. ETFs come with certain tax efficiencies (on average saving 0.7% per year). And the fees built in to ETFs are generally much lower than those in mutual funds—about 0.14% compared to 1.04%.

Moreover, whereas mutual funds can be bought and sold only once a day at a single price, investors have the ability to trade ETF shares any time the markets are open, just like common stocks. ETFs can also offer more frequent dividend distributions, in contrast to the more usual twice-yearly mutual fund distributions.

But as it turns out, these upsides also come with a serious downside.

ETFs encourage market-timing

According to Professor Bhattacharya’s research, the liquidity of ETFs makes investors that use them more susceptible to market timing behavior—behavior which has been proven to hurt returns.

The results were quite staggering: Out of two groups of 473 investors studied, the group that started using ETFs in their investment accounts lost 4.42% annually compared to the group that used only non-ETF investment products such as mutual funds and common equities.

The researchers were able to attribute the loss in performance specifically to market timing. It wasn’t that the assets themselves were underperforming, but that investors were using them to trade in and out of the market, and were doing so at the wrong times, incurring higher costs, and thus contributing to what you might call the ETF behavior gap.

Betterment harnesses the power of ETFs

In a cautionary article published in the Wall Street Journal in 2007, John Bogle warned that “after all the extra costs, the added taxes, the selection challenges and the timing risks, the typical ETF investor has absolutely no idea what relationship his investment return will bear to the return earned by the stock market.”

We use technology to harness the power of ETFs, while mitigating their risks.Here at Betterment there’s no need to fear that ETFs will derail your performance, because the Betterment portfolio leverages all of the advantages of ETFs, while mitigating the behavioral pitfalls.

To Bogle’s point above, one of the chief advantages is Betterment’s emphasis on long-term gains, by shielding you from short-term market fluctuations. However the markets did today has no effect on how your investments perform in the long-term—thus we’ll never show you the performance of individual assets.

We’ll let you know if you need to change something in order to meet your goal—by alerting you specifically when your goal is “on track” or “off-track.” But we’ll never interrupt your busy day with information that can lead to impulsive behavior that will hurt your returns.

We designed our products to provide other benefits as well:

  • By building a portfolio of ETFs with no load fees, and the smallest expense ratios around, Betterment insures that you’re not wasting your money lining the pockets of commission-based brokers, or paying for harmful active management. Betterment goes even further and charges no trading or transaction costs, ever. Thus, you reap the benefit of being able to make frequent deposits without worrying about those costs.
  • The flexibility of ETF trading enables us to get your money to work faster, and get it back faster if you need it, too.
  • Given that ETFs offer more frequent dividend distribution, we can use these to rebalance your portfolio in a tax-efficient manner. Mutual funds normally only pay distributions once or twice a year.
  • Our portfolio is an optimal blend of 12 different ETFs, designed for the best expected returns at each risk level. When certain asset classes drop as part of normal market movements, being well-diversified cushions against unnecessary volatility.
  • Because the Betterment method is based on a passive investing philosophy, we help offset the potential behavioral downside of ETFs. And because we don’t generate revenue from trades, our incentives are 100% aligned with yours—you can trust us to look out for you.

All the world’s investors owe a great debt to John Bogle, but we don’t share his pessimism about these efficient, powerful investment vehicles. A powerful tool is deserving of the appropriate safeguards. We didn’t give up on automobiles due to safety concerns—we invented airbags, anti-lock brakes, and seat belts that beep until you use them.

With the right technology, delivering a long-term strategy through diversification and rebalancing—and architecture that’s meticulously designed to encourage smart behavior—Betterment shows that ETFs can be harnessed as building blocks for the most efficient and investor-friendly platform we’ve seen to date.

New to Betterment? As the most trusted online financial advisor, Betterment offers a fully diversified investment portfolio of 12 global asset classes, optimized to provide you the best possible returns for both retirement planning and wealth building. Betterment costs 0.15% of assets under management annually for a portfolio of $100,000 or more. Learn more here.

This article was published on February 18, 2014

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