When we first started Betterment, our goal was to create the best possible portfolio for investors. To do this, we had to take into consideration cost, performance, and access. We needed products that could suit investors saving for a down payment on their house, major purchases and, of course, retirement.
Given all of these stipulations, it’s no coincidence that exchange-traded funds or ETFs make up the core of Betterment’s portfolios. First developed in the early 1990s, ETFs now account for $1.7 trillion in assets in the United States. Betterment selects the most appropriate ETFs for our clients to build a fully diversified, global investment ETF portfolio.
While registered investment advisors have been building portfolios of mutual funds for clients for decades, ETFs are the next level in access, flexibility and cost. Here’s a look at the five key attributes that make ETFs right for Betterment clients.
Most ETFs are index funds, aiming to deliver the performance of a stock, bond or commodity index, minus fees—no more, no less. These funds don’t have managers who are paid to “deliver alpha” or market-beating returns. Instead, ETF portfolio managers are quantitative disciplinarians with a laser-like focus on hugging the index. The cost of an ETF covers licensing the index from a data publisher, paying administrative fees (lawyers, trusts, exchanges) and compensating the managers, who tend to work on multiple ETFs at once. All of this is bundled together into what is known as the expense ratio.
In contrast, many mutual funds—particularly those that are actively managed—add costs through distribution agreements with brokerage platforms or financial advisors, and some are only available direct from the manager. With ETFs, the gatekeepers (and toll takers and middlemen) have been marginalized, allowing greater benefit to accrue to the end investor—you.
For individual investors who want to build a portfolio, basic stock and bond index ETFs tend to be cheaper than equivalent index mutual funds. Consider the price difference between Vanguard’s Total Stock Market ETF (VTI) and equivalent mutual fund (VTSMX). They both follow the same CRSP U.S. Total Market Index, but there is a significant cost difference. VTI has an expense ratio of 0.05% and VTSMX has an expense ratio of 0.17%. The expense ratios for the ETFs used by Betterment range from 0.05% to 0.40%.
For individual investors who want to build a portfolio, basic stock and bond index ETFs tend to be cheaper than equivalent index mutual funds.
Most exchange-traded funds—and all ETFs used by Betterment—are considered a form of mutual fund under the Investment Company Act of 1940, which means they have explicit diversification requirements. They do not have any over-concentration in one company or sector, unless called out specifically in the fund offering prospectus. Diversification, both within a fund and throughout a portfolio, has been said to be the “only free lunch” in finance. This is what drives Betterment’s focus on asset allocation, ensuring that our clients aren’t overly exposed to individual stocks, bonds, sectors or countries.
All mutual funds are required to distribute any capital gains to their investors at the end of the year, regardless of individual trading activity or the timing of a purchase—these are distinct from capital gains you would realize from selling the share of the fund itself. That means you could buy a new fund in December and receive a taxable distribution just a week or two later! But when it comes to tax efficiency, ETFs have two jewels in their crown.
First, most ETFs already have the tax efficiency of index funds—which don’t tend to generate internal capital gains due to churning (frequent buying/selling of stocks and bonds due to investor or manager movement).
Second, the two-tiered market by which shares of ETFs are transacted isolates investors from additional tax consequences and limits capital gains from accumulating within the fund. Because an ETF is a type of mutual fund, shares can only be issued or redeemed through a fund administrator, once a day at Net Asset Value, like every other mutual fund. Yet ETF shares trade all day long in transactions between buyers and sellers: How do these sync?
When large investors or market makers, known as authorized participants, notice an imbalance between the price of the ETF and the aggregate of the prices of the underlying securities the ETF tracks (or they need to fill a large order of ETFs for a customer), they essentially swap the underlying stocks or bonds for shares of the ETF, or vice versa. This transfer in (or out) of the fund is known as “in-kind” and limits the tax consequences for the fund by allowing it to constantly raise its cost basis of individual securities by swapping out the securities with the largest built-in gains first (swaps as opposed to sales don’t realize the gains.) In the event that the fund needs to sell securities itself, having a high basis would limit its tax liability. Non-ETF mutual funds don’t have this luxury.
ETFs are the duct tape of the investing world.
They can be accessed by anyone with a brokerage account and just enough money to buy at least one share (and sometimes less—at Betterment we trade fractional shares, allowing our customers to diversify as little as $10 across a portfolio of 12 ETFs.) While most ETFs are straightforward in their exposure, they are used in so many ways, that they have become an essential tool for all kinds of investors—short-term traders and long-term investors alike. This versatility as an investment vehicle helps keep ETF pricing true to the price of the underlying assets held by the fund.
ETFs take advantage of decades of technological advances in buying, selling and pricing securities. Alongside their modern structure sit myriad data points watched by investors and advisors who are constantly analyzing the funds and their investments to make sure that the fund prices stay true. They are looking at what they know about the portfolio, what is happening in the market, and how the ETF is trading throughout the day. The net effect: multiple market forces keep the ETF trading in-line with the underlying holdings.