This article was co-written by Ellie Lan, an Investment Analyst at Betterment, and Dan Egan, Betterment’s Director of Behavioral Finance and Investing.
When you use algorithms and data to make decisions, you agree to a very basic principle: You clearly and logically lay out the steps you follow, and then use the answers that your analysis produces—whether or not that jibes with a personal opinion or feeling, or worse, incentive provided by someone other than your customers.
At Betterment, this is a philosophy we apply at every level of the company—including how we selected the funds that are used in our portfolio.
As mentioned in our portfolio selection white paper, the following core criteria drove our ETF selection process:
- Positive expected return, after adjusting for taxes and risk
- Low cost
- Highly liquid
- Low turnover
- Tax efficiency
We considered the full universe of U.S.-listed exchange-traded funds (ETFs). For our ETF selection, we created a filtering and ranking algorithm (using the free open-source programming language R) to choose ETFs that met our core criteria and ranked highly on qualities aligned to our investment objectives. We applied these filters to remove asset classes and investment vehicles that did not meet our standards, and then selected from the top remaining candidates.
We assessed the universe of 1,654 ETFs (as of Sept. 4, 2015). This transparent process resulted in 30 different ETFs for customers to invest across 13 asset classes. We outline the type of ETFs we sought as well as the ones we actively avoided. The process reduced average expense ratio for the overall set from 0.64% to 0.20% for the final set.
ETF Exclusion By Category
An asset class is a group of investments that share similar characteristics and behaviors. Funds with an asset class of equity or fixed income were included in our analysis. Funds that were in alternatives, commodities, asset allocation, and currency categories do not align with our investment objectives. They are either highly speculative, expensive, or generate uncertain expected returns.
The average expense ratio of ETFs that were filtered out was 0.97%, while that of the included set was 0.57%. The spread was similarly reduced from 0.15% to 0.07%. By filtering out asset classes with high expense ratios and bid-ask spreads, our algorithms can steer clients away from expensive and illiquid investments right from the beginning.
Inverse ETFs are constructed using derivatives that allow the investor to profit from a decline in the value of the underlying benchmark. In line with Betterment’s investment philosophy, Betterment does not engage in strategies that mirror shorting because of its risky nature and negative expected returns.
Inverse ETFs were therefore eliminated altogether from consideration. The mean the expense ratio of inverse ETFs was 1% per year, while the mean expense ratio of the remaining noninverse ETFs was 0.5%.
Leveraged ETFs often allow for two or three times the exposure to the underlying indexes using derivatives. Betterment does not hold leveraged ETFs because of their high cost.
The mean expense ratio of the excluded set was 0.96%, while the mean expense ratio of the included set was 0.46%.
The total annual cost of ownership (TACO) is Betterment’s proprietary fund scoring method. TACO takes into account an ETF’s transactional and liquidity costs as well as fund management costs. TACO balances the expense that’s incurred annually (expense ratio) with a transactional cost such as the bid-ask spread.
The weight given to the bid-ask spread, which is incurred only when bought and sold, is calibrated to reflect the average turnover in a Betterment portfolio, which is designed to be bought and held. As such, the bid-ask spread is effectively weighted less than the expense ratio.
In other words, since we do not trade actively in our portfolios, we prefer a fund with an expense ratio of 0.10% and a bid-ask spread of 0.20% to a fund with an expense ratio of 0.20%, and a bid-ask spread of 0.10%.
Within each asset class, we specify a maximum acceptable TACO number. This serves to filter down the total number of funds per asset class to a top-tier set. The maximum TACO threshold differs by asset class. In general, emerging market equity and bond funds have a higher expense than U.S. corporate bond funds. The average expense ratio of the included set was 0.24%, and that of the excluded set was 0.35%.
Average Daily Volume and the 10% ADV Test
We then rank funds based on the liquidity and depth of their market, measured by the average daily volume (ADV) of their trading. ADV measures how deep the market is for a fund, in terms of the amount of shares traded by active buyers and sellers. A fund with a low ADV may have higher-than-expected liquidity costs on days when Betterment needs to buy or sell that fund. We therefore select the top 12 candidates in each component.
In addition to ranking based on ADV, to help ensure Betterment’s orders do not account for more than 10% of the funds’ total daily volume, we create a 10% of ADV test. The test uses an upper bound on expected daily volume in Betterment’s portfolio, and breaks down that volume into the volume per each component. Funds chosen for Betterment’s portfolio cannot exceed the 10% total traded daily volume threshold.
As with previous steps, eliminating thinly traded ETFs reduced expense ratios as well. The excluded set had a mean expense ratio of 0.50%, while the mean expense ratio of the included set was 0.21%.
While this list of our filters and criteria is far from being comprehensive, it gives a flavor for the kinds of characteristics we look for in an ETF.
All in, 30 ETFs met all selection criteria and were placed in the Betterment portfolio.
How We Decide to Change Our Funds
The process above is run quarterly to update our assessments. However, we do not thoughtlessly change our funds immediately when this output changes. By investing customers into a fund, we are potentially committing to them holding it indefinitely, or incurring tax or transaction costs to change it. We must consider if a relative improvement is likely to be permanent, or if a competitor is likely to match the reduction (hooray, competition!).
To decide to make a change, we convene our investment committee and discuss whether we believe such a change is merited based not only on current statistics, but on the trend and behavior of market participants.
We are constantly on the watch for new ETFs that come to market. Meanwhile, we are also monitoring our current portfolio for changes to our ETFs such as increases in expense ratio, tighter bid-ask spreads and shrinking assets under management.
The value of this ETF automation selection process is how easy it is to evaluate the full universe of U.S.-listed ETFs and select the ones that most closely align with our investment philosophy. Through this process, we seek to drive transparency, efficiency and cost-effectiveness on an ongoing basis when re-evaluating our portfolio of ETFs.
This article originally appeared on ETF.com.
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This article was last updated on March 17, 2016