- KEY TAKEAWAYS
Betterment's portfolio is designed to help customers achieve the optimal expected returns at every level of risk from their investments.
Next, we use a variety of strategies—including automation—to make sure investors keep as much of those returns as possible.
Remember when you got your first paycheck? That was probably the first moment when you saw the sizable difference between what you earned and what you actually took home.
There's a parallel to investing here. Often, there is a gap between the amount your portfolio earns (your investment returns) – and what actually lands into your pocket (your investor returns). But unlike the withholdings from your paycheck, that investment gap is something you can mitigate.
Betterment is designed to help you keep those investor returns that can be (and often are) gobbled up by excessive fees, poor investor behavior (i.e. market timing or undiversified risk), and other inefficiencies like poor tax strategies.
In fact, that's the fundamental reason Betterment exists: To offer you a better, more effective and ultimately more rewarding way to invest.
While this number depends greatly on how you choose to invest elsewhere, we estimate that you can potentially keep an additional 4.30% of your investor returns each year by using Betterment.
First, we start with the basic concept of passive investing, rather than active management.
Innovative research by Rick Ferri, CFA, founder of Portfolio Solutions, and Betterment's Alex Benke, CFP, published in the peer-reviewed Journal of Indexes in January 2014, demonstrated that over a 15-year period, an all index-fund portfolio outperformed a portfolio of active funds 83% of the time. The median annual shortfall of the losing active portfolios was -1.25%.
Passive investing is growing in popularity, but the vast majority of investments in the U.S. are still in actively managed funds. Recent research from Deutsche Bank showed that active mutual funds had market share of 76.2% in 2013, down from more than 95% in 1998. We select only low-cost index-tracking ETFs, making the Betterment portfolio the right vehicle to capture the average 1.25% advantage found by Ferri and Benke.1
You can view the full white paper here.
Index funds are the right building blocks, but they're just the start. Next, we achieve greater diversification by including all global asset classes, and using sophisticated techniques to optimize our asset allocation.
If you're familiar with investing principles you know that diversification is a good way to offset risk – it's akin to putting your eggs in many different baskets – so that you reap the benefits of market upswings, while softening the blow when there are dips. Yet doing it well is hard for DIY investors – the focus of an earlier blog post.
At Betterment, we start with 12 global ETFs to maximize our diversification – and then add an extra boost with our portfolio optimization techniques. When compared to a typical DIY-investor portfolio of two passive funds (similar to the one recommended by Warren Buffett, no less2), Betterment outperformed the benchmark by 1.40%, on a risk-adjusted, after-cost basis.
This includes all the trades necessary to keep that portfolio rebalanced; we do not charge for selling or buying shares due to a deposit or withdrawal, or as a result of a rebalance or reallocation.
Another benefit to investing with Betterment is smart, automated rebalancing – a key ingredient for optimal portfolio performance. When portfolios drift, it usually means you are taking on risk that you had not planned to take and that could hurt your performance over time. Rebalancing puts you back on the efficient frontier.
To be sure, rebalancing does not increase average returns in raw terms, but it does significantly reduce measures of risk-volatility and the the expected maximum drawdown, which can add back, on average, .40% into your returns.3 Better yet, our automated rebalancing not only keeps your asset allocation on track – it's also a way we reduce your tax bill.
Lastly, we are doing something that no other online investment manager is doing: We have built specific behavioral guardrails and nudges which help you be a better investor (sometimes despite yourself!)
Over the last decade, much research has been devoted to the role of behavior in investing. It turns out that bad behavior (like trying to time the market or reacting to temporary market news) hurts returns – a lot. We've put a lot of thought into helping you avoid that kind of behavior penalty. On average, a Betterment customer kept an extra 1.25% of returns as compared to an average investor, our analysis showed.
So when you add up the total potential Betterment advantage to you, it's quantifiably better.
1Some other investment companies cite the index-fund advantage as being closer to 2.1%. While this figure has credible research behind it – we consider this data to be dated and a poor comparison for contemporary investing. The study which found the 2.1% gap looked at data from 1979-1998 and compared mutual funds to the Vanguard 500 Index. Our research (view the white paper here) compared an all-index fund portfolio to 5,000 portfolios of randomly selected, comparable actively managed funds over a 16-year period (1997 to 2012).
2On page 20 of the 2013 Berkshire Hathaway shareholder letter, legendary investor Warren Buffett revealed his instructions to the trustee who will manage Buffett's bequest to his wife: an allocation between short-term government bonds and a very low-cost S&P 500 index fund. Buffett believes that such a strategy will result in long-term returns superior to those attained by most investors, who employ high-fee managers. We couldn't agree more – but as our analysis shows, further optimizing on the principles behind Buffett's assertion (extending the passive strategy by diversifying beyond domestic markets while keeping costs low) should lead to even better results.
3Swensen, David, Unconventional Success, 2005, pp. 195-96
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. Our portfolio costs 0.15% to manage $100,000 or more. Learn more here.
Determination of most trusted online financial advisor reflects Betterment LLC's distinction of having the most customers in the industry, made in reliance on customer counts, self-reported pursuant to SEC rules, across all online-only registered investment advisors.