Contributing Authors
Joe Wang
Lisa Huang
Director of Quantitative Investing
Dan Egan
Dan Egan
Director of Behavioral Finance

At every stage of the investing process, Betterment holds to the same basic philosophy: We use real-world evidence and systematic decision-making to increase the take-home value of our customers’ wealth. That’s not just a claim. It’s actually how we go about investing your money.

Our process for constructing portfolios is a great example of our investment philosophy at work. We start with a body of well-developed, robust research, then use a system of rules to remove bias and preconceptions from our decision-making process.

Through research, we can easily iterate on our portfolio strategy construction. Since we originated the Betterment Portfolio Strategy, we’ve found nuanced ways to improve it over time. It’s worth noting that any change to the Betterment Portfolio Strategy also results in updates to the Betterment SRI Portfolio Strategy.

In this article, we’ll provide an overview of how we make such improvements, in line with our investing principles.

What the Betterment Portfolio Strategy aims to achieve for you:

1. We set the stage for personalized planning and behavioral discipline.

When developing the Betterment Portfolio Strategy, we set some basic prerequisites based on our most fundamental principles.

Any good portfolio strategy should enable customers to pursue any of their goals and to implement their plan. The portfolio strategy should also set up investors for strong discipline. The strategy should enable easy goal-setting and keep investors focused on their bigger picture, rather than creating worry about comparative performance.

A result of setting these prerequisites of the portfolio strategy is our set of 101 allocations in the Betterment Portfolio Strategy, instead of just a few allocation settings, which is more conventional.

2. We use asset allocation to develop and maintain diversification.

At its foundation, Betterment’s portfolio strategy is based on Modern Portfolio Theory, which means we start by selecting asset classes that represent the total investable global market. Importantly, we exclude commodities and private equity, which have unusually high costs in products accessible for retail investors.

In traditional total market portfolio strategies, the “total market” was assumed to be the United States, so only U.S. stocks and bonds were included. However, since 2011, Betterment has included equities from both developed and emerging markets, reflecting the global market of today.

The portfolio strategy has held a diverse array of bonds since 2013, when we added granularity to the bond basket by including ultra short-term treasury bonds, inflation protected bonds, investment-grade corporate bonds, international developed market bonds, and emerging market bonds. In 2014, we made the portfolio strategy more tax advantaged by including municipal bonds in taxable accounts only.

You can read more about our full process for diversifying the Betterment Portfolio Strategy here.

3. We increase value by optimizing the portfolio.

The series of additions above encapsulates changes to the strategy’s basic asset class selection meant to capture the total market, and it’s equivalent to our target anchor portfolio.

We then optimize the portfolio strategy by mathematically maximizing each portfolios’ forward-looking return given the correlated risk. In other words, we try to develop portfolio combinations with realistic alignment with the efficient frontier. While there are plenty of practical constraints involved with portfolio optimization, our process results in 101 different portfolios within the strategy, each with value and size tilts shown to increase your clients’ returns.

In 2017, we updated our portfolio optimization techniques, resulting in improved diversification in each individualized portfolio and better expression of portfolio tilts toward value and small capitalization. The main objective of these changes are higher expected returns. Building on our existing process, we improved how we forecast returns and the way we apply factors historically shown to drive performance. Due to price movements in various markets compared to our previous optimization, our optimization resulted in different weights.

The tilts of the Betterment Portfolio Strategy—toward value and small capitalization—arise from the landmark research of Fama-French, which demonstrate how the returns of any equity security are driven by three factors: market, value, and size. The underlying structure of the Betterment Portfolio Strategy ensures the market factor is incorporated, but to gain higher returns from value and size, we must tilt the portfolios, using a framework known as Black Litterman. The final weights of each portfolio are influenced by constraints imposed by the liquidity of the underlying fund and are controlled by our level of confidence in each factor.

4. We tilt the portfolio strategy in taxable accounts to help manage taxes.

For investors with taxable accounts, portfolio returns can be further improved on an after-tax basis by utilizing municipal bonds. This is because the interest from municipal bonds is exempt from federal income tax. To take advantage of this, the Betterment Portfolio Strategy in taxable accounts is tilted toward municipal bonds.

Other types of bonds remain for diversification reasons, but the overall bond tax profile is improved. For investors in states with the highest tax rates—New York and California—Betterment can optionally replace the municipal bond allocation with a more narrow set of bonds for that specific state, further saving the investor on state taxes.

We’ll continue to improve the Betterment Portfolio Strategy

Our investment philosophy is to use rules-based decision-making whenever we see evidence that Betterment’s investment strategies can be improved. Over time, we continue to evaluate new portfolio construction research and carry out our own analysis.

As with improvements to any Betterment offering, our goal is to help each and every Betterment customer maximize the value while invested at Betterment and when they take their money home.

For more information about the Betterment Portfolio Strategy, check out our full whitepaper here.