Navigating Market Stress: Betterment’s Approach to Brexit
The morning after the “Brexit” vote, Betterment instituted a short delay in trading to avoid the worst of a potentially erratic market. Here’s why and how we made this decision.
At Betterment, we help you achieve your financial goals by building and managing your portfolios, which includes trading securities on your behalf.
When we make trading decisions, we look out for our customers’ best interests.
The morning after the “Brexit” vote, Betterment instituted a short delay in trading to avoid the worst of a potentially erratic market.
As your advisor, Betterment takes on a wide range of tasks to help you reach your financial goals. Based on what you tell us about your objectives, we build portfolios appropriate for each of your goals. We then manage them on a discretionary basis, handling the day-to-day management of your account. Because you entrust us with discretion, we are responsible for making decisions on your behalf, and because we are your fiduciary, we make these decisions with your best interest in mind. These decisions can take a number of forms.
Should you need your money, we choose the optimal assets to sell in order to fund your withdrawals. In doing so, we also manage the trades needed to make all of this happen. So, for example, if you tell us you need $10,000, you don’t have to decide which securities to sell—we’ll leverage our technology and our expertise to sell the right amount of securities, while minimizing your taxes and keeping your portfolio on track. This is what good financial advisors do.
This process involves making determinations not just about about which securities to trade, but also when to trade them and, even more importantly, when not to trade them.
A Note About Markets
When they are functioning properly, markets serve as efficient and accurate price discovery mechanisms, matching buyers and sellers and contributing to second-to-second, minute-to-minute, and hour-to-hour pricing stability of listed assets.
At certain times of day, however, the fast-paced dynamics of modern markets shift away from that efficient ideal, creating conditions that are not optimal for typical long-term investors. The most apparent and predictable of these periods is directly after market open, as participants react to events that have occurred since the last market session. Stock exchanges use an auction process to set opening prices of listed securities. This drives a period of elevated volatility that should be avoided by long-term investors because it can result in inflated transaction costs and short-term price dislocation.
What does this extreme volatility look like in the real world? On Aug. 24, 2015, the market suffered a “flash crash.” On that morning, the market experienced massive volatility, price dislocations, and execution delays. Certain ETFs temporarily experienced large—and temporary—price swings of 20% or more, although the value of the underlying assets of the funds remained constant. Many (non-Betterment) investors traded into this whirlwind and were surprised to receive pricing that differed dramatically from what they expected.
The Betterment Approach
From our inception, Betterment has sought to manage this risk for our customers. We believe that in periods of extreme dislocation, waiting a short period of time to ensure a more predictable and lower-cost transaction is the sensible thing to do, especially when your horizon is years, not minutes.
We generally wait 30 minutes after market open before trading on any given day. As discussed above, we believe that the market open is a poor time for a retail investor to be trading. Last year’s “flash crash” was a perfect demonstration of why this approach is effective. It allowed us to sidestep the massive volatility, price dislocations, and execution delays that plagued the market at large.
June 24, 2016, was not a normal day. The night before, news organizations began calling a surprise victory for the “Leave” campaign in the U.K.’s Brexit referendum. Although U.S. markets would not open for another 12 hours, a number of indicators gave a clear preview. U.S. equity index futures, which trade overnight, revalued substantially. European markets, which opened at 3 a.m. ET, were roiling. As our team monitored this activity overnight, it became apparent that the U.S. market open would be extremely volatile—in other words, a poor environment for long-term investors.
To be prudent, we closely monitored market conditions to determine whether to extend our standard 30-minute waiting period until we were comfortable that conditions had stabilized. Among other factors, we monitored bid-ask spreads in the ETFs we use in our portfolios, some of which were wider at market open than usual. We looked for the reappearance of normal market maker participation and a stabilization in order book dynamics. We waited for a reversion to stable short-term price action. At around 11:45 a.m., we determined that conditions had generally normalized, and we resumed trading.
To be clear, there was never a question of technical capacity—our broker-dealer was fully capable of executing any and all trades. Nor was there any benefit to Betterment in waiting until the markets had stabilized to commence trading. Our purpose, as always, was to leverage our expertise to act in the best interest of our customers.
It’s also important to note that our objective was not to avoid a falling market (though certain assets in the Betterment portfolio did fall, while certain others rose). Markets will sometimes fall—enduring such fluctuations is the risk we bear in exchange for market returns. Dan Egan, our Director of Behavioral Finance and Investing, addressed the issue of Brexit more broadly. As always, the world will continue to produce surprises, and markets will react, but we are managing your investments to help you achieve your goals. A key component to reaching your goals is to stay the course.
At Betterment, our goal is to manage your wealth seamlessly, efficiently, and prudently. That includes account opening, advice, planning, rebalancing, and tax management. At the core of this experience is trading, which implements these services. Whether it comes to helping you to determine how much you need to save, or making sure you get a fair price when we transact on your behalf, as a fiduciary, Betterment puts our customers’ interests first.
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