Funds And Investments
Diamond Hands And Financial Plans: Betterment’s Advice For Investing In Crypto
Is there a way to invest in cryptocurrencies responsibly? We certainly think so. Here are five ...Diamond Hands And Financial Plans: Betterment’s Advice For Investing In Crypto Is there a way to invest in cryptocurrencies responsibly? We certainly think so. Here are five tips to help guide you through the process. Even though cryptocurrencies have only been around for a short period of time, it’s abundantly clear that they’re here to stay. As a financial advisor, we at Betterment want to share our guidance on how to invest responsibly in cryptocurrency, if that’s something you choose to do. Fortunately, Betterment has a set of five universal investing principles that serve as a guide for the investment advice we give our 600,000+ customers, and that can help you make educated decisions about cryptocurrency yourself. 1. Make a personalized plan. As an investor, you have your own unique goals and values. Depending on those goals and values, the role cryptocurrency plays in your overall financial plan—if it has a role at all—will vary. Let’s start with your personal values. Many individuals are fans of cryptocurrency for reasons beyond just the potential to see their net worth go “to the moon.” You may be fascinated with crypto from an engineering perspective, or maybe for the societal impact it could have. Ultimately, it’s okay to invest your money in a way that reflects your personal values; just do so in an informed, principled manner. The second component of personalization is your financial goals. Your goals will also affect if and how cryptocurrency should be implemented into your portfolio. For example, if your child is going to college next year, their tuition money likely shouldn’t be invested 100% in Dogecoin. The volatility is far too large for a goal so short-term. Likewise, your emergency fund shouldn’t be held in Bitcoin either, because of the large price swings it’s experienced over the past few years. But, if you have a play account on the side, or a long-term goal where you’re able to tolerate more ups/downs, cryptocurrency may be an appropriate component of your portfolio. The overall point is that, just like any other investment, there is no one-size-fits-all answer: The best financial advice incorporates the unique goals and values of each person. 2. Diversify your investments. Even if cryptocurrency as an asset class may be here to stay, it’s impossible to know which cryptocurrencies will thrive and which will go extinct. There are currently over 4,000 unique cryptocurrencies, with new coins popping up seemingly every week. It’s likely many, if not most, will fail. With any type of investment, it’s not wise to “put all your eggs in one basket.” That’s why diversification is a critical piece of any financial plan. In early 2021, the cryptocurrency market as a whole passed $1 trillion for the first time. That’s quite an accomplishment. But when compared to the size of the global stock and bond markets, we see just how new and small cryptocurrency is. All the cryptocurrencies combined total just about 0.5% of the global stock and bonds markets, which exceed $200 trillion. Global Market Capitalization of Stocks, Bonds & Cryptocurrency Sources: Reuters and SIFMA Betterment doesn’t include cryptocurrency in our recommended investment portfolios, but if you do decide to invest in cryptocurrency, it should be in moderation. If you take a market capitalization approach, crypto would make up about 0.5% of your overall portfolio. Even if you are very bullish on crypto, Betterment doesn’t recommend it exceeding a maximum of 10% of your portfolio. We also recommend diversifying across multiple cryptocurrencies. 3. Prepare your taxes. Tax management is part of any investment strategy. Afterall, it’s not what you earn, but what you keep. When it comes to the taxation of cryptocurrency, the word that best describes it is “confusing.” If you’re going to invest in crypto, be sure to comply with all relevant laws and reporting requirements. The IRS published an FAQ page that addresses most common questions, such as: How is virtual currency treated for Federal income tax purposes? Will I recognize a gain or loss when I sell my virtual currency? Where do I report my capital gain or loss for virtual currency? If you invest in crypto, one strategy you may consider to manage taxes is tax loss harvesting. Betterment implements this strategy at the flip of a switch for our investment customers and we’ve automated the process so that our customers don’t have to do it manually. For example, losses that Betterment harvests can be used to offset gains in your cryptocurrency investments. 4. Weigh the overall costs and value. With all the hype and talk of double-digit—even triple-digit—growth in the world of cryptocurrencies, it’s easy to forget about the potential costs incurred from investing in them. Costs, when taken holistically, not only include how much you pay out of pocket, but also the execution quality of your trades, and the opportunity cost of your time. Depending on where you buy and sell cryptocurrency, you could pay transaction fees of over 1% for each trade. Newer cryptocurrencies, or those that don’t trade very frequently, may have larger bid-ask spreads. This means the price for which you can sell your cryptocurrency is lower than what it would cost you to purchase more. Lastly, when there are large price swings, you also must be careful about order execution. All of these direct or indirect costs can chip away at your take-home returns from trading cryptocurrency. 5. Grow investing discipline. Warren Buffet is famous for saying the market is “a device for transferring money from the impatient to the patient." He was referring to the stock market, but the saying also applies to the cryptocurrency market. Almost all investments have ups and downs, and the cryptocurrency market is no different. Bitcoin lost 80% of its value in 2018, over 1,000 currencies have failed, and stories of fraud are not hard to come across. These challenges -- price shocks, bankruptcy, panic, theft -- are not unique to crypto; however the risks are magnified because of the new technology, lack of regulation, and intense media hype around the cryptocurrency market. You must be willing to HODL, even when your portfolio is dropping. As an asset class, cryptocurrencies are extremely volatile, and it’ll likely be the disciplined investors who’ll be rewarded. Before you purchase any crypto, make sure doing so is appropriate for your risk tolerance, and that you have a plan in place for if and when you encounter volatility. Manage your investments purposefully. Cryptocurrency is a novel type of investment, and carries a lot of risk. That’s why having a clear set of investing principles is important. These principles can help guide your investment decisions and help you avoid getting caught up in the news hype of particular cryptocurrencies. While Betterment doesn’t include cryptocurrency in our portfolios, we acknowledge that many investors want to own them. If you are one of those people, hopefully these five principles will help you decide if and how to invest some of your investment portfolio in cryptocurrency.
Understanding Crypto Fundamentals
Cryptocurrency is a complicated technology, but it’s also accessible. It can be understood by ...Understanding Crypto Fundamentals Cryptocurrency is a complicated technology, but it’s also accessible. It can be understood by anyone, regardless of your background. At this point, it’s highly likely you’ve at least heard the many buzzwords associated with cryptocurrency. Blockchain, Bitcoin, or Ethereum ring a bell? But how many times has someone also said, “You should definitely invest in crypto” and then done a poor job of describing what any of it actually means? I’m all for movements and trends that create engagement within the investing space, but most of us require more before we feel comfortable taking action. My hunch is that some of the qualities that help make an investor successful—being thoughtful and disciplined, for example—can also be our Achilles heel when it comes to crypto and other speculative investments. And while I’m not suggesting that we set our principles aside and immediately add crypto to our portfolio, (heck, only 15% of women are actually investing in it and we’re the better investors, aren’t we?), understanding the fundamentals should help unlock the door to the possibility. At the very least, I hope it prepares you for the next time crypto is inevitably brought up in conversation. So let’s master the three main areas, eh? What it actually is. Considerations for investing. And how to do so, if you so wish. Section 1: So, what’s crypto, anyway? First things first, it’s important to understand a few key definitions. Only then can we piece them together to try and make sense of it all. Three key terms: Cryptocurrency “Crypto”: a form of payment for goods and services that can only be exchanged virtually (digital currency). It’s also decentralized, meaning the transaction doesn’t have to be made through an official financial institution, such as a bank. Blockchain: the technology behind crypto that enables virtual records of all digital transactions to be created and stored securely across computers. This helps verify ownership and prevents fraud. Bitcoin: one of the MANY types of cryptocurrencies that exist. Tied together, crypto is basically a decentralized form of currency that relies on blockchain technology to facilitate secure and strictly digital transactions. Bitcoin, while by far the most popular cryptocurrency, is really just one of many that exist. Bitcoin can be acquired and used to exchange goods and services and/or as an investment opportunity. Still confused? Analogy time. It’s kind of like when you go to a carnival and you use tickets instead of cash. The ticket is your Bitcoin (or another crypto, like Ether) and it carries a perceived value that can be exchanged for something else: Say, a ferris wheel ride. Your primary motivation for having the tickets could be purely transactional, like paying for the fun night at the carnival. But what happens if you wind up with leftover tickets at the end of the night, either intentionally or unintentionally? By not timely exchanging those tickets for other goods and services, it’s expected that their value could change. Over time, the same leftover tickets could potentially buy you 2x the ferris wheel rides, for example, or the same ride could require more tickets than before. To tie it back to cryptocurrency, what continues to attract investors is the idea that the value of cryptocurrency could increase over time. Section 2: To invest or not to invest? The considerations associated with investing in the digital currency space are unique and complex. Does one invest in a single cryptocurrency? A mixture of the 1,000+ possible currencies? Or, is it actually the technology behind cryptocurrency that has the most potential? And exactly how much exposure should one have? If you were hoping for a straightforward answer, I'm sorry to disappoint. Take Bitcoin, for example. Satoshi Nakamoto created Bitcoin in 2009, in response to the financial crisis of 2008. His primary intention was for Bitcoin to act as an alternative to your traditional, bank-controlled currency. Fast forward to today and Bitcoin is still far from being a convenient, 1:1 replacement for cash. Instead, retail investors are flocking to it for its growth potential, betting its value will continue going up. And even though Bitcoin is far and away the single largest cryptocurrency—and the fastest ever asset class to reach a $1T market cap thanks to a $500B surge in 2021 alone—its historical price fluctuations and inherent volatility often make it too risky to be trusted as a standalone investment. Bitcoin’s extreme price fluctuations in April should be a caution sign to all investors. After cracking $60,000, a 15% flash crash had Bitcoin’s price as low as $50,900, and as of end of month April, it was still down about 8%. And if you’re looking for a sound reason as to why the crash happened...good luck. There is no true consensus. So, even if you believe in the technology and conclude crypto’s here to stay, one thing is certain: Right now, this is not a stable asset class and buying Bitcoin is absolutely not the same as holding a regulated currency, like U.S. dollars. That said, even if stability and a disciplined investment approach is important to you, there could still be room for crypto in your strategy. Like anything else, having some exposure is reasonable. You just want to be sure it’s in balance with your broader strategy, explicitly categorized as “play money”, and not being counted towards any specific goal or future need. Until there’s an easier way to actually exchange your crypto for goods and services (at a steady price), you should be buying it primarily for its growth potential. Read more on Betterment's advice for investing in crypto responsibly. Section 3: I think I’m ready to buy. So, you’re ready to join the club. You’ve decided that based on your financial goals and strategy, you’re willing to invest some of your excess cash in crypto. Great. Like the many currencies and tangent technologies, there are several platforms to choose from, possibly even through one of your existing accounts. Unless you have the ability to easily track and monitor your crypto, keeping it separate from your established portfolio may help you better maintain your core strategy moving forward. As you evaluate your options, here are some additional considerations to keep in mind. Safety and security: Use a centralized exchange, or one that’s required to register and follow standard “know your customer” rules (at least when you’re first starting out). Cost: Depending on the platform, there can be trade specific fees, ongoing management fees, and additional costs to send your currency to someone else. General platform functionality: Do you want to be able to simply buy and sell currency? Or do you also want to be able to exchange your currency for additional goods and services and send it to other people? Since this asset class is so volatile, what is your chosen platform’s track record of uptime? Nobody wants their platform to be down while they are trying to make a trade. Companies like Coinbase are often touted as good enough options for beginners and have seemingly avoided the fraud and funny business that other exchanges have fallen victim to. They also have a lot of resources and tools you can access as you get your feet wet. Consider using them as a jumping off point for further exploration. Be an informed crypto investor. So, while this asset class is relatively new and is constantly evolving, it’s important to get familiar with the basics. It’s clear that cryptocurrencies aren’t going anywhere, and the sooner you have the tools to understand what cryptocurrency is—and the consideration related to investing in it—the more empowered you’ll feel participating in the ongoing conversation, and ultimately investing (responsibly), if you so choose.
How Much Crypto Should I Own?
What’s the right amount to keep in a portfolio? If investors want to dip their toes into ...How Much Crypto Should I Own? What’s the right amount to keep in a portfolio? If investors want to dip their toes into crypto, we recommend aiming for this allocation. Many of us have followed the dramatic rises and precipitous falls of bitcoin, and cryptocurrencies in general, over the past few years. Some may have written them off entirely after 80% declines in 2018, only to see them roar back into investors’ collective consciousness in 2020. Certainly sentiment has shifted over a short two years—more institutional investors are taking a hard look at crypto and previous naysayers have softened their view. This all leads to one question: How much cryptocurrency should I own? Math to the rescue. It goes without saying that this is a hard question to answer. But, we can borrow a page from modern quantitative finance to help us arrive at a potential answer. For years, Wall Street “quants” have used a mathematical framework to manage their portfolios called the Black-Litterman model. Yes, the “Black” here is the same one from the famous Black-Scholes options pricing formula, Fischer Black. And “Litterman” is Robert Litterman, a long-time Goldman Sachs quant. Without getting into too much detail, the model starts with a neutral, “equilibrium” portfolio and provides a mathematical formula for increasing your holdings based on your view of the world. What’s amazing is that it incorporates not just your estimate about how an investment might grow, but also your confidence in that estimate, and translates those inputs into a specific portfolio allocation. Your starting point: 0.50% The Black-Litterman model uses the global market portfolio—all the asset holdings in the world—as its starting point for building a portfolio. This means that, if you don’t have any other views on what investments might perform better or worse, this is the portfolio you should consider holding. In early 2021, the global market for stocks totaled $95 trillion and the global bonds market reached $105 trillion. The cryptocurrency market as a whole was valued at roughly $1 trillion. This means that cryptocurrency represents 0.50% of the global market portfolio. The Global Market Portfolio In Early 2021 Source: Betterment sourced the above cryptocurrency data and stock and bond data from third parties to produce this visualization. Just as there are plenty of arguments to hold more cryptocurrency, there are also many arguments to hold less. However, from the model’s standpoint, 0.50% should be your starting allocation. Now, add your views. This is where the mathematical magic comes into play. For any given growth rate in cryptocurrency (or any investment for that matter), the Black-Litterman model will return the amount you should hold in your portfolio. What’s more, you can specify your level of conviction in that assumed growth rate and the model will adjust accordingly. In the below chart are the portfolio allocations to bitcoin derived from the Black-Litterman model. This chart can serve as a useful, hypothetical guideline when thinking about how much cryptocurrency you might want to hold. How to use it: Select how much you think bitcoin will overperform stocks, from +5% to +40%. Each return expectation corresponds to a line on the chart. For example, if you think that bitcoin will outperform stocks by 20%, this corresponds to the purple line. Now, follow the line left or right based on how confident you are. If you’re at least 75% confident (a solid “probably”), the purple line lines up with a 4% allocation to bitcoin. Graph represents a hypothetical rendering of confidence of return value based on inputs to the Black-Litterman model. Image does not represent actual performance, either past or present. One of the most interesting things to note is how high your return estimate needs to be and how confident you need to be in order to take a sizable position in bitcoin. For example, for the model to tell you to hold a 10% allocation you need to be highly confident that bitcoin will outperform stocks by 40% each year. Also of note, it does not take much to drive the model’s allocation to 0% allocation, ie: no crypto holdings. If you don’t think that there’s a 50/50 chance that bitcoin will at least slightly outperform, the model says to avoid it entirely. How we got here. The inputs to the Black-Litterman model tell an interesting story in and of themselves. The main inputs into the model are global market caps, which we discussed earlier, asset volatility, and the correlation between assets. It goes without saying that cryptocurrencies are risky. Over the last five years, bitcoin’s volatility was six times that of stocks and 30 times that of bonds. At its worst, the digital coin saw an 80% drop in value, while stocks were down 20%. Other cryptocurrencies fared even worse. Source: Betterment sourced the above ACWI data and Cryptocurrency data from third party sources to create the above visualization. Visualization is meant for informational purposes only and is not reflective of any Betterment portfolio performance. Past performance is not indicative of future results. If an asset is volatile, and one is not able to diversify that volatility away, then investors will require a higher rate of return on that investment, otherwise they will choose not to invest. The fact that bitcoin is so volatile, but has such a small number of investors (relative to stocks or bonds) suggests that many investors still do not see the potential returns worth the risks. On the other hand, cryptocurrencies are at their core a new technology, and new technologies always have an adoption curve. The story here may be less about expected return versus risk and more about early adoption versus mass appeal. The final ingredient in the model is bitcoin’s correlation with stocks and bonds. Bitcoin has some correlation with both stocks and bonds, meaning that when stocks go up (or down), bitcoin may do so as well. The lower the correlation, the greater the diversification an asset provides to your portfolio. Bonds have a low correlation with stocks, which makes them a good ballast against turbulent markets. Bitcoin’s correlation is higher, meaning that it can provide some diversification benefit to a portfolio, but not to the same degree as bonds. Cryptocurrencies can be a component of your financial plan—but it shouldn’t be the only thing. While it can’t tell you if bitcoin will be the next digital gold, this mathematical model can help you think about what kind of allocation to crypto might be appropriate for you and what assumptions about risk and return might be underlying it. Even though Betterment currently doesn’t include cryptocurrency in our recommended investment portfolios, you can learn more about how to invest appropriately in it using our cryptocurrency guide. Since crypto should only comprise a small percentage of your overall portfolio, you should still have a diversified portfolio and long-term investment plan that will help you meet your financial goals. Betterment can help you plan for the short and long term, recommending the appropriate investment accounts that align with your financial goals and allowing you to select your preferred risk-levels. You can also align your investments with your values by using one of our three socially responsible investing portfolios.
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How to Make a Tax-Smart Investment SwitchHow to Make a Tax-Smart Investment Switch Calculate the value of realizing gains to move to a potentially better investment. A customer once called us to discuss moving significant assets from another provider to Betterment. He asked if he would have to pay a one-time tax cost to liquidate, and considering that cost, would the switch still be worth it? We thought we'd share with everyone a way to figure out the cost and benefits of switching. Depending on your particular circumstances, the answer is likely yes to both questions—selling off a long-established portfolio may trigger taxes, but in the long term, it can be worth it. As an example, you might want to move out of an actively managed mutual fund. Research has shown that a portfolio of actively managed funds is expected to underperform by 1.01% a year on average, after fees, compared to an all index-fund portfolio. Or perhaps you're interested in lowering your fees over the long term or diversifying your investments from a single stock to a multi-asset class portfolio. While nothing in this piece should be construed as tax advice, since individual circumstances can vary greatly, the following should serve as a general illustration of the cost and benefit of transitioning to a potentially better investment. Informed Trade-Offs The key here is making an informed trade-off—you may trigger a tax bill today by selling your current holdings, but if you're in it for the long haul, moving to a better portfolio consisting of all index ETFs should make up for that tax cost. The real question to ask yourself when looking to move your investments to Betterment is: How long do I intend to hold this investment for? If you’re a short-term investor and plan to hold assets for a couple of years, or less, there's not much to gain from transitioning to a more efficient portfolio (although it should be noted that under this scenario, you'll realize the capital gains very soon in any case.) And as a general rule, you should only consider moving appreciated investments that you've held for more than a year in order to qualify for long-term capital gains on liquidation. If your investments have not appreciated since you bought them, or if they are held in an IRA or 401(k), you can generally transition them tax-free.1 Tax Cost vs. Excessive Fees The process by which we pay tax versus fees on our investments subtly biases us to overestimate the impact of taxes, and underestimate the impact of fees. Fees are generally taken out of returns before they ever hit our accounts—it's money we never even see. Tax on realized capital gains is assessed for an entire year, and results in a clear and visible liability, paid out of funds that are already in your possession. It's no wonder that irrational tax aversion is a well-documented, widespread phenomenon, whereas millions of people unwittingly go on paying unnecessarily high fees year after year. Your key decision boils down to comparing the long-term benefit of switching to a potentially better investment and paying more upfront tax, versus staying put in a portfolio of less optimal investments with higher expenses (that might also be a drain on your time, which is worth something). It's also important to keep in mind that unless you gift or bequeath your portfolio, you will one day pay tax on these built-in gains. Tax deferral is worth something, but how much? The 3 Key Financial Drivers to Consider 1. You could be invested in better assets. Take a hard look at your investor returns in your current investments. Could they be better? If you’re invested in actively managed funds, you may be losing, on average, 1.01% in returns, compared to an all index-fund portfolio, research shows. Betterment’s portfolio is made up entirely of index-tracking ETFs. 2. Automation and good behavior drive returns. We automatically take care of maintaining your investments for you—including rebalancing, dividend reinvestment, diversifying, tax efficiency, free trades and more. If you’re handling your own investments, consider what you're missing (and also how you're spending your time.) We perform automatic, regular rebalancing, which is expected to add 0.4% to returns, on average; a global, diversified portfolio is expected to add 1.44% in returns as compared to a basic two-fund portfolio and the average Betterment customer has enjoyed a behavior gap that's narrower by 1.25% as compared to the average investor. All told, including the demonstrated benefit of index funds—these advantages are expected to contribute to returns over the long run. 3. If you're paying what a typical mutual fund charges, you could be paying much less in fees. The average expense ratio for a hybrid (stock and bond) mutual fund is 0.79%.2. Betterment’s underlying ETF portfolios have an average expense ratio of 0.06% to 0.17%, depending on your allocation. Note that the range is subject to change depending on current fund prices. Our management fee is either .25% or .40%, depending on your plan. Your all-in cost at Betterment is between 0.31% and 0.57%. As smart investors know, every basis point matters.3 Taxes are a cost, but generally a cost you'll eventually pay anyway. Meanwhile, the cost of being in a sub-optimal investment over the years can far outweigh any benefit of tax deferral. Need a second opinion? If you’re still not sure if transferring your taxable portfolio is worth the upfront costs, we can weigh in. If your taxable portfolio holds more than $250,000 in assets, stop stressing and simply reach out to our licensed transfer specialists at email@example.com. The team can review the specifics of your portfolio and provide you with a recommendation on how to best move—or not move—your assets to Betterment. 1 The discussion here only applies to taxable investment accounts. All types of IRAs (traditional and Roth) and 401(k)s don’t typically trigger taxes when rolling over from one provider to another. (An exception is converting from a traditional IRA to a Roth, which will trigger taxes. However, there are smart ways to lower these, too.) 2 2021 Investment Company Fact Book 3 We've updated our pricing structure since this article was published. Learn more at betterment.com/pricing.
How Much Could You Be Losing To Fees?How Much Could You Be Losing To Fees? Unexpected or hidden fees can damage your long-term investment returns. Sync your outside accounts with Betterment now and see how much you’re being charged by other investment providers. When you invest in valuable items, it’s easy to overlook the hidden fees. Buying a house certainly requires property tax and insurance payments, but you may quickly discover hidden fees in your investment—such as home repair and maintenance costs—of which you were never aware nor did you expect. Purchasing a car results in a similar scenario, in that taxes and insurance are rarely the only expenses. Repair, cleaning, maintenance, and miscellaneous fees can catch you off guard. You’ll soon realize that it’s more expensive than you ever thought to manage these assets. The same is true with investment accounts. At Betterment, we think all investment accounts should be clearly and transparently priced, without any hidden fees. Now, we can help you discover if you’re paying high advisory or hidden fund fees across all of your investments. Here’s a deeper dive into the types of fees you may encounter in your investments with outside fund providers. Understanding Fund Fees Expense Ratios When investing in any mutual fund or exchange-traded fund (ETF), the investor pays fees that cover the management, administration, and operations of the fund. These fees are summarized in the expense ratio. This fee may also include marketing costs which go to the salesperson, known as 12b-1 fees. The expense ratio is visible in the fund’s prospectus, but in general people rarely read that long document. It often goes unnoticed because the fee is not explicitly charged from the balance, but is instead built into the fund’s daily pricing. Contrary to general assumptions, paying higher expense ratios does not guarantee higher returns in an investment portfolio. Since paying higher fees does not necessarily equal high returns, choosing funds with a lower expense ratio is a simple yet generally sound investment strategy. Advisory Fees If you hire an advisor to choose and manage your investments, including one such as Betterment, you’ll most likely pay for the service received. This is known as an “advisory fee.” If you pay advisory fees with an outside investment provider, you can include the fees after you sync your outside accounts with Betterment. We then summarize how much you are paying in fees per year, and also take that number into account when providing retirement advice. Some advisors do not charge fees in an overly transparent manner but earn revenues in other ways. This can include the 12b-1 fees mentioned above, which are built into the expense ratio of the fund, or through load charges, explained below. Lesser-Known Fees Aside from expense ratios and advisory fees, some investment funds have even less transparent costs. One reason Betterment chooses ETFs for our portfolios is because they do not contain the fees mentioned below1, and they are often tax-efficient. On the other hand, mutual funds can have additional fees and revenue-sharing relationships, due to the level of trading and activity involved with the fund’s management. When investing in mutual funds, they typically have the following costs which are borne of the investor, but not included in the expense ratio. These include: Sales load fee: A sales charge imposed by “Class A” or “Class B” mutual funds when you purchase shares. “Class C” shares can have a load fee when you withdraw your money from the fund. These loads are commissions that pay the professional adviser or broker who sold you the fund. Trading fee: Trading fees when you buy or sell stocks in a brokerage account, or when the manager of a mutual fund pays to make trades within the fund. These expenses are taken out of the daily pricing of the fund, but not included in the expense ratio. These fees are hard to estimate, but in general a fund that has a high turnover, like an actively managed fund, will have higher trading fees. Redemption fee: Also referred to as a “market-timing fee,” or “short-term trading fee,” mutual funds charge this fee to discourage investors from making short-term “round trip” transactions (i.e., a purchase, typically a transfer, followed by a sale within a short period of time). 4 Steps to Minimize Investment Fees As a smart investor, there are four steps you can take to help minimize your investment fees. Know where you stand. Look up the expense ratios for all of your investments, or simply sync your outside accounts with Betterment to see a summary of the total advisory and fund expenses you are currently paying. Choose low cost funds. Typically, index ETFs are cheaper than mutual fund equivalents. They generally have no loads or marketing expenses. They also have lower turnover, which means lower internal trading costs and low taxes. Avoid trading costs. If you envision lots of trading activity across your investments, try choosing a platform that has no trading costs. Trading costs can be a constant drag on returns, especially when you use smart strategies like rebalancing and tax loss harvesting. Betterment includes both smart rebalancing and Tax Loss Harvesting+ (TLH+) benefits at no additional cost for customers. Select a low cost advisor. If you have investments with other providers, inquire regarding what fees outside of expense ratios are being charged. You can then enter these additional fees to appear on your synced non-Betterment accounts. Betterment is the largest independent online financial advisor, and we also deliver enhanced value with transparent pricing and lower fees than traditional financial services. When you sync your accounts, not only can you see all of your wealth in one place—we’ll also help you discover which outside investments are charging you high fees so that you can take action accordingly. Get started with opening a Betterment account today. For existing Betterment customers, get started syncing your accounts now. 1Some brokerages charge trading fees for ETFs. Trading fees are included in Betterment’s flat advisory fee.
Optimizing Performance in Lower Risk Betterment PortfoliosOptimizing Performance in Lower Risk Betterment Portfolios In this methodology, we provide insight into how we optimize the performance of the lower risk bonds in Betterment's portfolios. TABLE OF CONTENTS The Role of Ultra Low-Risk Assets in a Bond Portfolio How we optimize ultra-low-risk bonds to target a higher yield Why Two Low-Volatility Funds Result in Our Ultra-Low-Risk Asset Allocation Using 30-day historical yields to inform future yields Continued bond portfolio research In this methodology, we provide insight into how we optimize the performance of the lower risk bonds in our 100% bond portfolio. Primarily, Betterment’s optimization method involves the inclusion of short-term, investment-grade bonds in lower-risk allocations of the Betterment Portfolio Strategy. Why are we exploring this part of how we manage the Betterment Portfolio Strategy? First, over time, we’ve improved the mix of bonds in our portfolios to control risk without compromising expected performance—the main focus of this methodology. Second, many investors may not yet know about the important role of ultra-low-risk bonds in the portfolio we recommend. When investors opt for a 100% bond, 0% stock allocation in their Betterment portfolio, the only assets in the portfolio are bonds with ultra-low-risk profiles. The Role of Ultra Low-Risk Assets in a Bond Portfolio We have constructed the Betterment Portfolio Strategy—our set of recommended portfolios—to fulfill our five investing principles that guide our advice for you. One of our key investing principles is maintaining diversification. Effective diversification means taking as little risk as possible to achieve your growth target. For portfolios with lower risk levels, adding in ultra-low-risk bonds can help reduce risk without adversely affecting returns. We consider U.S. short-term Treasuries and other US. short-term investment-grade bonds to be ultra-low-risk (although all investments carry some measure of risk). At every risk level, Betterment invests in a portfolio that we expect to have the highest rate of return relative to its risk. These portfolios are considered to be on the “efficient frontier,” or the boundary of highest returning portfolios at any given level of risk. By further diversifying bond holdings with ultra-low-risk assets, the Betterment Portfolio Strategy pursues higher expected returns with less risk than portfolios that do not include these low-risk assets. Graphically, you can see below that the highest returning portfolios for lower risk levels (i.e., levels of volatility) are portfolios that include ultra-low-risk bonds (the black line). Additionally, certain low risk portfolios could not be achieved at all without adding ultra-low-risk assets. As you can see below, portfolios constructed without ultra-low-risk bonds (the blue line) are unable to achieve a volatility lower than approximately 7%. Figure 1. Betterment’s efficient frontier including ultra-low-risk bonds Expected returns are computed by Betterment using the process outlined in our methodology optimizing the Betterment Portfolio Strategy. Volatilities are calculated by Betterment using monthly returns data provided by Xignite. At a certain point, including ultra-low-risk bonds in the portfolio no longer improves returns for the amount of risk taken. This point is called the ‘tangent portfolio.’ For the Betterment portfolio strategy, the tangent portfolio is our 43% stock portfolio. Portfolios with a stock allocation of 43% or more do not include ultra-low-risk bonds. When a portfolio includes no stocks—100% bonds—the allocation suggests an investor has no tolerance for market volatility, and thus, our recommendation is to put the investor’s money completely in ultra-low-risk bonds. How we optimize ultra-low-risk bonds to target a higher yield As you can see in the chart below, we include our U.S. Short-Term Investment-Grade Bond ETF and our U.S. Short-Term Treasury Bond ETF in the portfolio at stock allocations below 43% for both the IRA and taxable versions of the Betterment Portfolio Strategy. https://d1svladlv4b69d.cloudfront.net/src/d3/allocation-mountain-chart/aa-chart.html At 100% bonds and 0% stocks, a Betterment portfolio consists of 80% U.S. short-term treasury bonds and 20% U.S. short-term investment-grade bonds. If an investor were to increase the stock allocation in their portfolio, the allocation to ultra-low-risk bonds decreases, though the relative proportion of short-term U.S. treasuries to short-term investment-grade bonds remains the same. Above the 43% stock allocation threshold, these two assets are no longer included in the recommended portfolio because they decrease expected returns given the desired risk of the overall portfolio. Fund selection In line with our fund selection process, we currently select JPST – JPMorgan Ultra-Short Income ETF to gain exposure to the U.S. short-term investment-grade bonds and we’ve selected SHV – iShares Short Treasury Bond ETF to gain exposure to U.S. short-term treasury bonds. To summarize the fund selection process, we start with the universe of bond ETFs with average maturities of less than 3 years, given the relationship between maturity length and risk. We further reduce the set of candidates by ruling out ETFs with unfavorable risk characteristics, including those with excessive interest-rate risk or high overall volatility. We then filter for funds with sufficient liquidity, so that we can maintain low costs for investors. Finally, we select the fund with the lowest combination of expense ratio and expected trading costs: JPST. The same process led to our selection of SHV. Why Two Low-Volatility Funds Result in Our Ultra-Low-Risk Asset Allocation Short-term US treasuries and investment-grade bonds are both inherently low-risk assets. As can be seen from the chart below, short-term U.S. treasuries (SHV) have low volatility (any price swings are quite mild) and smaller drawdowns (the length and magnitude of periods of loss are muted). Though slightly more volatile than short-term treasuries, the same can be said for short-term investment grade bonds (JPST). Figure 2. SHV and JPST The above chart shows the historical growth of $1 invested in each investment option from 9/30/2013 (the first date both funds SHV and NEAR (which is used as a historical proxy for JPST) were in existence) to 5/23/2018. Performance is net of fund-level fees and does not include any management fees from Betterment. Dividends are assumed to be reinvested. The composite is assumed to be rebalanced daily at closing prices. JPST fund inception as in May, 2017. For returns data in May, 2017 and earlier, we use returns from a comparable fund, NEAR. JPST replaced NEAR as our U.S. short-term investment-grade bond fund in Dec, 2019. Data: xIgnite. It’s also worth noting that these two asset classes do not always go down at exactly the same time. By combining these two asset classes, we are able to produce a two-fund portfolio with a higher potential yield and the same low volatility. In fact, combining these asset classes resulted in smaller historical drawdowns in performance that lasted for fewer days than was the case for either asset class individually. As you can see from the chart below, the combination of U.S. short-term treasury bonds and U.S. short-term investment-grade bonds used for the Betterment 100% bond, 0% stock portfolio (blue) generally had shorter, less severe periods of down performance than either fund by itself. Figure 3. Drawdowns in performance The above chart shows the largest drawdowns in performance from Sept 30, 2013—the first date both funds SHV and NEAR, which is used as a historical proxy for JPST—were in existence) to 11/14/2019. Performance is net of fund-level fees and does not include any management fees from Betterment. Dividends are assumed to be reinvested. The composite portfolio (blue) is assumed to be rebalanced daily at closing prices to maintain a 80% SHV, 20% JPST weighting. JPST fund inception was in May, 2017. For returns data in May, 2017 and earlier, we use returns from a comparable fund, NEAR. JPST replaced NEAR as our U.S. short-term investment-grade bond fund in Dec, 2019. Data: xIgnite. Using 30-day historical yields to inform future yields A reasonable question about this methodology is how to interpret the potential returns of the composite looking forward. As with other assets, the returns for ultra-low-risk bonds include both the possibility of price returns and income yield. Generally, price returns are expected to be minimal, with the primary form of returns coming from the income yield. Below you can see that the prices for the composite of 80% SHV and 20% JPST tends to stay fairly constant, while the price with dividends grows through time. This shows that the yield (paid by the funds through monthly dividends) is responsible for almost all of the growth in these funds. Figure 4. Growth of $100 in the Betterment 0% stock portfolio The above chart shows the historical growth of $100 invested in a portfolio that consists of 80% SHV and 20% JPST. Data is from 6/1/2017 (the first full month both funds SHV and JPST were in existence) to Nov. 14, 2019. Performance is net of fund-level fees and does not include any management fees from Betterment. Dividends are assumed to be reinvested. The portfolio is assumed to be rebalanced daily at closing prices. Data: xIgnite. Looking at 30-day SEC yield—a standardized calculation of yield that includes fees charged by the fund—we can get a good sense of the expected performance for these low-volatility assets. Why can we believe this? First, performance is determined by both yield and price change, and because there is low price volatility in these assets, yield is the primary component of performance. We use the SEC 30-day historical yield as an expectation of annualized future yield because it’s the most recent 30 days of yield performance, and we generally expect future yield to be similar to the last 30 days, although past performance does not guarantee future results. We expect this to be the case because the monthly turnover in these funds is relatively low. However, the yield can be expected to change—either up or down—as market conditions, including interest rates, change. The yields you receive from the ETFs in Betterment’s 100% bond portfolio are the actual yields of the underlying assets after fees. Betterment does not adjust the yield you earn according to our discretion, as a bank savings account could. A bank may choose not to adjust its interest rate higher as prevailing rates rise, or may cut its interest rate. Because we are investing directly in funds that are paying prevailing market rates, you can feel confident that the yield you are receiving is fair and in line with prevailing rates. Below we can see that over the 30 days ending Nov. 14, 2019, SHV had an annualized yield of 1.59%, net of fund fees, which is dispersed to shareholders on a monthly basis. Over the same period, JPST yielded 2.12%. The 100% bond portfolio, composed of 80% SHV and 20% JPST, has yielded 1.70%. Table 1: Risk and Yield Ultra low-risk bond baseline (SHV) Additional candidate fund (JPST) SHV 80% + JPST 20% SEC 30-day yield (includes fund expense ratios) 1.59% 2.12% 1.69% Annual Volatility 0.30% 0.38% 0.30% Deepest drawdown return -0.12% -0.34% -0.12% Expense ratio 0.15% 0.18% 0.16% SEC 30-day yields are as of Nov. 14, 2019. Annual volatility and drawdown return are calculated from Sept. 30, 2013 —the first date both funds SHV and NEAR, which is used as a historical proxy for JPST—were in existence) to Nov 14, 2019. For returns data in May, 2017 and earlier, we use returns from a comparable fund, NEAR. JPST replaced NEAR as our U.S. short-term investment-grade bond fund in Dec, 2019.SEC 30-day yields, annual volatility and drawdown are net of fund fees and do not include Betterment’s management fee. Data from Xignite and Betterment calculations. Bond portfolio research never stops. By combining multiple low-risk assets, we seek to deliver higher expected returns, through higher yields, while keeping risk in check. The diversification benefits of U.S. short-term treasuries and investment-grade bonds allow us to construct low-risk portfolios with shorter and less severe downturns. As always, we iterate on our portfolio optimization methods. We update our changes in this overview of our financial advice as we develop improved ways of helping you reach your financial goals.
How Much Are You Losing To Idle Cash?How Much Are You Losing To Idle Cash? Uninvested cash may feel more readily available compared to when it's invested, but there can be better ways to manage your funds. Find out how. So far, we’ve told you about the consequences of having uninvested cash in your investment portfolio. But cash is king, and so even the most savvy investors still keep money in places like checkings and savings accounts in order to have easy access to those funds, which then can be used for day-to-day expenses. Here at Betterment, we want you to do better. What Is “Idle Cash”? Idle cash is money that is not invested in anything and is therefore not earning investment income. It’s money that is not actually participating in the economy-- not being spent on anything and not increasing in value. Therefore, it can’t earn you anything. Ultimately, keeping idle cash on hand is simply not as beneficial as you may think. In fact, these funds are frequently considered wasted, as they typically cannot keep up with the effects of inflation. In the U.S., the inflation rate that the Federal Reserve targets is 2% annually-- given that your idle cash likely does not increase in value, its purchasing power actually decreases as time passes. That’s right—uninvested funds gradually lose value, since they are unable to keep up with the rate of inflation, which means that as time goes on, the $100 under your mattress can eventually only buy $98 worth of things, then $96, then $94, and so on. And that’s just inflation—the opportunity cost of keeping cash that you otherwise could invest in the market is even worse. Why do people keep uninvested cash? Despite the fact that keeping idle cash can be detrimental to a successful, long term savings plan, there are still plenty of reasons for people to keep cash on hand. Accessibility and liquidity are huge factors—investors want to be able to pay their bills from their checking accounts with the click of a button, for example—as is safety and security, and the fact that savings accounts from member banks are FDIC-insured. The current reality is that among the checking and saving accounts out there, the return on deposited funds is very low. In fact, the FDIC announced that as of February, the average yield on a savings account is 0.09% APY—in a 2% inflation environment, this is still a purchasing power losing investment. The yield on checking accounts is even worse—most of these products have very low interest rates. How much uninvested cash can I get away with keeping? While a small portion of uninvested cash may seem insignificant, it can be disadvantageous for at least two reasons: Preventing it from keeping up with inflation rates means your cash loses value over time, and You fail to benefit from money that can compound over time and garner even higher returns. Typically you shouldn't reinvest cash if it costs you more to actually invest it than what you would earn, due to, for example, broker commissions. However, at Betterment, the absence of trading commissions, as well as our ability to support fractional shares, help ensure that every last cent of your cash is being put to work for you. If we assume an average trading cost of $7 per trade (typical of discount brokerages) and you don’t want to reduce your returns by more than 1%, then you should have, at most, $700 of cash. Even though we recommend having no cash at all because any amount may reduce your returns, for practical reasons we believe portfolios have too much cash when they exceed $700 in cash. How should I manage the rest of my cash instead? There are many schools of thought as to how cash can be managed, but the most common objectives are the following: Yield (without meaningful risk) and liquidity-- simultaneously making sure that your cash does not waste away due to the effects of inflation while mitigating potential high risk. That you are able to access your cash within a reasonable amount of time. Consider Using Cash Reserve At Betterment, we spend a lot of time thinking about how to help you make the most of all your money. In fact, we recently launched Cash Reserve, a high-yield cash account that’s designed to help you manage your idle cash and can earn you a variable rate up to 0.10% ,* once at our program banks. For example, our Two Way Sweep feature for Cash Reserve runs an automated daily cash analysis on your checking account, in order to determine if your account is holding too much, or too little, cash. We’ll then adjust it accordingly, all automated for your convenience. Idle cash can also result from cash dividends which are not reinvested: at Betterment, your dividends are automatically reinvested, resulting in zero idle cash and zero cash drag from your accounts. In addition, we provide you with a holistic picture of all your investment accounts from a cash management perspective, from idle funds in external accounts to the cash inside the funds you purchase. We highlight each portfolio’s total idle cash, along with a simple projection of how much potential returns could be lost by holding that cash amount long-term.
Understanding The Inverted Yield CurveUnderstanding The Inverted Yield Curve Our economy is about to make history. June of 2019 marked 10 years of expansion of the U.S. economy, which ties with the previous record spanning March 1991 to March 2001. The economy is on track to have its longest period of economic expansion in U.S. history, meaning that various measures of our country’s economic success are on an upward trend. June of 2019 marked 10 years of expansion of the U.S. economy, which ties with the previous record spanning March 1991 to March 2001. 10 years of expansion is nearly double the average expansion since the 1940’s. This may leave an investor wondering if the end of growth may be near. However, economic expansions don’t simply die of old age. You can look to Australia’s economy, which has been growing for the past 28 straight years, as a good example. What ultimately directs growth is the underlying health of the economy. Economic health is typically measured by factors such as employment levels, inflation, and gross domestic product (GDP). Unemployment is currently at multi-decade lows and inflation remains in check. Both are positive signs of a healthy U.S. economy. Recently, attention has turned to the bond market, where the yield on longer-term U.S. Treasury bonds is lower than their short-term equivalents. This phenomenon—known as yield curve inversion—has received a fair amount of media coverage recently, and it’s often described as a sign that a recession could be coming. Though an inverted yield curve has preceded a number of recent recessions, the timing around a recession is uncertain, often happening years later. Additionally, stocks can still have positive performance while the yield curve is inverted. What is the yield curve, and why is it inverted? The yield curve refers to the yield paid on bonds at different maturities. Bond maturity refers to the amount of time between when the bond is issued and when it reaches its end date and the issuer must redeem it. Generally, bonds with longer maturities have higher yields to compensate investors for tying up their money for longer. This is called an upward sloping yield curve. Upward Sloping Yield Curve (US Treasuries—June, 2018—1 Year Ago) Data: US Treasury The yield curve inverts when longer maturity bonds—10 year bonds for example—have a lower yield than short-term bonds. To describe the slope of the yield curve, yields on three-month or two-year maturity bonds are often compared to the yield on 10-year bonds. If three-month or two-year bonds have higher yields than the 10-year bonds, the yield curve is considered inverted. Inverted Yield Curve (US Treasuries—June, 2019) Data: US Treasury The yield curve generally inverts when investors collectively think that short-term interest rates will fall in the future. In that case, investors rush to “lock in” a rate for a longer period of time, and in the process, they drive down yields. During recessions, the Federal Reserve generally lowers short-term interest rates to stimulate growth. In the past, an inverted yield curve has often preceded a recession as bond investors looked to lock in a rate for a longer time period in anticipation of actions taken by the Federal Reserve. How predictive has the yield curve been? To be fair, an inverted yield curve has preceded a number of recessions. However, an inverted yield curve does not make an upcoming recession a sure thing. In fact, three of the last 10 times that the yield curve inverted, no recession occurred over the following two-year window, per Goldman Sachs research in March of 2019. Even in the times when a recession did follow, the timing has been fairly uncertain, starting anywhere from 8 to 22 months after the curve inverted. This lead time was often longer during periods of low inflation—like the current inflation environment, which has been hovering at or below 2% for a number of years now. Finally, there just haven’t been enough historical business cycles to confidently say an inverted yield curve means a recession is coming. Business cycles represent the rise and fall of the economic output of goods and services and are generally measured by a country’s GDP. There have been 33 full cycles since the mid 1850’s, and only 11 in the modern, post-war era. With such few instances in the past to draw from, it’s hard to say that an inverted yield curve on its own means a recession is on its way. What should an investor do? Often, more money can be lost trying to avoid a down market than in the down market itself. In general, stocks have risen even as the yield curve was inverted. It’s also important to remember that a market decline of 10% or more has lasted four months, on average. Therefore, trying to time the next downturn generally isn’t a good strategy. Instead, investors should make sure that the risk in their portfolios matches their investing time horizon. Smart investors align the risk in their portfolio to reflect how long they plan to invest. Money that you will need soon should skew towards lower risk investments. At Betterment, we’ll help you do this automatically by setting your portfolio up at an appropriate allocation (your mix of stocks and bonds) and with auto-adjust turned on in your portfolio, we’ll automatically adjust your allocation as your goal’s end date approaches. Betterment’s portfolio recommendations take the potential for down markets into account and seek to align your risk with your investment horizon to help you have the best chance of reaching your goals—whether there is a recession in the future or not.
Investing in Different Assets: What Are Your Possible Choices?Investing in Different Assets: What Are Your Possible Choices? You want to begin investing, but have no idea where to start. Here is your guide to investing in different assets, jargon-free. It’s easy to get overwhelmed by the number of new and foreign terms we encounter while investing. In this article, we will provide a basic overview of different types of investments and how you should think about using them. Before we get started, the first jargony term that you may encounter is “asset class.” Though it sounds fancy, it simply describes a broad group of fundamentally similar investments. You can think of different asset classes as different species of investments -- investments in each asset class share common traits. Stocks, bonds and cash are three of the most common asset classes in the investing world. There are others, like commodities (raw materials or agricultural products) and real estate, but they fall outside the scope of this article and are less common for investors to consider. One final note—here at Betterment, we invest your funds in stock and bond ETFs that we’ve researched and selected for you. You can read more about our investments and portfolio strategies here. The information in this article is intended to be educational so that you can be an informed investor no matter where you choose to invest. Investing In Stocks First, let’s understand exactly what we are getting when we buy a stock. When you buy a stock you are getting partial ownership of the company, and with that comes all the benefits (and risks) of being an owner. You get a vote in how the company is run -- which often takes the form of proxy votes. You participate in the value creation when the company does well -- generally in the form of an increase in the value of the stock or dividends. You also experience the downside when the company performs poorly --- generally in the form of lower share prices or reduced dividends. As a stockholder you have a claim on a company’s earnings after debts are paid. This is a fundamental feature of stocks and differentiates them from bonds and cash. The most meaningful difference here is that potential future value of a stock is not limited. So, if a company does very well, you participate in all the positive performance after debts are covered. The flip side of this is that if the company does poorly, stockholders are the first to absorb losses, before lenders are impacted. Overall, this means stocks are more risky than bonds but also have the potential to generate higher returns. Historically, stocks have outperformed bonds. The chart below shows the historical growth of a broad stock investment compared to bonds and cash, after adjusting for inflation. As you can see, stocks are more volatile, but also generated the most growth. Data source: Stocks For The Long Run. Page 10. 1998. Buying Bonds Bonds are essentially IOU’s from companies or governments. A bondholder essentially owns a loan that must be repaid in the future. Bondholders earn income from interest payments and return of the initial loaned amount, called principal, at the bond’s maturity. Unlike stocks, the return on a bond is capped. The payments to the bondholder are predetermined at the time the bond is issued. This means that even if a company does extremely well, the bondholder will only get what was agreed upon in the terms of the bond. This is why bonds are often called “fixed income” investments -- because the amount of income generated by a bond is fixed at the time of purchase. If a company does poorly, however, bondholders have priority when it comes to getting paid. This makes bonds less risky than stocks. In general, bonds are a safer asset class than stocks. Holding Cash And Equivalents Cash is the asset class you might be most familiar with. There are a wide range of places you can park your cash and earn interest in the process. Cash and cash equivalent assets are very low risk, highly liquid (easily convertible to cash), short term investments. These include money markets, treasury bills, certificates of deposit (CDs), and short-term corporate debt. Because cash and cash equivalents tend to be very safe, the biggest risk is inflation eroding the buying power of your dollars. In fact, historically holding cash can lose an investor money after accounting for inflation. Below is a chart of interest rates on a savings account after accounting for inflation. As you can see, after accounting for inflation, the “safe” investment in cash can actually lose value. Purchasing Funds Now that we understand the different kinds of assets in which we can invest, it’s worth considering one additional concept -- investment funds. Mutual Funds vs. ETFs Investment funds will select a group of stocks or bonds and manage those assets for the benefit of fund shareholders. The two most common type of funds are mutual funds and exchange traded funds (ETFs). The advantage of an investment fund is that you immediately benefit from since a fund holds many individual assets. Diversification is the process of investing in different assets to reduce exposure to risk. In fact, investment funds allow you to invest in broad swaths of asset classes in one fell swoop. For example, Vanguard’s Total Stock Market ETF (VTI) invests in the entire U.S. stock market. The fund owns over 3,000 individual US stocks. There are some subtle, but meaningful distinctions between mutual funds and ETFs. Perhaps the most obvious is that ETFs, as the name suggests, are traded directly on the stock exchange. This means that you can buy or sell shares of an ETF throughout the trading day. Mutual funds transactions, on the other hand, occur once at the end of each day at the funds closing Net Asset Value (NAV). ETFs are also more tax efficient than mutual funds. Without getting into too much detail, ETFs are able to swap out investments with large taxables gains with new shares of the same investment. This means that ETFs are substantially less likely to generate capital gains inside the fund. Ultimately, there are many advantages to using ETFs that could better serve your financial plan. How To Invest We know that stocks are generally more risky than bonds and that we can use investment funds to get broad exposure to these asset classes. The next logical question is: What exactly should I buy and how much of each? To answer this, we want to focus on two things: risk level and diversification. First, we want to make sure that we are building a portfolio of stocks and bonds that takes an appropriate amount of risk for your investment goal and time horizon. In general, shorter term goals should take less risk, which means holding more bonds and fewer stocks. As your investment horizon (or the length of time you are aiming to invest your portfolio) lengthens, you should consider investing a larger part of your portfolio in stocks. More time allows for more opportunities to participate in the upside potential that stocks provide. However, you should think broadly about all the factors influencing your financial life and set customizable goals to further your financial plan. You also want to make sure that you are selecting stocks and bonds in our portfolio that maximize the level of diversification in your portfolio. Simply put, you want to add investments that you believe will grow in value but also don’t go up or down in value in exactly the same way at exactly the same time. In the illustrative example below, you can see that by combining U.S. and international stocks, the overall portfolio is less volatile. A portfolio with good diversification overall will typically grow while the value of the overall portfolio remains more stable compared to individual investments. Let Us Take The Wheel Here at Betterment, we’ll take care of it all for you. We’ll invest your funds in a mix of globally diversified stock and bond ETFs, chosen to help you earn better returns at various levels of risk. Speaking of risk, we’ll recommend how much to take on based on when you'll need your money. Get started with us and put your investment choices on auto-pilot today.
This Is Why an ETF Portfolio Serves You BetterThis Is Why an ETF Portfolio Serves You Better 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 customers. 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. Low cost 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. Diversified 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. Tax-efficient 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. Flexible 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. Sophisticated 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.
Debunking Myths About ETF LiquidityDebunking Myths About ETF Liquidity What exactly happened with ETFs on Aug. 24? Here’s what: A sequence of global volatility, trading disruptions, and thoughtless selloffs. We break down what happened and why. On Aug. 24, 2015, the Dow Jones Industrial Average saw its largest-ever intraday decline. Major stocks, such as JPMorgan, KKR, Ford, and General Electric, all experienced at least 20% price declines before recovering, according to Blackrock1 and Barron’s. The disruption was short-lived, but while it lasted, a set of ETFs traded at large discounts to the underlying securities. ETFs were supposed to be liquid in good and bad markets, but there is the perception among investors that they played a major role on August 24 in causing the market’s strange interlude. But, in reality, based on the factors below, ETFs were not the cause of the trading problems; they were a victim of them. The trading problems occurred because of volatility from the previous night’s global market activity, and (counter-intuitively) the exchange circuit-breakers that were meant to prevent such problems. The Setup Even before markets opened in the United States, markets were already anticipating significant price volatility. Asian markets sold off substantially overnight, with the Shanghai Composite down 8.5%—its worst plunge since 2007. This weakness in Asian markets rattled the U.S. market, putting the latter under selling pressure before its trading day began. U.S. investors started placing aggressive sell orders without restrictions. The First Crack: Rule 48 Prior to the opening bell, market makers typically disseminate price indications of where they think securities will trade. This allows traders to facilitate an orderly market open and have more stable prices when the market opens. This did not occur on the morning of Aug. 24 because the New York Stock Exchange (NYSE) invoked Rule 48, which suspends the requirement of stock prices to be announced at market open. According to a Blackrock report, almost half of NYSE equities failed to open that morning, even after the stock market had been open for 10 minutes. The lack of information made it difficult for traders to know where they should price stocks and give accurate bid-ask spreads. In effect, traders worried that without transparency, they could be overpaying or under-selling for securities. Amidst the turbulence and lack of clear prices during the first 30 minutes of trading, traders acted conservatively and quoted bid prices that were abnormally low (if buying) or ask prices that were abnormally high (if selling). As a result, the stocks that did open on time generally traded at unusually low levels. This in turn led to larger price moves, resulting in widespread trading halts in individual securities, further aggravating liquidity issues. Widespread Trading Halts A trading halt occurs when a stock’s price has moved up or down too quickly in a particular trading range. According to an ITG report, on Aug. 24 there were almost 1,300 such occurrences, which is 30 times the daily average of 40 halts over the past year. ETFs typically represent one-third of the total trading halts. On Aug. 24, ETF halts made up 78% of total halts. The widespread trading halts in ETFs were partly the result of Rule 48’s impact on a specific subset of securities. Despite some stocks not opening on time, many ETFs did open on time, as rule 48 did not apply to them. The ETFs were more liquid than their underlying securities; research shows this is true a surprising amount of the time. But, the underlying securities were impacted, so many ETFs opened without valuations for some portion of their underlying assets. Traders quoted wide bid-ask spreads (high sell prices and low buy prices) on the ETFs to generally to protect their own positions, in case the underlying assets traded at abnormally low levels when they did begin trading. ETFs can often provide more liquidity, but in this case, not when there is none in the market and there are artificial limits to trading. ETFs aim to trade closely to the value of the securities that they track, and they usually do. But on Aug. 24, some of the biggest and most well-known U.S.-listed ETFs traded at steep discounts to the value of their underlying securities. This meant that the ETFs declined more in price than their underlying holdings (noting that it’s not clear what the correct price for their underlyings was, given that they were halted). For example, according to the Wall Street Journal, the Vanguard Consumer Staples Index ETF plunged 32%, while the value of the underlying holdings in the fund fell 9%. The substantial price dislocation experienced by many U.S. ETFs led some to conclude that ETFs were to blame for the widespread market disruption. But in fact, their volatility was a byproduct of the illiquidity of the underlying instruments. Lessons from Aug. 24 Lesson 1: Invest in Funds Tied to Liquid Assets ETFs can be more liquid than their underlying assets, but only get good pricing when those underlying assets are actually tradeable. When trading in the basic securities is halted, the ETF that tracks those securities may also be difficult to trade. Without liquidity, market makers cannot keep ETFs in line with the securities to which they’re tied. Thus, it is important to pick ETFs that track as liquid underlying investments as possible. Although many ETFs that saw trading disruptions do track liquid markets, picking ETFs that only track liquid markets can help prevent liquidity crunches in your portfolio. It’s also worth noting that trading halts on Aug. 24 caused a normally liquid market to generally become illiquid. The same is largely true for mutual funds, as well, and they cannot provide additional liquidity by delivering in-kind redemptions, as ETFs can. When Betterment chooses ETFs for our portfolios, we filter for liquid ETFs that also track liquid markets; for example, we don’t recommend high-yield bond ETFs. Lesson 2: Don’t Sell When Others Are Selling For steady, passive investors, the price dislocations experienced on Aug. 24 probably went by unnoticed. However, those who saw the problems and chose to sell as others were selling may have incurred substantial losses. Had they ignored the market, a significant portion of the losses seen in the initial minutes of trading would have appeared as a blip rather than a serious portfolio hit. Betterment knows that market opens and closes are typically more volatile than any other times during the trading day, so we purposely avoid trading during those windows. We do not guarantee specific execution timelines. Deposits generally trade the same day if requested at least a half an hour prior to market close. Otherwise, withdrawals will be executed the following trading day. Lesson 3: Avoid Stop-Loss Orders Some investors were impacted on Aug. 24 because of stop-loss orders. These are orders that are automatically triggered when certain trade price thresholds are met, regardless of why they are met. In a market where ETF prices drop abruptly, investors may have stop-loss orders executed automatically at a price dramatically lower than the trigger price. When the market bounces back, the investorwho sold at the lower price may have to get back into the same security at a much higher price level. This is the classic “sell low, buy high” scenario that investors should avoid. Looking Back The price dislocations of Aug. 24 were the result of global market volatility that led to disrupted pricing and trading in the U.S. market. This negatively affected ETF market trading, which was further exacerbated by stop-loss orders and a lack of liquidity providers. The events from that day can teach us to invest in funds tied to liquid assets, avoid stop-loss orders, and hold steadily as others sell. 1https://www.blackrock.com/corporate/en-us/literature/whitepaper/viewpoint-us-equity-market-structure-october-2015.pdf, pp. 2-3 This article originally appeared on ETF.com.
The ETF: Portfolio Management’s Best ToolThe ETF: Portfolio Management’s Best Tool We believe ETFs’ superior cost, transparency, and tax management make them the ideal investment tools for the modern world. When John Bogle, Vanguard’s founder, pens an op-ed calling ETFs “the greatest marketing innovation,” we had to read it. And we’re happy to see that we agree with him for the right reasons … and disagree with him for the right reasons. For a quick review, unlike mutual funds, ETFs can be priced and traded intraday by exchanges and market makers. Mutual funds can only trade once per day, right after the close of the markets. Mr. Bogle quite rightly is concerned that ETFs can trade intraday means that some investors will speculate with them by buying low in the morning, and selling high in the evening. Such short-term speculating is likely to harm long-term successful investing. On that score, we’re 100% with him. However, the difference in how ETFs and mutual funds trade and price has significant benefits for portfolio management, too. For one, ETFs trade throughout the day, and therefore see a wider range of prices in a single day, allowing tax loss harvesting and rebalancing to provide more value. In fact, we believe ETFs’ superior cost, transparency, and tax management make them the ideal investment tools for the modern world. For example, ETFs are more transparent, as they don’t embed 12b-1 fees, which a salesman or broker can earn from selling the mutual fund (creating a conflict of interest in the mutual funds they sell). Here, we’ll focus on how ETFs are superior investment vehicles when it comes to portfolio management. When it comes to portfolio management, short-term fluctuations in the prices of securities may not be a bad thing—they can create more opportunities to rebalance and tax loss harvest. These aren’t short-term speculative moves—they are long-term tax and risk management benefits, made possible by efficient technology. In addition, they can more correctly reflect current underlying prices. However, because of intraday fluctuations, it is possible for ETFs to trade at prices very different to the underlying index in the very short term. If you care a lot about getting a perfect price open-end mutual funds may be more attractive, as they always are priced at the net asset value of the underlying assets… but once per day, after close. The one-time pricing has its own downsides. Fund Types and Characteristics ETFs Open-End Mutual Funds Closed-End Funds Diversification Benefits Yes Yes Yes Share price determined by supply and demand Yes No, price determined by net asset value of the underlying assets Yes Can new shares be created? Yes, through creation and redemptions Yes, through creation and redemptions No generally, the pool of money collected for the investment vehicle does not change after the initial IPO however shelf programs can be created to help w/ liquidity Can trade at premium/discount to NAV Yes No Yes Intraday NAV? Yes No No Below we took a look at how intraday changes could significantly affect how your portfolio is managed by comparing the frequency of tax loss harvesting and rebalancing when observing intraday prices rather than just closing prices. The chart below depicts the close-to-close return (represented by the dot), which is the closing price for a certain date compared to the closing price of the day before. We’ve normalized it so that all close-to-close returns have a value of zero, to compare other returns to. It also shows the return generated by the daily high and low of intraday trading for EEM, the iShares MSCI Emerging Markets ETF. This lets us see the range of returns we observe with an ETF compared to a mutual fund. When the close is the high or low price of the day, the high/low bracket is not plotted. As you can see, on the vast majority of days, the highest or lowest return is very different from the close to close return. In other words, ETFs have significantly more tax loss harvesting opportunities (the lows) and rebalancing opportunities (both lows and highs) than mutual funds. One-Day Range of EEM Returns Prior Day Close to Today’s High and Low The Opportunities for Intraday Trading Most days have a range of returns that is significantly different from the close-to-close return. Both mutual funds and ETFs price daily, but only ETFs can trade intraday. How much opportunity actually occurs intraday? And, more importantly, how much incremental opportunity does intraday provide? It turns out, quite a lot. In the table below, we present the count of observing a 3% loss, when looking at close-to-close prices for one day’s return. Count of Close-to-Close Losses Intraday Loss AGG VTI EFA EEM -1% 14 397 487 656 -2% 4 130 189 282 -3% 1 49 83 142 -4% 1 28 42 76 -5% 1 13 24 42 -6% 1 9 11 29 -7% 0 3 7 23 -8% 0 3 4 13 -9% 0 2 3 9 -10% 0 1 3 7 The above table shows four different ETFs, each representing a different asset class. We chose the AGG, a bond ETF that encompasses the broad U.S. bonds market; VTI, the total U.S. stock market ETF; EFA, a developed markets stock ETF; and EEM, an emerging markets ETF that covers the emerging markets. We chose these ETFs because we wanted to look at several different geographies and asset classes. The table above illustrates the number of times one can expect a mutual fund (using close-to-close returns) to experience a portfolio management event, whether it’s tax loss harvesting or rebalancing, because the mutual fund experienced a 3% loss. As we move down each column, the loss level hurdle increases and the number of occurrences decreases for all four funds. If we look at the same data below, but for close-to-low prices (the difference between closing price and the lowest price for that day), we have how likely it is that an ETF sees a given loss when we can observe intraday prices. The number of occurrences increases by a significant magnitude if an investment trades throughout the day rather than trading only once at market close. Count of Close-to-Low Losses Intraday Loss AGG VTI EFA EEM -1% 43 702 865 1108 -2% 9 209 319 492 -3% 5 79 125 224 -4% 2 41 70 119 -5% 1 26 38 72 -6% 1 17 21 49 -7% 1 14 15 36 -8% 1 11 10 20 -9% 0 5 8 14 -10% 0 2 3 10 The table below shows the increased odds of seeing a level of loss for an ETF relative to a mutual fund. As you can see, being able to trade intraday generally creates roughly a 2x increase in potential tax loss harvesting opportunities per day. Increase in Likelihood of Loss Intraday Loss AGG VTI EFA EEM -1% 307% 177% 178% 169% -2% 225% 161% 169% 174% -3% 500% 161% 151% 158% -4% 200% 146% 167% 157% -5% 100% 200% 158% 171% -6% 100% 189% 191% 169% -7% NA 467% 214% 157% -8% NA 367% 250% 154% -9% NA 250% 267% 156% -10% NA 200% 100% 143% It might not be obvious, but these are intraday return differences that are resolved by the end of the day—ETFs and mutual funds have the same close-to-close return. So these are ephemeral opportunities to tax loss harvest and rebalance. But the good news is even if we look over larger periods, we still see significant increase in potential tax loss harvesting opportunities by looking at intraday prices. Instead of looking at just the one-day intraday differences, we can check on a longer five-day range, and find that ETFs will still see many more opportunities to tax loss harvest and rebalance than mutual funds. Increase in Likelihood of Loss Over Five Day Period Loss AGG VTI EFA EEM -1% 165% 138% 130% 125% -2% 208% 142% 128% 129% -3% 233% 153% 139% 133% -4% 300% 144% 134% 148% -5% 150% 177% 145% 144% -6% 100% 162% 159% 145% -7% 200% 147% 153% 145% -8% 200% 200% 168% 151% -9% 100% 176% 153% 140% -10% 100% 193% 154% 155% Up-to-Date Prices on International ETFs The fact that ETFs can price intraday provides other benefits. With ETFs that track international indexes, but trade here in the United States for local investors, when the international markets are closed investors can use them to provide an estimate of the value of the underlying index. This is especially true with international ETFs because when the underlying markets are closed, the ETF still trades in the United States. As information and news about those countries break and are continuously processed throughout the day, the prices are not reflected by the underlying securities (as that market is closed) but are reflected in the prices of the ETFs that trade in the United States. So if you look at the net asset value (NAV) of a mutual fund, it probably doesn’t reflect the most up-to-date information about the price. But the ETF will. The reality is ETFs are sometimes the only tools for discovering the price at which the underlying assets should trade. While they may not reflect 100% accurately the movement in the underlying market, ETFs hold substantial predictive value when it comes understanding the underlying market. Bogle may have penned an attack on ETFs, his attack is really an attack on trading concentrated niche ETFs that are active in nature for speculative purposes. Betterment’s portfolio of ETFs are all passive ETFs that track an index. We never buy or sell for speculative purposes. Rather, we trade if there’s value to be gained from portfolio management. The way that Betterment uses ETFs very much resembles Bogle’s philosophy of long-term index investing: buy and hold, and don’t try to beat the market. This article originally appeared on ETF.com.
Eliminating the Black Box: How We Automated ETF SelectionEliminating the Black Box: How We Automated ETF Selection The 30 funds we use in our portfolio were selected on merits so clear that we codified it. Here’s how we narrowed our ETFs down to 30 from more than 1,600 choices. 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 Passive/index-tracking 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 Asset Class 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 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 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 TACO 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.
Municipal Bonds: When Does It Make Sense to Go Local?Municipal Bonds: When Does It Make Sense to Go Local? The case for munis, certainly relative to Treasurys, seems clear. Yet as with most investments, there's more to the story. It generally makes sense for investors to expand their horizons and diversify into foreign stocks and bonds, but when it comes to one type of asset, municipal bonds, could a local outlook be more suitable? Well-off investors have long used municipal bonds, often called munis, for tax-smart investing, particularly because their interest generally incurs no federal income-tax liability. Munis became even more useful in 2013, when tax rates went up. The top rate was raised to 39.6% from 35%, and an additional 3.8% tax on investment income for high earners, a provision of the Affordable Care Act, was introduced. But why settle for one tax write-off when you can get two or even three? States generally don't tax interest on munis issued within their borders, so residents who buy them can collect interest free of state and federal tax alike. Residents of cities or counties that assess their own income tax could deduct income on munis issued within the state on their city tax forms, too, completing a tax-break trifecta. New York is the most notable example of a city that has its own income tax, but it's far from alone. Yonkers, just over the New York City border from the Bronx, is another one, as are Wilmington, Delaware; Birmingham, Alabama; eight cities in Kentucky and on and on. Muni-bond investments in taxable accounts are smart choices for residents of New York or other cities with income taxes, and a sensible (or clear) choice for those who live in high-tax states. But they may even make sense for everyone else who gets to deduct the earnings from their federal income taxes. Consult a tax professional to learn the full tax consequences of munis for your financial situation. By investing locally, you may get all the tax breaks, but you leave yourself highly exposed to other breaks that may not go your way. The federal tax deduction would seem to make municipal bonds excellent assets for high-income investors. The state deduction would seem to make homegrown issues even better holdings for investors who live in high-tax states such as New York, New Jersey and California, and seem even better still for residents of New York City and, perhaps, Wilmington. Some financial advisors encourage their clients to keep nearly all, or at least most, of their bond exposure in munis. It's easy to see why with a look at mutual fund performance over the medium to long run. The average municipal bond fund returned 4.7% a year in the five years through this March, according to research firm Morningstar, about the same as for the average bond fund that provides no tax break. Municipal yields continue to exceed those of Treasury instruments across the yield curve. Ten-year munis recently yielded 2.3% on average, according to Bloomberg, compared with 2.1% for 10-year Treasurys. The corresponding figures for two-year issues were 0.65% and 0.5%. The case for munis, certainly relative to Treasurys, seems clear. Yet as with most investments, there's more to the story. It's important to remember, for instance, that while muni returns have been adequate, they have not been spectacular despite nearly ideal conditions of a slowly recovering economy and ultra-low interest rates. Interest-Rate Connection With rates on nearly all debt low by historical standards, the path of least resistance seems up. If Treasury yields move higher, municipal yields are likely to do the same; that raises the chance of a capital loss to go along with coupon income that could start to look meager compared to alternatives in the marketplace. If Treasury rates stay low, on the other hand, it's likely to be a reflection of worsening economic conditions. That could leave state and local authorities in a bind by limiting tax receipts, along with the usage fees that big municipal borrowers, like operators of transportation and utility infrastructure, depend on. Behind Muni Yield: Tax Rates You may try to reassure yourself that authorities can resort to Plan A and raise tax rates to get over the hump, but that opportunity may be nearing exhaustion. In theory, anyway, the ability to raise taxes should give state and local governments a ready supply of cash to cover debt payments. In practice, however, the powers that be in many states don't see taxation and borrowing as an either/or proposition. States that borrow a lot to fill their coffers also have a habit of raising taxes and making already high rates even higher. California, first in the nation in so many ways, has a top income-tax rate of 12.3%, plus a surcharge of one percentage point—called the Mental Health Services Tax—on incomes above $1 million. That rate puts California ahead of all other states in that category. Even so, Standard & Poor's, as of 2014, gives it the second-lowest credit rating—A—among all 50 states. An A may look good on your kid's report card, but rating agencies grade government finances on a much higher curve; the only state with a lower rating, A-, is Illinois, another high-tax state. Florida and Texas, by contrast, which have no income tax on individuals, get S&P's highest rating, AAA. These details reveal the wisdom of an old saying: If you give politicians more money to spend, they'll spend it. And not always wisely, as confirmed by the 2013 bankruptcy of Detroit and the downgrade last month of Chicago's debt to junk status by Moody's Investors Service after the Illinois Supreme Court ruled that the city couldn't cut benefits to shore up its teetering pension system. Developments like these highlight the double-edged sword of concentrating on local municipal bonds and ignoring the usual—and usually wise—advice to diversify a portfolio. By investing locally, you may get all the tax breaks, but you leave yourself highly exposed to other breaks that may not go your way. This article originally appeared on CNBC.
Why Your Index Fund Has a Different Return Than Its IndexWhy Your Index Fund Has a Different Return Than Its Index When it comes to your returns, indexes matter. But the fund you choose to mimic that index matters even more. Index funds are turning 40 this year, but they’re hardly over the hill. In fact, quite the opposite—investors are investing in them now more than ever. In 2014, investors poured $250 billion into U.S.-listed index-tracking exchange-traded funds (ETFs), shattering the 2013 record inflow of $188 billion. Market share paints a similar picture. In 2014, traditional index funds and ETFs made up a quarter of total bond and stock fund assets, compared to just 1% in 1990. Index Funds: Assets and Market Share Investors use index-tracking funds because they’re typically cost-effective, transparent, easy to use, and give investors access to their preferred indexes, such as the S&P 500. But many investors are confused when their index return doesn't match that of the index it's tracking. What they may not know is that the index itself is just one factor to consider when choosing a fund. It's also important to look at an array of characteristics, including degree of turnover, frequency of rebalancing, how reasonable the expense ratio, and transparency of fee reporting. A Quick Guide to Indexes An index is nothing more than a basket of securities. The way indexes differ from each other is how they select and assign importance (i.e., weight) to those securities. For example, the S&P 500, an index that’s made up of the largest 500 publicly traded companies in the United States, weights its securities by market capitalization. So, if Apple makes up 5% of the total size of those 500 companies, then it gets assigned a 5% weight inside the S&P 500 index. Similarly, the CRSP U.S. Total Market Index is weighted by market cap, but instead of including just the top 500 companies, it includes nearly all publicly listed U.S. stocks. While you can’t invest directly in an index, you can invest in a fund that tracks an index. This is called an index-tracking fund. For example, if you wanted to invest in the S&P 500, you can buy SPDR’s S&P 500 ETF (SPY), Vanguard’s S&P 500 ETF (VOO), or alternatively iShares Core S&P 500 ETF (IVV). VOO has the lowest expense ratio of the three. Domestic and International Indexes In the United States today, the main index providers are: MSCI (Morgan Stanley Capital International) FTSE (the Financial Times Stock Exchange Group) Standard & Poor’s (S&P 500) Dow Jones Each index provider uses its own criteria in selecting and weighting companies. When it comes to indexes that track markets outside of the United States index providers classify geographies differently. For example, FTSE classifies South Korea as a developed country, whereas MSCI classifies South Korea as an emerging market economy, putting it in the same index with China, India, and Brazil. This divergence in geographical classification may impact the risk and return of your portfolio if you are heavily invested in emerging markets. Choosing which emerging markets fund to invest in can translate to real differences in country exposure. Differences in Market Coverage Even if two indexes classify geographies similarly, be aware that they may not define large-, mid-, and small-cap segments the same way. Take the treatment of companies that are small in market capitalization, otherwise known as small-cap stocks, as an example. Traditionally, the FTSE All-World Index (an index of approximately 2,900 stocks in 47 countries) excluded small-cap stocks, whereas the S&P Global Broad Market Index, also a broad global index, included small-cap stocks in addition to large and mid cap companies. Furthermore, indexes may define smalls caps differently. For example, FTSE includes the smallest 10% of all securities in their small-cap exposures while MSCI, S&P, and Dow Jones cover the smallest 15%. An investor who is not aware of this difference may unintentionally create an unwanted overlap in a portfolio by obtaining the larger segments of the market from one provider and smaller segments of the market from another provider. What Makes a Good Index-Tracking ETF? As index-tracking ETFs become more popular, there are more and more that track the same index. However, this overlap doesn’t necessarily mean they’re created equal—some are better than others at exposing investors to their intended markets while reducing costs. So how do you know what to avoid and what to look for? Choosing a good fund is not just about the index—it’s also about what’s true of the fund that tracks it. In general, a good index-tracking ETF is accurate in tracking its underlying index, intelligent about managing turnover and trading, reticent to pass on capital gains generated internally, diligent in rebalancing, generally inexpensive to access, and transparent in its fee reporting. It’s important to understand each of these characteristics and how to measure them. Tracking Error: This is the standard deviation of the fund’s excess returns vs. its benchmark. Tracking Difference: Similar to tracking error, tracking difference is the annualized difference between a fund’s return and its benchmark’s return. A small difference indicates that the ETF has done a good job of mirroring its index. Expense ratio, rebalancing costs, cash drag, and dividend tax can all contribute to tracking difference. Fund Turnover: This is a measure of how frequently assets within a fund are bought and sold. Higher turnover leads to higher transaction cost. Fund turnover costs are not included in the expense ratio. They can represent a significant additional cost that reduces your long-term investor returns. Rebalancing: Whether and how often a fund changes its holdings to maintain established asset allocations. Rebalancing does not impact portfolio returns as much as it minimizes risks. Expense Ratio: This is the annual cost that a fund charges for managing assets. It does not include portfolio transaction fees and brokerage costs. Expense ratio is reflected in the tracking difference. There are also two expense ratios: gross expense ratio and net expense ratio. Gross expense ratio is the expense ratio before fee waivers and reimbursements. Net expense ratio is post fee waivers and reimbursements. If there is a big difference between the two expense ratios, it could be a sign that the fund’s expense ratio may increase once the fee waiver expires even though the investor is locked into the fund. Tax Cost Ratio: The reduction in a fund’s annualized tax return because of taxes on distributions. The degree of turnover, frequency of rebalancing, how reasonable the expense ratio, and transparency of fee reporting can be gleaned from an ETF’s prospectus. Good ETFs, in short, minimize unnecessary distortions and provide easier access for the everyday investor to invest in her desired market. S&P 500 Index and Funds That Track It, 2004-2015 How ETFs Reflect Index Composition Changes But what happens if the underlying index that the ETF tracks changes its constituents or even the methodology it uses to track indexes? How will the ETF provider respond? Recently, two index providers, MSCI and FTSE, made different decisions about including China A-shares in their core emerging market indexes. If you’re new to A-shares, they are shares that are traded on the biggest Chinese stock exchanges in local currency (Renminbi), and they have not been available to foreigners for purchase due to government restrictions. Despite being the world’s second largest economy, China’s stock market has been difficult to access for foreign investors. Historically, foreign ownership of China A-shares have been limited to those who hold unique licenses that allow them to invest in domestically domiciled and listed Chinese companies. But China has made significant efforts in opening its market to international investors. License and quota approvals have been increasing at a rapid pace since 2001. Because of the recent developments in regulatory reform, market accessibility, and expansion of the stock market, FTSE recently decided to include China A-shares into its emerging market benchmark. Most of the time, when there is a change in the index, the associated ETFs mirror that change. This is true of Vanguard, a provider of funds that track some of FTSE’s indexes. When FTSE announced that it would include China A-shares in its Emerging Market Index, Vanguard followed suit by adding China A-shares to its Vanguard Emerging Markets exchange-traded fund, VWO. MSCI, another index provider, decided against including China-A shares in its global benchmarks as it awaits the resolution of several issues surrounding market access. EEM, the iShares ETF that tracks MSCI’s Emerging Markets Index, mirrored the decision of MSCI to not include A-shares. Wolf in Sheep’s Clothing: Active Indexes The examples we mention above involve passive index-tracking ETFs. However, there are ETFs that are active, which means they don’t track the performance of the index. These active ETFs have grown significantly in the last decade. They allow fund managers to change their allocations and deviate from the index as they see fit. Active ETFs tend to generate higher costs in the form of higher expense ratios, turnover, and taxes. At Betterment, our portfolios only consist of ETFs that are passive ETFs because we believe that active ETFs do not generate higher returns over the long term. Therefore, we don’t think their higher fees are necessary and justified. To screen out ETFs with higher fees and expenses, we identify categories of ETFs that are associated with higher costs and exclude them from our basket. An example is inverse ETFs. These ETFs are created for the purpose of profiting from a decline in the price of the underlying benchmark. The average expense ratio associated with inverse ETFs is around .99%, while those that are not inverse have an average expense ratio of .61%. Our algorithm screens out inverse ETFs automatically. For the same reason, we screen out active funds. One way to identify these active funds is to look at their weighting method, which tend to be weighted based on beta, volatility, momentum, or entirely proprietary. How Do A-Shares Affect My Betterment Portfolio? While FTSE’s composition change certainly affects the Betterment portfolio, the effect is rather small. The launch of two transition indexes will start out by weighting China A-shares at 5%. As an example, a 70% stock 30% bond portfolio at Betterment only has a .32% exposure to Chinese companies. However, the index change does signify the willingness and readiness of index providers to get broader market access to the second largest stock market in the world. The change allows investors to have exposure to a more global and comprehensive portfolio.
Currency Risk Does Not Belong in Your Bond PortfolioCurrency Risk Does Not Belong in Your Bond Portfolio International bonds can help improve your portfolio’s performance, but leave currency bets to gamblers. When you buy things in a foreign currency—whether that’s goods and services as a traveler, or stocks and bonds as an investor—you are faced with a central issue: How far will your dollar go? Exchange rates ebb and flow on a daily basis, which creates currency risk. For the infrequent traveler, that may be an acceptable risk, but for the investor, the currency risk could wipe out his portfolio gains. Today, this is an increasingly visible issue for investors as the integration of global financial markets is making it easier for investors to access far-flung markets and asset classes. When foreign investments are denominated in a currency other than U.S. dollars, the returns you make on them must be translated back to American currency. That means an international fund’s performance, when reported in U.S. dollars, also includes the effect of exchange-rate movements. Individual investors are not immune to currency movements, either. If his or her own investments are issued in a foreign currency, he or she may lose if the exchange rate moves against them, even if the investment itself has a positive return. For example, if John is invested in Apple Inc. bonds that are denominated in the yen, and the yen depreciates against the dollar, when John converts from the depreciated yen back to the dollar, his investments may be worth less even if Apple sees great returns. Yet a well-diversified portfolio can help avoid that risk, allowing investors to tap the upside of diversification while managing risk associated with currency fluctuations. The Origin of Currency Risk Governing bodies around the world set economic agendas independently. Monetary policies, as a result, range from economic region to economic region, resulting in varying interest rates. Interest rates, in short, are the rate at which borrowers pay lenders. Countries use interest rate targets as tools to manage their own economies. For example, central banks can reduce interest rates to encourage investment and consumption in that country—or raise rates to deter borrowing. Interest rates directly affect currency exchange rates and thus create currency risk. While rates are being re-evaluated by countries, the good news is that rate changes do not work in lock step. For an investor who’s invested in bonds of different countries, the internationally diversified bond portfolio may allow investors to lessen their overall interest rate risk. Importantly, however, this exposure to currency risk is an uncompensated risk. Changes in exchange rates create return volatility without introducing additional expected returns. While rate changes may randomly add returns in your favor in the short term, the expectation should always be of zero return over the long term. It is true that currency moves can be profitable if you are on the right side of them. The “carry trade” involves borrowing from low-interest rate currencies to invest in high-interest rate currencies. This strategy has demonstrated it can be profitable over some periods of time.1 However, the same carry strategies exhibited large losses during the 2008 financial crisis, making the point that such strategies’ “tail risk” (risk of unpredictable losses) potentially cancels out their profitability during more normal times.2 How to Mitigate Currency Risk in Bonds There are two ways to mitigate currency risk: 1. Buy foreign securities issued in U.S. dollars. A U.S. investor who wants to invest in the bonds of the Mexican government, for example, can invest in bonds that are purchased, have income issued, and have principal returned in U.S. dollars. By doing so, he or she she is never exposed to USD/MEX currency risk. In contrast, a U.S. investor who purchases a U.S. bond issued by Apple Inc. but denominated in Japanese Yen (JPY) is exposed to currency volatility. So a U.S. investor investing in a U.S. company can still be exposed to currency fluctuations if the bond is denominated in another currency. 2. Hedge currency risk. Another way to mitigate currency risk is to put on a hedge. In the simplest terms, a currency hedge is insurance against a currency move in either direction, for or against you. A currency hedge technically involves two parties exchanging a set amount of one currency for another at a predetermined exchange rate and amount at a future date. When you hedge currency risk, you can remove currency risk from your investment… at a cost. The hedge itself costs something to manage and maintain. The cost depends on the currency being hedged—liquid developed currencies are generally easier and cheaper to hedge than emerging ones. In exchange for this cost, your investment will likely have lower volatility, as the currency fluctuations are removed. There are many ways to hedge currencies. These include forwards, swaps, futures, and options. All of these methods allow investors to lock in a set exchange rate today to eliminate potential exchange rate volatility that may arise in the future. To permanently hedge an investment, an investor must continually close contracts that have come due, and invest in new ones further into the future. This process is called “rolling” the contracts, and can have a small ongoing transaction cost. Hedge International Bonds, Not International Stocks Currency hedging, like most insurance, is not free, and so the benefits need to be balanced against the cost. If hedging costs you more than it benefits you, you shouldn’t do it. To find out, weigh the reduction in volatility against the incremental cost of buying the hedged (rather than unhedged) version of the ETF. A Vanguard study analyzed the impact of currency hedging on foreign bonds and stocks and found that hedging is beneficial for bonds but not for stocks.3 This is because of the different volatility characteristics of stocks and bonds, and their correlations with currency moves. Bonds, as an asset class, are typically less volatile than both stocks and currencies: Equity Volatility > Currency Volatility > Bond Volatility When you take a position in unhedged foreign currency bonds, the volatility of the investment will come predominantly from the currency fluctuations, not the bonds themselves. Research has shown that the volatility of unhedged currency fluctuations often overwhelm the diversification benefits that international bonds bring to a portfolio. In contrast, because currency risk is usually a very small proportion of volatility in foreign stocks, there is far less benefit from hedging the stock exposure. Compare the relative contribution of the currency component to the overall return and volatility in bonds and stocks: Impact of Currency Risk on Bonds vs. Stocks Whether it’s stocks or bonds, currency does not contribute substantial returns. However, it has a substantial risk in terms of volatility, and all the more so when it comes to bonds. The increase in risk of not hedging bonds is significant and cannot be overlooked. Currency Hedging Reduces Volatility The graph above illustrates the volatility difference between international bond ETFs with currency risk versus their currency risk-free counterpart. Vanguard’s Total International Bond ETF (BNDX) hedges out the currency risk through currency forwards. In contrast, the iShares International Treasury Bond ETF, IGOV, keeps the currency volatility intact. The daily volatility inherent to IGOV is more than twice that of BNDX. The sharp increase in volatility because of currency fluctuations applies to emerging market ETFs, as well. The Vanguard emerging market government bond ETF, VWOB, eliminates currency risk by investing in dollar denominated government bonds issued by emerging markets. The iShares emerging markets bond ETF, LEMB, likewise tracks emerging market sovereign bonds but includes currency risk by investing in bonds denominated in the local currency. The local-currency version has nearly twice the volatility of the dollar denominated version. Balancing Cost and Volatility Reduction Volatility is only part of the equation. The other aspect of making the decision about hedging is the cost of hedging. The below chart illustrates the additional cost of the hedged ETF and the volatility reduction associated with using a hedged ETF. As is seen with the Vanguard Total International Bond ETF, BNDX, the ETF without the currency risk is not always the most expensive. Although BNDX eliminates the currency risk, it also charges 15bps less in terms of expense ratio cost. The reduction in currency volatility associated with stocks, on the other hand, is less drastic despite the higher cost of hedging. If you are not as familiar with the funds, see the bulleted list below. Volatility Reduction and the Additional Cost of the Hedged ETF Asset Class Hedged Fund Expense Ratio Unhedged Fund Expense Ratio Additional Cost of Hedged ETF Volatility Reduction Developed International Stocks 0.70% HEFA 0.09% VEA 0.61% -3.40% Emerging Market Stocks 1.46% HEEM 0.15% VWO 1.31% -5.60% Developed International Bonds 0.20% BNDX 0.35% IGOV - 0.15% -7.90% Note: HEFA, HEEM have fee waivers until 2020. We are using the expected long-term expense ratios. HEFA: iShares Currency Hedged MSCI EAFE ETF tracks the performance of large and mid-cap equities in Europe, Australasia, and the Far East. VEA: Vanguard FTSE Developed Markets ETF tracks the performance of the FTSE Developed ex North America Stock Index. The companies are mostly large and mid-cap companies. Canada and the U.S. are excluded. VEA is in the Betterment portfolio. HEEM: iShares Currency Hedged MSCI Emerging Markets ETF tracks the performance of large and mid-cap emerging market equities. The currency exposure is offset through currency forwards. VWO: Vanguard FTSE Emerging Markets ETF invests in large-, mid-, and small-cap equities in emerging markets. VWO is in the Betterment portfolio. BNDX: Vanguard Total International Bond ETF tracks the performance of the Barclays Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD Hedged). BNDX is in the Betterment portfolio. IGOV: iShares International Treasury Bond ETF tracks the performance of an index of non-U.S. developed market government bonds. Currency Risk at Betterment If you invest with Betterment, we have designed your bond portfolio to mitigate currency risk. We believe that the volatility attributed to currencies is not a compensated risk, and so, when affordable, it should be avoided. Whether we eliminate the risk through hedging or through a direct purchase of U.S. denominated bonds largely depends on the geography of the bond ETF. (See our interactive graphic to determine the exact geographical allocation of your portfolio.) Geography is an important factor to take into account when determining the best way to mitigate currency risk. While it’s prohibitively expensive to hedge emerging investments due to the larger number of currencies and the inefficiency of those markets, a basket of developed market currencies can be hedged efficiently. Because of these considerations, your international developed-country bond ETFs at Betterment are hedged at the ETF level (BNDX). BNDX hedges currency fluctuations inside of the fund. In this case, the fund purchases one-month forward contracts to exchange currencies in the future at today’s rates. If rates move between now and then, the investor is not exposed to those moves, because the value of the forward contract will offset the moves in currency. In contrast, your emerging market bonds are denominated in USD (VWOB, EMB, PCY) because of the cost considerations when it comes to hedging multiple emerging market countries. While the bonds are issued from developing countries, both their value and interest is defined in USD, removing concerns about currency risk. 1Burnside, Craig, Martin Eichenbaum, and Sergio Rebelo. "Carry Trade and Momentum in Currency Markets." Annu. Rev. Fin. Econ. Annual Review of Financial Economics 3.1 (2011): 511-35. Web. 2 Lustig, Hanno, and Adrien Verdelhan. "The Cross Section of Foreign Currency Risk Premia and Consumption Growth Risk." American Economic Review 97.1 (2007): 89-117. UCLA Publications. UCLA, 2007. Web. 16 June 2015. https://www.econ.ucla.edu/people/papers/lustig/lustig303.pdf. 3 Thomas, Charles, and Paul Bosse. "Understanding the ‘Hedge Return’: The Impact of Currency Hedging in Foreign Bonds." Understanding the 'Hedge Return': The Impact of Currency Hedging in Foreign Bonds(2014): n. pag. Vanguard Research, 1 July 2014. Web. 1 June 2015. https://personal.vanguard.com/pdf/ISGHC.pdf. * Volatility based on MSCI EAFE (hedged and unhedged) indices from Figure 4: Average rolling 12-month standard deviation over 10 years (7/1/04–6/30/14). Kittsley, Dodd, and Abby Woodham. Purer Return and Reduced Volatility: Hedging Currency Risk in International-equity Portfolios. N.p.: Deutsche Asset and Wealth Management, Sept. 2014. PDF. Deutsche Asset calculations ** Volatility based on MSCI Emerging Market (hedged and unhedged) indices from Figure 4: Average rolling 12-month standard deviation over 10 years (7/1/04–6/30/14). Kittsley, Dodd, and Abby Woodham. Purer Return and Reduced Volatility: Hedging Currency Risk in International-equity Portfolios. N.p.: Deutsche Asset and Wealth Management, Sept. 2014. PDF. Deutsche Asset calculations * Volatility based on MSCI Barclays Agg (hedged and unhedged) indices from Figure 4: Average rolling 12-month standard deviation over 10 years (7/1/04–6/30/14). Kittsley, Dodd, and Abby Woodham. Purer Return and Reduced Volatility: Hedging Currency Risk in International-equity Portfolios. N.p.: Deutsche Asset and Wealth Management, Sept. 2014. PDF. Deutsche Asset calculations This article originally appeared on ETF.com.
The Hidden Costs Inside Mutual FundsThe Hidden Costs Inside Mutual Funds Investors pay, on average, 0.35% more for an index-tracking mutual fund than for an index-tracking ETF, based on the expense ratio. They say you get what you pay for, but sometimes you don’t. Even when you do, you may not understand how much you had to shell out and exactly what for. In the case of mutual funds, you may have to pay a lot more than you realize—and keep paying for as long as you own them. Typically, mutual funds that passively track a stock or bond index are cheaper to operate than actively managed funds. Exchange-traded funds (ETFs) are even cheaper because nearly all ETFs track indexes, too, and the ETF structure lets them do that more efficiently than mutual funds. Mutual funds are usually more expensive than ETFs. The average asset-weighted total expense ratio (TER) for a mutual fund investing in a blend of all equities is 0.74% of assets, according to the most recent information from the Investment Company Institute. That number encompasses the management fee and certain other outlays. Because many of those costs are fixed costs (the same regardless of the size of the fund), smaller funds tend to have larger expense ratios, all things being equal. The “asset-weighted” average corrects for that phenomenon. The corresponding figure is 0.39% for ETFs, according to Morningstar. So a mutual fund costs you 35 basis points more than an ETF right there—or $3.50 for every $1,000 invested per year. These higher expenses come out of shareholders’ pockets. That helps to explain why a majority of actively managed funds lag the net performance of passively managed funds, which lag the net performance of ETFs with the same investment objective over nearly every time period. These higher expenses come out of shareholders’ pockets. Funds are required to disclose their TERs, so at least investors can make an informed choice about whether owning a mutual fund or availing themselves of a manager’s skill is worth the extra money. Fair enough. The problem is that the TER is not the only cost of fund ownership; there are others that can be significant but are not clearly disclosed and, therefore, harder for investors to quantify. Add trading and turnover costs. It should come as no great shock that there can be a lot of activity involved in actively managing a mutual fund, but the sheer amount of trading may surprise investors. Many funds have an annual turnover exceeding 100%, meaning that every stock or bond bought for the portfolio is sold, on average, within a year. It’s also not uncommon for funds to take positions in hundreds of securities, producing a frenzy of trading. A fund’s TER includes the expense incurred when investors buy or sell fund shares, but it doesn’t account for trading costs incurred by the fund itself, such as brokerage commissions (for the fund’s active trading), the bid-ask spread (the gap between what the seller of a security receives and the higher price that the buyer pays), and market impact. That’s the term applied to the fact that a big order can move a stock’s or bond’s price disadvantageously; buyers may have to pay more than prevailing market prices to find enough shares to fill their orders, and sellers may have to accept lower prices to dispose of all of their shares. When you add up all these costs, well, they add up. A study by the think tank Demos highlighted research indicating that a fund’s trading costs can exceed its TER, more than doubling the total cost. ETFs and other index funds can have large numbers of holdings and incur trading costs, too, but they tend to be far lower, as the portfolio holdings change only occasionally. That means that the true gap in expenses between ETFs and actively managed mutual funds may be far wider—and impact returns to a far greater extent—than the difference in TERs. Add load fees. The added expense of active management doesn’t stop there. The way that financial advice is dispensed and paid for has changed dramatically in recent years, but some funds still tack on a sales charge, or load, ostensibly to compensate the investor’s advisor. A typical load is 5% and assessed when a fund is bought—though it can be lower. Still, investors pay. Todd Rosenbluth, director of fund research at S&P Capital IQ, a financial data provider that is part of McGraw-Hill Financial, pointed out that some funds feature a trailing commission instead, say 1% deducted from a fund’s returns, that’s kicked back to the advisor for every year that the shareholder remains invested. “Trailing fees are spelled out front and center, but people may not realize it,” Rosenbluth said. “That’s 1% a year on top of everything else.” Lastly, add taxes. Beyond sales charges, trading costs, and administrative and marketing expenses, “everything else” includes tax liability. ETFs and mutual funds alike are required to distribute capital gains to shareholders each year. Distributed (taxable) gains are likely to be higher in the case of actively managed mutual funds because they engage in more trading in the normal course of running their portfolios and also because they must do more buying and selling to accommodate investors entering and exiting their funds. To make matters worse, investors often are forced to pick up someone else’s tab. The gains that a fund distributes may have been realized on positions held for many years, Rosenbluth explained, but all current shareholders, even recent investors in the fund, are on the hook for them. The amount can be substantial after a lengthy bull market. “What we saw in 2014 is that some actively managed mutual funds had capital gains of as much as 10% of net asset values,” he said. “Active management creates capital gains [and the taxes on those gains] eat into investor returns more than you realize.” Sometimes managers organize their buying and selling to be as tax-efficient as possible, he added. They try to book long-term gains instead of short-term gains or wait until after the start of the year to lock in a gain. But other managers pay far less regard to tax issues, he noted. In contrast, the ETF structure can provide a persistent boost in returns. What’s so insidious about hidden fund costs is that they are seldom seen but always there, eroding returns year in and year out. But it works in reverse, too. Any savings that accrue from owning vehicles with lower expense ratios like ETFs, for example, will provide a persistent boost to returns for as long as investors own them. To be sure, some brokerages do add trading and other fees for ETFs as well, but generally ETFs will be less expensive. As Rosenbluth put it, by owning more expensive funds, “you’re already starting off behind on your goals, so anything you can do to shave those costs down will help you get ahead of the game.”
Fractional Shares Improve Portfolio EfficiencyFractional Shares Improve Portfolio Efficiency Betterment’s fractional share technology ensures that Tax Loss Harvesting+ is effective, regardless of your investment size. Imagine walking up to a salad bar, putting together a nutritious, well-balanced plate, and being told to put everything back, because the restaurant only sells each item as an entree. Seems crazy, yet that is exactly the way traditional investing has worked. Exchange-traded funds, or ETFs, give us access to cheap, globally diversified portfolios, but traditional brokerages only allow you to buy and sell ETFs in whole shares. So for example, if you want exposure to U.S. stocks via Vanguard's VTI ETF, you must do so in multiples of $107 (the most recent price VTI traded at). Any extra cash will sit on the sidelines. If you are looking to put together a portfolio of a handful of ETFs, the problem compounds itself. If this seems inconvenient and antiquated, that’s because it is. A smarter, modern investment service should abstract you from constraints such as the prices at which shares are trading, and it should let you invest precisely to your allocation, down to the penny. Betterment was built from the ground up as a next-generation investing platform in order to democratize sophisticated portfolio management that has traditionally been available only to higher-balance investors. A key part of our design ensured that investors could buy and sell fractions of ETFs, down to six decimal places. As a result, Betterment is more efficient at portfolio management for customers at every balance size—ensuring that every customer can fully benefit from features like tax loss harvesting, even if they are in the early accumulation phase. Automated investing services that only use whole shares will be less efficient than Betterment at investing your money. Here are several practical issues for investors’ portfolios when they are only invested in whole shares: Your portfolio always carries a cash remainder because funds don’t line up perfectly—that leads to cash drag, which can hurt returns. It is difficult to precisely achieve your target allocation, causing you to take too much or too little risk. Automated tax loss harvesting is less effective, as there are fewer opportunities to buy and sell securities to harvest a loss. Problem # 1: Cash Drag Imagine an investment service called WholeShare, which cannot trade in fractional shares. A customer deposits $5,000 into an newly opened taxable account. For illustration, let's assume a Betterment target allocation at 90% stocks. Using market prices from April 2, 2015, WholeShare might make the following purchases in an attempt to get to the target allocation: WholeShare 90% Stock, Matching Target Allocation Asset Target Value Share Price Whole Shares Purchased Actual Value Cash $0 - - $331 MUB $274 $110.18 2 $220 LQD $28 $121.73 0 $0 BNDX $119 $54.02 2 $108 VWOB $79 $77.99 1 $78 VTI $808 $107.36 7 $751 VTV $808 $83.39 9 $751 VOE $259 $91.90 2 $184 VBR $226 $109.73 2 $219 VEA $1,874 $40.33 46 $1,855 VWO $525 $41.94 12 $503 Total $5,000 WholeShare would need to buy $808.14 of VTI to hit the target allocation. However, VTI is trading at $107.36, which means it can only buy seven whole shares, worth $751, leaving $57 sitting on the side in cash. Across the entire $5,000 deposit, for each asset, this limitation leaves us with with $331 in cash, or 7% of the original deposit. That is 7% of the intended investment that’s not actually invested. The result is cash drag, which means a lower expected return than you could have achieved if your portfolio could hold fractional shares. Problem # 2: Systematically Unbalanced Portfolio WholeShare can mitigate the cash drag problem, but only at the expense of creating another one. For instance, it can use as much of the pooled cash as possible to over-purchase underweight assets. However, that would create substantial drift away from your desired allocation, because you would now be over-allocated to those portfolio components which were over-purchased. Let's assume one straightforward approach to use up as much cash as possible: start with the most expensive share that is underweight, buy one, and repeat until you can buy no more shares of anything. WholeShare 90% Stock, Minimizing Cash Allocation Asset Target Value Share Price Whole Shares Purchased Actual Value Cash $0 - - $2 MUB $274 $110.19 3 $331 LQD $28 $121.69 1 $122 BNDX $119 $54.02 2 $108 VWOB $79 $78.03 1 $78 VTI $808 $107.44 7 $752 VTV $808 $83.47 9 $751 VOE $259 $92.00 3 $276 VBR $226 $109.76 2 $220 VEA $1,874 $40.35 46 $1,856 VWO $525 $41.97 12 $504 Total $5,000 In this case, we’ve virtually eliminated the cash drag. Yet here is the resulting drift away from the desired allocation: Allocation Drift Due To Whole Shares When a portfolio’s actual allocation diverges from its target allocation, the result is "allocation drift". Allocation drift is undesirable because it can lead to an investor being exposed to a portfolio which no longer reflects the desired risk level. It usually occurs because of normal changes in the prices of the securities over time, and is addressed by rebalancing the portfolio. In this case, the allocation is substantially off on day one, before any market changes, and rebalancing is of no help, because the size of the portfolio building blocks prevents a more precise allocation. Problem # 3: Less effective tax loss harvesting The problems above also come into play when combined with tax loss harvesting. In our white paper, we explain in detail why regular deposits make tax loss harvesting more effective. The more frequently you purchase a volatile security, the more price points you have that can potentially present a harvesting opportunity. This is another case where the ability to purchase fractional shares offers an advantage. To illustrate the concept, let’s look at a very simplified hypothetical. Say that our $5,000 portfolio is generating $10 of dividends a month. Assume we are underweight VTI, so this is the asset we want to buy with any incoming cash flows. For illustrative purposes, we'll assume that VTI, which can be quite volatile, is swinging back and forth in value each month. Let’s look at how WholeShare might make the purchase, as compared to a service that supports fractional share trading. WholeShare Purchases Using Dividend Cash Month Hypothetical price of VTI Shares of VTI bought Price paid (cost basis) Cash available January $100 - - $10 February $95 - - $20 March $105 - - $30 April $95 - - $40 May $105 - - $50 June $95 - - $60 July $105 - - $70 August $95 - - $80 September $105 - - $90 October $100 1 $100 $0 Total 1 $100 Fractional Purchases Using Dividend Cash Month Hypothetical price of VTI Shares of VTI bought Price paid (cost basis) Cash available January $100 0.100 $10 $0 February $95 0.105 $10 $0 March $105 0.095 $10 $0 April $95 0.105 $10 $0 May $105 0.095 $10 $0 June $95 0.105 $10 $0 July $105 0.095 $10 $0 August $95 0.105 $10 $0 September $105 0.095 $10 $0 October $100 0.100 $10 $0 Total 1 $100 In both cases, we wind up with one share, with an aggregate basis of $100. However, with fractional shares, each $10 dividend was immediately invested, offering a variety of price points. Say we now check for harvesting opportunities, and the market price is still $100. With WholeShare, there are no built-in losses available—you are holding a single tax lot, with a basis equal to the current price. But with a fractional portfolio, four of the lots you are holding (those bought in March, May, July and September, totaling .38 shares), are at a loss, with an aggregate basis of $40. A tax loss harvesting service can sell only these lots at the current price ($38 for .38 shares) and realize a $2 loss, which is 2% of the value of the position. In actuality, daily automated tax loss harvesting, such as Betterment’s Tax Loss Harvesting+, would have been operating throughout the year, potentially realizing bigger losses on each lot, each time the price dipped to $95. These small benefits will add up over the years. Fractional shares squeeze every efficiency out of tax loss harvesting, utilizing every cash flow, no matter how small, keeping you in balance, always keeping you out of cash, and creating multiple tax lots at every opportunity across all positions in the portfolio. Tax loss harvesting is not appropriate for everyone, which we discuss in detail in our white paper. In particular, those who are in a low enough income tax bracket to realize capital gains at a 0% rate should not use it. However, a smaller portfolio does not necessarily imply a lower tax bracket. Investors who are in the early accumulation phase are often earning enough to benefit from Tax Loss Harvesting+. Fractional share technology is the foundation of a service that truly enables advanced portfolio management strategies at every balance size.
The Real Cost of Cash DragThe Real Cost of Cash Drag A broker that’s selling you cash as an investment should make you think twice, especially when it’s not in your best interest—but it is in theirs. Cash has a significant chance of a real negative return over time due to inflation risk. Cash assets can present a conflict of interest when the investment manager is advising cash and then re-investing it for its own revenue. For the goals you set at Betterment, you never hold cash because we use fractional shares to invest every cent you deposit. Every dollar—down to the penny—is fully invested in a diversified portfolio of stocks and bonds. It’s pretty plain and simple: Cash is not a good investment for the long term. After taxes, inflation, and its current expected return (zero), you are actually losing money when you hold cash in your investment portfolio over the long term. In other words, cash is a drag on your returns. If you must hold excess cash, you should do so in a vehicle that helps to mitigate the effects of inflation and is tax-efficient. We are hardly the only investment manager to take this stance. In a research paper published in Financial Analysts Journal last year, Vanguard founder John Bogle cited cash drag as one of the ways investors are not making the most of their investments.1 Cash Costs You Returns Certain investment services require you to hold cash in your account. In practice, your cash holdings could range from a tiny fraction of your balance to a substantive allocation in your portfolio. Across the universe of U.S. equity mutual funds, Morningstar Inc. calculated an average cash weighting of 3.2%.2 As Bogle noted in his paper, index-tracking funds tend to carry a lower cash load than active funds. One recent example is with Schwab’s new automated portfolio, one of the latest imitators of Betterment’s automated investing technology. Its new offering requires a cash position from a minimum of 6% to as much as 30% cash, according to Schwab’s disclosures.3 Then there are other automated services and traditional managers that force you to keep a small amount of cash on the side because they aren’t able to do fractional share trading. We’re not fans of either scenario, but the first one is especially troublesome. For the smart investor, there are several red flags here. Cost No. 1: You’re not earning returns, and are losing money. First, the most obvious issue is that cash is simply not a risk-free investment and doesn’t belong in any moderate to long-term investment portfolio. It currently returns almost zero and when you factor in inflation, can lose you money. That means the more cash in your portfolio, and the longer you invest, the less your portfolio may be worth compared to a portfolio without cash. Be wary of any advisor who talks about cash without adjusting for inflation. While a small portion of cash, for example an allocation of 6%, may seem like an insignificant amount, it still can have a significant drag on returns. This is especially true for a long-term investor who should be in a high-stock allocation. For illustrative purposes, let’s have a look at Schwab’s recommendation for “Investor 2,” a 40-year-old with moderate risk tolerance. The portfolio is 61% stocks, but you’re forced hold 10.5% cash.4 A Betterment portfolio at 61% stocks, with no cash drag, has an expected annual return of 5.8%. Let’s generously assume that cash returns 1% annually (currently, it’s much less than that). With 10.5% of your assets on the sidelines, the effective cost would be 0.5% in lower expected returns every year. The Cost of “Cash Drag” on a $100,000 Investment Over the next 30 years, having 10.5% cash in your portfolio will cost you $73,417 compared to the same portfolio with zero cash drag Cost No. 2: It’s a conflict of interest. A small amount of cash in your portfolio resulting from an inefficient trading structure is one thing. But an entire asset dedicated to cash holding should raise eyebrows. This is particularly important when it comes to a portfolio that is billed as “free.” For example, Schwab is marketing its new portfolio as “free,” yet there exists a very real underlying cost hidden in the allocation structure. You, the individual investor, are paying a hidden fee via the cash allocation you are forced to hold. (We’re not the only ones to point this out.) How does that work? In Schwab’s fine print, Schwab is explicit that it will use your cash, held in its company’s bank, for its own investing, providing them with revenue and reducing your expected returns.5 Herein lies the conflict of interest: As a customer, you now have a portfolio manager who is incentivized to have you hold more cash than might be optimal for your investment strategy—simply because they make money on it. Schwab even acknowledges this conflict of interest in its recent filing with the U.S. Securities and Exchange Commission (SEC), specifically calling out that not even other Schwab entities would allocate so much of a portfolio to cash: In most of the investment strategies, the percentage of the Sweep Allocation is higher than the cash allocation would be in a similar strategy in a managed account program sponsored by a Schwab entity or third parties. This is because, as described below under “Fees,” clients do not pay a Program fee. (page 3)5 This conflict can have some unexpected consequences. For instance: such an allocation to cash might feel intuitively sensible because of a mental association with a “rainy day” fund. We’ve written before about how you can do better. However, let’s assume you do want a cash safety net. With an automated, enforced cash allocation such as Schwab’s, you will never be able to withdraw just the cash if a rainy day does come. Since the cash allocation is the backdoor method by which Schwab gets paid, the service would rebalance you back into the target cash allocation, selling securities in the process, and possibly triggering capital gains. From the same filing: [Schwab] may terminate a client from the Program for withdrawing cash from their account that brings their account balance below the minimum… (page 4)6 If you want some cash on the side, this is not it: you’ll need another cash stash in your bank account, both costing you returns over the long term. Cost No. 3: You can better manage risk with bonds. “But cash is safe,”’ I hear you say. “It helps stabilize the portfolio.” “Actually so do bonds,” I say. “And they don’t reduce your expected returns like cash does.” The vast majority of the time, you’ll be better off using bonds rather than cash. You can achieve both the lower drawdown risk while protecting against inflation risk with high-quality inflation-protected bond funds, such as Vanguard Short-Term Inflation-Protected Securities (VTIP). The chart below depicts the rolling two-year real returns of a basket of five-year Treasury bonds versus a cash savings account. When assessed properly (at a portfolio level), Treasury bonds have dominated cash for any non-immediate time horizon. Even through the 2008 financial crisis, you would have been better off investing in Treasury bonds than cash. Critically, bonds tend to rally when stocks are crashing, a process called the “flight to quality.” Moreover, it’s not just the frequency with which bonds win, but also the extent of the advantage. Let’s look at the cumulative performance of a portfolio of stocks and Treasury bonds versus a portfolio of stocks and cash savings since 1955. It turns out that investing in a $100,000 portfolio of stocks and Treasury bonds in 1955 would have outperformed the same stock portfolio with cash by $44,013. Cash Drag Reduces Portfolio Returns Bonds beat cash by $44,013 on $100,000 initial investment Cost No. 4: It’s not efficient. Lastly, let’s talk about efficiency. As you may know, trading on an exchange only happens in round, whole share amounts. The result is a little bit of cash permanently left on the side. This is not an efficient way to do things. Imagine that you have a portfolio with 12 ETFs, and one share of each ETF costs $100. Now, you make a $90 deposit (or your ETFs pay a total of $90 of dividends). With a platform that only uses whole shares, you cannot use any of that cash—read: zero dollars—to add to your investments because it’s not enough to buy a single share of anything. So that 90 bucks will just remain uninvested, waiting for additional cash, before you can buy even a single share. As deposits and dividends flow through this account over time, it will always have some amount of pesky cash remainder sitting there. This is sub-optimal investing. At Betterment we use fractional shares, which means you invest down to the penny. In the end, it’s important to understand the role investing has in your financial plan—and the role cash plays. When you pay for investments, whether that’s through an expense ratio or a management fee, you’re paying for the potential to earn returns, not to lose money with cash. If you’re comfortable keeping cash on the side, remember, you can always use a savings account. The results above are hypothetical and for illustrative purposes only. Investing in securities always involves risks, and there is always the potential of losing money when you invest in securities: even Treasury bonds. Past performance does not guarantee future results, and the likelihood of investment outcomes are hypothetical in nature. Before investing, consider your investment objectives and Betterment’s charges and expenses. 1https://johncbogle.com/wordpress/wp-content/uploads/2010/04/FAJ-All-In-Investment-Expenses-Jan-Feb-2014.pdf 2https://www.investmentnews.com/article/20150206/FREE/150209947/low-mutual-fund-cash-levels-not-telling-the-whole-story 3 https://www.adviserinfo.sec.gov/Iapd/Content/Common/crdiapdBrochure.aspx?BRCHRVRSNID=277224 (page 2); https://intelligent.schwab.com/public/intelligent/insights/whitepapers/role-of-cash-in-asset-allocation.html 4 Under “Can you give me an example of what these asset allocations look like?” https://intelligent.schwab.com/public/intelligent/about-intelligent-portfolios 5 “Schwab Bank earns revenue based on the interest we receive by investing the cash, minus the interest paid on the deposit and the cost of FDIC insurance (which Schwab pays).” https://intelligent.schwab.com/about-sip.html 6 Schwab goes into more detail in its disclosure brochures: “Schwab Bank earns income on the Sweep (i.e., cash) Allocation for each investment strategy. The higher the Sweep Allocation and the lower the interest rate paid the more Schwab Bank earns, thereby creating a potential conflict of interest. The cash allocation can affect both the risk profile and performance of a portfolio.”
Why Index Fund Portfolios WinWhy Index Fund Portfolios Win A groundbreaking study by Rick Ferri of Portfolio Solutions and Alex Benke of Betterment sheds new light on why index portfolios beat active investing. The debate over active and passive investment strategies, now more than 60 years old, shows no signs of ebbing. If anything, this controversy has spawned a cottage industry, including dedicated blogs, sparring matches, and even a yearly scorecard—Standard & Poor’s Indices Versus Active, or SPIVA. Despite the volume of data and opinion fueling each side, the bottom line remains that index funds predominantly outperform comparable active funds. But until now the industry hasn’t fully explored the following question: Given that index funds tend to outperform active ones, will an all index-fund portfolio likewise outperform a portfolio of comparable actively managed funds? Now, Alex Benke, CFP® and product manager at Betterment, Rick Ferri, CFA, founder of Portfolio Solutions, have tackled just that issue in an innovative new study. Alex Benke (left) and Rick Ferri discuss their research for a Dow Jones video. In their analysis, originally released as a white paper in June 2013 and in the Journal of Indexes in July 2013, Benke and Ferri pitted all index-fund portfolios against portfolios holding comparable actively managed funds under six different conditions. The results demonstrate that “a diversified portfolio holding only index funds in all asset classes is difficult to beat in the short-term and becomes more difficult to beat over time,” the authors wrote. The study documents yet another significant advantage of investing in index funds—and it unearthed several other insights that can serve as guiding principles for all investors. Index funds perform better together One of the first compelling new insights to emerge was that an all index portfolio tends to perform better than just the sum of its parts, compared to an active portfolio. This surprising result emerged from the following test: The authors created a basic 60-40 portfolio with three of the most commonly held asset classes: 40% in a broad U.S. equity fund, 20% in a broad international equity fund, and 40% in a U.S. investment-grade bond fund. They then compared this all-index portfolio to 5,000 portfolios of randomly selected, comparable actively managed funds over a 16-year period (1997 to 2012). Read details on the experimental methodology in our white paper. The basic result was eye-opening, but not unexpected: The all index-fund portfolio outperformed the active ones 82.9% of the time during the 16-year period. The median annual shortfall of the losing active portfolios was -1.25%, and of those that outperformed, the median outperformance was 0.52%. (The authors note that while outperformance of actively managed portfolios is clearly possible, it wasn’t robust enough to make up for the downside.) But what really stood out was the combined performance of the index funds. When the authors examined the individual performance of each index fund in the portfolio, they all tended to outperform comparable active funds—but the result was higher when taking the three index funds together. Table 1. Estimated winning percentage of an all index fund portfolio over 16 years (1997-2012) VTSMX (US equity: 40%) 77.1% VGTSX (Int’l equity: 20%) 62.5% VBMFX (US bonds: 40%) 91.5% Weighted 40%/20%/40% 79.9% Scenario 1 Results 82.9% As the authors wrote, “index funds, when combined together in a portfolio, have a higher probability of outperforming actively managed funds than they do individually,” a phenomenon that was persistent in every scenario they tested. While the weighted outperformance of the individual funds was 79.9%, the outperformance of the index portfolio as a whole was 82.9%. Indexing long-term boosts returns Next, the authors looked at the difference in the probability of an all index-fund portfolio outperforming an all-active portfolio in the short-term versus the long-term. The authors tested the same basic three-fund index portfolio as above, in three five-year periods ranging from 1998 to 2012, as well as that entire 15-year period. Again, the results weren’t unexpected (as buy-and-hold investors could guess). In the long-term scenario, the outperformance of the all-index portfolio was higher than the average of each of the three five-year periods tested. But here another striking phenomena emerged: The outperformance average for the three five-year time periods was 76.5%; but if you held onto the index-fund portfolio for 15 years, it outperformed a comparable active portfolio 83.4% of the time—a significant difference. Reflecting real-world behavior Needless to say, few investors actually stick to simple three-fund portfolios. To give their research more real-world validity, Ferri and Benke then added more asset classes to create equally weighted five-fund and 10-fund index portfolios, which they then tested against portfolios of comparable actively managed funds (also equally weighted). Table 2. Index fund portfolio win rates and percentages by the number of funds 2003-2012 Run 1: Three-fund portfolio 87.7% Run 2: Five-fund portfolio 87.8% Run 3: 10-fund portfolio 90.0% But there was an unexpected twist to the results: It turns out that adding additional asset classes to the active portfolio actually reduced both its potential for loss, and its upside potential. The median win became smaller, and the median loss became smaller. Thus it seems that the more diversification there is in actively managed fund portfolios, the less variation there is relative to an all index fund portfolio. How many funds do you need? The real trouble for investors seems to lie in the assumption that more funds equals better performance. The authors note that many investors often hold more than one actively managed fund in each asset class (e.g. an investor might have a couple of U.S. equity funds to diversify fund companies or managers) to hedge their bets. Is this a good idea? No. In fact, as more active funds are added per asset class, this study found, the more an all index-fund portfolio is likely to outperform an all actively managed portfolio. In other words: Multiple active funds within each asset class skunk performance. Adding funds to increase overall diversification helps the performance of an all index fund portfolio, as above, but when active investors add funds within asset classes it actually decreases an all-active fund portfolio’s performance. Three guiding principles Thus, Ferri’s and Benke’s research demonstrated the indexing advantage from the fund level to the portfolio level. It also surfaced three powerful insights that can serve to guide investors in their real-life choices. An all index portfolio is greater than the sum of its parts. Index funds, when combined together in a portfolio, have a higher probability of outperforming actively managed funds than they do individually. An all-index portfolio performs best over longer time periods: an all-index portfolio held for 15 years significantly outperformed the average of three five-year periods. Adding more funds within an asset class in an actively managed fund portfolio typically results in even worse underperformance relative to an all index-fund portfolio. But of course, the merits of these conclusions hinge on the integrity of the methodology, which sought to level the playing field as much as possible between active and index funds. Transparent methodology In devising research conditions to deliver results that would be most useful for real investors, Ferri and Benke sought to imitate certain real-life conditions that investors face. They only used funds that were actually available to investors during the time periods tested (avoiding so-called survivorship bias). They used a common 60-40 equity asset allocation for both index and active test portfolios. The three-, five- and 10-fund index portfolios tested were based on the most common passive (mostly) Vanguard funds. The authors also made an effort to level the playing field between index and active funds in order to focus as much as possible on actual performance. They excluded sales loads and redemption fees from active fund performance, because the fees have a negative impact on returns. They selected the index fund share class with the highest expense ratio when two or more share classes existed. The authors did not rebalance the portfolios in any of the tests; and they analyzed pre-tax performance even though index funds tend to have better tax efficiency. How active funds were chosen The authors used a random portfolio selection process to run 5,000 simulated trials of available actively managed fund portfolios, except in one experimental condition. In one of the test conditions, the authors applied a low-fee filter to the active funds, because so much research has documented that fees are the leading cause of underperformance. But when they ran simulated trials only using funds that are in the lowest 50% in terms of their expense ratios (and excluding front-end and deferred load funds), the authors note: A common belief in the investment community is that low-fee actively managed fund portfolios have a meaningfully higher chance for outperforming an all index fund portfolio. We find no evidence to support this view. The authors conclude that future research could deepen this exploration by taking into account a longer time horizon (in this study, the authors were limited to a 16-year period because many index funds didn’t exist prior to 1997). And they recommend applying other filters to better hunt for alpha among active funds. For example, new data shows that active managers who are truly active outperform those who are less active but still charge high management fees for their services. Perhaps this or other factors—e.g. funds with higher ratings or bigger AUM, the fund managers’ ages or education—could become other filters that might shed light on active funds’ top performance. In the mean time, the jury's no longer out: An all index-fund portfolio statistically wins.
Fractional Shares Are Essential to Efficient InvestingFractional Shares Are Essential to Efficient Investing Fractional shares are an efficient way to diversify every penny in your investment account. Here’s how we do it. Investing builds wealth. Holding cash doesn’t. While this is a radical simplification, it reflects a core investing principle: Over the long term, the more you have in the market, the more opportunity you have to earn returns. Or, to put it another way: if you’ve allocated money for investment, then all of that money should always be invested, precisely in the way that you intend. At Betterment, we use fractional shares to make this happen. But in some investment services, that’s not the case. Some of your money may be sitting on the side, uninvested, and not working for you. Let’s look at why that is, and how our consistent use of fractional shares puts you and your money in a more advantageous position. Never leave money out of the market As you may know, trading on an exchange can only happen in whole shares, which is why many investing platforms only allow you to trade whole shares. But this is not really an efficient way to do things. For example, imagine that you have a portfolio with 12 ETFs, and one share of each ETF costs $100. Now you make a $90 deposit (or your ETFs pay a total of $90 of dividends). With a platform that only uses whole shares, you cannot use any of that cash—read: zero dollars—to add to your investments because it’s not enough to buy a single share of anything. So that 90 bucks will just remain uninvested, waiting for additional cash, before you can buy even a single share. As deposits and dividends flow through this account over time, it will always have some amount of pesky cash remainder sitting there. This is sub-optimal investing and a wasted opportunity over the years. Technology means less waste As efficiency junkies at Betterment, we can’t stand the thought of even a penny sitting on the sidelines not earning returns. Inefficiency is our enemy. That’s why, when we launched our service in 2010, we put a lot of work into supporting fractional shares. The full investment of every dollar according to your desired asset allocation means that your money is getting absolutely the most value possible out of investing. This is part of our thoughtful application of technology. It means an investor with a $2,500 account receives the same diversification benefit as one with a $2.5 million account (and we don't require a minimum balance). Down to 1/1,000,000th of a share You can’t go to market and buy or sell fractional shares. However, a Betterment customer’s trades and resulting positions can be fractional—down to 1/1,000,000th of a share—putting every dollar to work while allowing every investing goal to be perfectly diversified according to its target allocation. This is part of Betterment’s unique sophistication. In practice, it also makes our service equal opportunity for all investors. It means an investor with a $2,500 account receives the same diversification benefit as one with a $2.5 million account (and we don't require a minimum balance). And every investor has the benefit of automatic, perfectly allocated dividend reinvestment, with no odd amounts just being wasted in cash. How it works To see how fractional shares look in a real-life example, here’s how $100,000 is actually invested at a 70% stock allocation in our portfolio. Ticker Price per share (from 10/31) Percentage in 70% stock portfolio Dollar value in $100,000 portfolio How many shares required? SHV $110.24 0 $0 0.000 VTIP $49.47 0 $0 0.000 AGG $107.9 10.4 $10,400 96.386 LQD $115.2 5.2 $5,200 45.139 BNDX $50.05 10.3 $10,300 205.794 VWOB $77.75 4.2 $4,200 54.019 VTI $91.39 12.9 $12,900 141.153 IVE $81.75 12.9 $12,900 157.798 IWS $63.7 4.1 $4,100 64.364 IWN $94.58 3.6 $3,600 38.063 VEA $40.85 30.1 $30,100 736.842 VWO $41.87 6.3 $6,300 150.466 Note: For clarity in the table, we’ve rounded to three decimal places, but our algorithms trade to six decimal places. What does our fractional share platform mean for you? You are more likely to reach your goals faster because all the money you have available for investment is always working for you. If you want to invest $100,000 that's what we do. Not $99,987 or other smaller amount. You choose exactly how much to invest; we do all the math for you. You never have to think about the cost of any individual asset when you make deposits or withdrawals from your portfolio. Your goals are properly diversified on an ongoing basis. We’ve already discussed how Betterment strategically uses your cash flows (dividends, deposits) to rebalance your goals, keeping your tax bill low by minimizing the need to rebalance by selling. Betterment’s trading algorithms work with six decimal points of precision, using all incoming funds (even odd amounts like dividends) to shore up any imbalances in your positions, no matter how tiny. And if you have an investment account with leftover cash just sitting there, ask yourself: If I didn’t want that money invested, why would I have put it there in the first place?
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