Funds And Investments

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. At Betterment, we spend a lot of time thinking about how to help you make the most of all your money. Idle cash results from cash dividends which are not reinvested. When you use 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.

This 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.

Why 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 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 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, 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 can't 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.”