Funds And Investments

The 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 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? 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 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 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 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 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 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 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?