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Introducing the Innovative Technology Portfolio
If you believe in the power of tech to blaze new trails, you can now tailor your investing to ...
Introducing the Innovative Technology Portfolio If you believe in the power of tech to blaze new trails, you can now tailor your investing to track the companies leading the way. The most valuable companies of today aren’t the same bunch as 20 years ago. With each generation comes new challengers and new categories (Hello, Big Tech). And while we can’t predict the next class of top performers exactly, innovation will likely come from parts of the economy that use technology in new and exciting applications, industries like: semiconductors clean energy virtual reality artificial intelligence nanotechnology This dynamic led us to create and add the Innovative Technology portfolio to our group of low-cost, diversified, and managed portfolios. What is the Innovative Technology Portfolio? The portfolio increases your exposure to companies pioneering the technology mentioned above and more. These innovations carry the potential to reshape the way we work and play, and in the process shape the market’s next generation of high-performing companies. Using the Core portfolio as its foundation, the Innovative Technology portfolio is built to generate long-term returns with a diversified, low-cost approach, but with increased exposure to risk. It contains many of the same investments as Core, but swaps specific exposures to value stocks with an allocation to the SPDR S&P Kensho New Economies Composite ETF (Ticker: KOMP). For a more in-depth look at the portfolio’s methodology, skip over to its disclosure. How are pioneering companies selected? The Kensho index that KOMP tracks uses a special branch of artificial intelligence called Natural Language Processing to screen regulatory data and identify companies helping drive the Fourth Industrial Revolution. After picking companies across 22 categories, each is combined into the overall index and weighted according to their risk and return profiles. Why choose this portfolio over Betterment’s Core portfolio? We built the Innovative Technology portfolio to perform more or less the same as an equivalent stock/bond allocation of the Core portfolio. It may, however, outperform or underperform depending on the return experience of KOMP and the companies this fund tracks. So, if you believe the emerging tech of today will drive the returns of tomorrow—and are willing to take on some additional risk to make that bet— this is a portfolio made with you in mind. Risk and early adoption go hand-in-hand, after all. Why invest in innovation with Betterment? Full disclosure: we’re a little biased when it comes to making bets on new frontiers and the plucky companies exploring them. We may be the largest independent digital investment advisor now, but the category barely existed when we opened shop in 2008. Innovative tech is in our DNA, so when you invest in it with Betterment, you not only get our professional portfolio management tools, you get an advisor with first-hand experience in the field of first movers. -
Diamond Hands And Financial Plans: Betterment’s Advice For Investing In Crypto
Is there a way to invest in cryptocurrencies responsibly? We certainly think so. Here are five ...
Diamond Hands And Financial Plans: Betterment’s Advice For Investing In Crypto Is there a way to invest in cryptocurrencies responsibly? We certainly think so. Here are five tips to help guide you through the process. Even though cryptocurrencies have only been around for a short period of time, it’s abundantly clear that they’re here to stay. As a financial advisor, we at Betterment want to share our guidance on how to invest responsibly in cryptocurrency, if that’s something you choose to do. Fortunately, Betterment has a set of five universal investing principles that serve as a guide for the investment advice we give our 600,000+ customers, and that can help you make educated decisions about cryptocurrency yourself. 1. Make a personalized plan. As an investor, you have your own unique goals and values. Depending on those goals and values, the role cryptocurrency plays in your overall financial plan—if it has a role at all—will vary. Let’s start with your personal values. Many individuals are fans of cryptocurrency for reasons beyond just the potential to see their net worth go “to the moon.” You may be fascinated with crypto from an engineering perspective, or maybe for the societal impact it could have. Ultimately, it’s okay to invest your money in a way that reflects your personal values; just do so in an informed, principled manner. The second component of personalization is your financial goals. Your goals will also affect if and how cryptocurrency should be implemented into your portfolio. For example, if your child is going to college next year, their tuition money likely shouldn’t be invested 100% in Dogecoin. The volatility is far too large for a goal so short-term. Likewise, your emergency fund shouldn’t be held in Bitcoin either, because of the large price swings it’s experienced over the past few years. But, if you have a play account on the side, or a long-term goal where you’re able to tolerate more ups/downs, cryptocurrency may be an appropriate component of your portfolio. The overall point is that, just like any other investment, there is no one-size-fits-all answer: The best financial advice incorporates the unique goals and values of each person. 2. Diversify your investments. Even if cryptocurrency as an asset class may be here to stay, it’s impossible to know which cryptocurrencies will thrive and which will go extinct. There are currently over 4,000 unique cryptocurrencies, with new coins popping up seemingly every week. It’s likely many, if not most, will fail. With any type of investment, it’s not wise to “put all your eggs in one basket.” That’s why diversification is a critical piece of any financial plan. In early 2021, the cryptocurrency market as a whole passed $1 trillion for the first time. That’s quite an accomplishment. But when compared to the size of the global stock and bond markets, we see just how new and small cryptocurrency is. All the cryptocurrencies combined total just about 0.5% of the global stock and bonds markets, which exceed $200 trillion. Global Market Capitalization of Stocks, Bonds & Cryptocurrency Sources: Reuters and SIFMA If you take a market capitalization approach, crypto would make up about 0.5% of your overall portfolio. Even if you are very bullish on crypto, Betterment doesn’t recommend it exceeding a maximum of 10% of your portfolio. We also recommend diversifying across multiple cryptocurrencies. 3. Prepare your taxes. Tax management is part of any investment strategy. Afterall, it’s not what you earn, but what you keep. When it comes to the taxation of cryptocurrency, the word that best describes it is “confusing.” If you’re going to invest in crypto, be sure to comply with all relevant laws and reporting requirements. The IRS published an FAQ page that addresses most common questions, such as: How is virtual currency treated for Federal income tax purposes? Will I recognize a gain or loss when I sell my virtual currency? Where do I report my capital gain or loss for virtual currency? If you invest in crypto, one strategy you may consider to manage taxes is tax loss harvesting. Betterment implements this strategy at the flip of a switch for our investment customers and we’ve automated the process so that our customers don’t have to do it manually. For example, losses that Betterment harvests can be used to offset gains in your cryptocurrency investments. 4. Weigh the overall costs and value. With all the hype and talk of double-digit—even triple-digit—growth in the world of cryptocurrencies, it’s easy to forget about the potential costs incurred from investing in them. Costs, when taken holistically, not only include how much you pay out of pocket, but also the execution quality of your trades, and the opportunity cost of your time. Depending on where you buy and sell cryptocurrency, you could pay transaction fees of over 1% for each trade. Newer cryptocurrencies, or those that don’t trade very frequently, may have larger bid-ask spreads. This means the price for which you can sell your cryptocurrency is lower than what it would cost you to purchase more. Lastly, when there are large price swings, you also must be careful about order execution. All of these direct or indirect costs can chip away at your take-home returns from trading cryptocurrency. 5. Grow investing discipline. Warren Buffet is famous for saying the market is “a device for transferring money from the impatient to the patient." He was referring to the stock market, but the saying also applies to the cryptocurrency market. Almost all investments have ups and downs, and the cryptocurrency market is no different. Bitcoin lost 80% of its value in 2018, over 1,000 currencies have failed, and stories of fraud are not hard to come across. These challenges -- price shocks, bankruptcy, panic, theft -- are not unique to crypto; however the risks are magnified because of the new technology, lack of regulation, and intense media hype around the cryptocurrency market. You must be willing to HODL, even when your portfolio is dropping. As an asset class, cryptocurrencies are extremely volatile, and it’ll likely be the disciplined investors who’ll be rewarded. Before you purchase any crypto, make sure doing so is appropriate for your risk tolerance, and that you have a plan in place for if and when you encounter volatility. Manage your investments purposefully. Cryptocurrency is a novel type of investment, and carries a lot of risk. That’s why having a clear set of investing principles is important. These principles can help guide your investment decisions and help you avoid getting caught up in the news hype of particular cryptocurrencies. -
Crypto Investing 101
Three questions to ask yourself before you invest in crypto.
Crypto Investing 101 Three questions to ask yourself before you invest in crypto. If you’re taking your first steps into the world of cryptocurrency investing, we recommend asking three questions to gain your footing. Don’t worry, we have some answers to get you moving when you’re ready. And remember, to invest in crypto you don’t have to be an expert. We’re here to be your guide so you can make the best decision for you. Question 1: What is crypto? A simple question with a not so simple answer. To date, there are over 17,000 types of crypto in existence.1 Bitcoin and Ethereum may be household names but the world of crypto extends far beyond their influence. In order to understand crypto, it helps to understand its underlying technology: blockchain. Blockchain is a technology that, in the context of crypto, provides recordkeeping through five foundational features: Immutable: The data can’t be changed. Decentralized: Controlled by a large network of computers instead of a central authority. Distributed: Many parties hold public copies of the ledger. Cryptographically Secure: Makes tampering or changing the data basically impossible. Permissionless: Open to anyone to participate. If you don’t remember any of the five features above, here’s the big idea: The internet enabled the digital flow of information. Blockchain technology enables the digital flow of almost anything of value. What does that mean? It means we can create systems to record ownership without the need for third parties. And we can transfer ownership—using blockchain—between each other without a third party. This creates potential for new economic and business models, which is why there are more than 17,000 types of crypto. Crypto use cases span from art (for example, you can bid on a bored looking ape for only a few hundred thousand dollars) to banking (making financial services available to marginalized groups) to gaming (better grab that plot of land in the metaverse before Snoop Dogg does). All of this is made possible because crypto, built on blockchains, creates new ways to transact in a growing digital economy. Question 2: Why should I invest in crypto? If you want to invest in crypto, reflecting on why can help guide your investments. Crypto is an emerging asset class and is transforming the financial industry. However, you should be careful to understand the risks of cryptocurrency, which can be highly speculative and volatile and can experience sharp drawdowns. Like all investing, this is personal and not without risk, and we encourage you to invest in crypto only when you are comfortable bearing the risk of loss. One of the things that excites us about crypto is the diversity of the ecosystem that is being created. Crypto is far more than simply a digital currency used to buy NFT art or “digital gold” as we see in the headlines. The use cases are creating global investment opportunities available to anyone who chooses to participate. Keep in mind, across the thousands of crypto projects, you do have to look out for scams and fraud. For example, Squid Game may have been a TV show worth binge watching but ended up being a crypto worth almost nothing. But that’s not to say that crypto can’t be used for good. (Fun Fact: Did you know that you can donate crypto to charity? GiveWell, one of Betterment’s partner charities, accepts many different types of crypto!) Here are a few common reasons people invest in crypto: Make Money Crypto investing comes with risks. There can be extreme price fluctuations compared to traditional asset classes. With that said, there is the potential for crypto to rapidly increase in value both over short and long periods of time. Based on Betterment’s research, this is the #1 reason people invest in crypto. And that’s perfectly fine—we invest to create wealth for ourselves and loved ones. Decentralization Many of the projects that create crypto tokens are considered decentralized, which means they aim to remove the control banks and large institutions have on financial services and other business models such as advertising. When applied to traditional finance, this sector of crypto is called Decentralized Finance, or DeFi. Blockchain technology, including digital wallets and smart contracts, can be used to replace banks and other third parties. In theory, this can put users in control, reduce fees, and speed up transactions. (You can send crypto almost instantly to another digital wallet.) Oh, and did we mention that crypto transactions can occur 24/7/365? Another benefit of its decentralized nature. Invest in the Future As we’ve mentioned, crypto spans a broad spectrum of our lives, and it's changing the future, even if we don’t know how yet. By now, you’ve likely heard the term metaverse being casually used, whether by Facebook’s (sorry, we mean Meta’s) CEO Mark Zuckerberg or by a family member at a holiday dinner. It’s everywhere we look. And one way or another, many investors believe the metaverse will be part of our future. Similarly, the concept of Web 3.0, which is a broader evolution of the internet, offers investors many forward thinking investments to consider. The best part? It’s generally accessible to anyone, not just angel investors and venture capitalists. Stepping back, a more general reason for investing in crypto, especially if you are completely new to it, is diversifying your broader investment portfolio. If done correctly, including a small amount of crypto in your overall portfolio may help prevent you from being overly exposed to concentrated risks. Depending on what crypto investments you select, you’ll gain exposure to advancements in the metaverse, decentralized finance, and Web 3.0 technologies, among others. Question 3: How should I invest in crypto? There are many ways to invest in crypto but we’ll boil this down to two categories for you to choose from: Do-It-Yourself Crypto and Managed Crypto Portfolios. Do-It-Yourself Crypto DIY crypto investing involves navigating digital wallets, selecting crypto exchanges, and safekeeping keys (so important!). Before you do any of that, don’t forget you need to research which of the 17,000-plus cryptos you want to invest in while navigating the crypto ecosystem yourself 24/7/365. Particularly because cryptocurrency is so varied and prone to speculation, DIY crypto involves significant upfront research to understand which crypto is the right fit for you. Managed Crypto Portfolios Crypto managed portfolios function similarly to managed equity portfolios. The technology and investment experts that manage the crypto portfolio do much of the heavy lifting (the nitty gritty research of which cryptocurrencies may be appropriate for you based on your financial situation and preferences, the rebalancing and reallocation, and the managing of your account, including wallets/keys) while you can focus on the bigger picture like creating the life you want through your investments. There is still risk with this method of investing in that the underlying cryptocurrencies may experience losses, but it can help you invest in crypto based on your needs and interests, creating a personalized crypto investing experience. Plus, you’ll save time and not have to stress about remembering your digital wallet’s password for fear of losing your Bitcoin forever. Are you ready to invest in crypto? Before you step into crypto investing, make sure you know what you are investing in and why it’s important to you, and try to understand the risks involved. Remember, you don’t have to be an expert. If you reserve the term DIY for weekend trips to the Home Depot, not crypto investing, consider a managed crypto investing portfolio.
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Should You Invest in Crypto? Q&A with Makara Co-founder Jesse Proudman
Should You Invest in Crypto? Q&A with Makara Co-founder Jesse Proudman We asked Makara co-founder and CEO, Jesse Proudman, a few questions about why he believes in crypto and how it compares to traditional markets. Crypto can democratize finance by removing gatekeepers and intermediaries present in the existing financial system. Crypto is intended to have no central approver, no hidden fees, and be completely transparent. Given the proliferation of the internet and the digitization of everyday life, cryptocurrency's transformative potential is clear. We see crypto as an investment, of course, but also as a way to redefine the future of money and what can be done with it. Our co-founder, Jesse Proudman, has been involved in digital assets since 2017. First it was as an investor, then systematically trading cryptocurrency as the founder of the quantitative hedge fund Strix Leviathan, and finally as a co-founder behind the launch of Makara. We asked him a few questions about why he believes in crypto, how it compares to traditional markets, and why, if you’re on the fence, he may not try to convince you to join him. What is it that you like so much about crypto? This is seemingly the first opportunity that all investors have had to participate in an evolving asset class from its inception. If you think about angel investing, startups, or real estate deals, participation is often reserved for a select few—these are selective investment opportunities and you usually have to be an insider to be a part of them. But with crypto, the same technology that makes it so innovative also is designed to make it open to all. With global liquidity, likely anyone on earth can invest across a breadth of offerings at any time and be a part of this innovative, evolving new technology. How does it compare to traditional markets? When you’re buying stocks, you’re buying equity in a company, equity that is reflective of ownership with specific and defined rights. In this landscape, you’re not buying equity in a company. You are instead buying participation in a network. You’re potentially buying the direct ability to influence that network via governance tokens. Investing in this asset class is akin to being part of a community. It’s a fundamentally different type of investment with its own risks. At the end of the day, these are behavioral markets, which makes it hard to say, “Bitcoin at $60,000 is expensive or reasonable.” That almost seems like it would make people more nervous. When you buy into a company, you can judge based on performance indicators. It’s true. In the stock market, there are valuation models that investors generally agree upon. There are understood ways, like price per earnings, to value a specific stock. While there are valuation models for crypto, they are still early and evolving. They’re not shared among enough market participants to have material weight. That means the reason you value Bitcoin at a certain level and the reason I do are probably very different. In our eyes, that’s simply an argument for long-term investing and diversification. Long-term investing gets a little harder during a bull market though, doesn’t it? If you bought Bitcoin at the top of 2017 and held it, certainly you went through a long and painful drawdown. It wasn’t until the fall of 2020 that your investment was back in the green. But if you did hold on to everything, between then and now, the value has almost doubled. These markets go through cycles, and the potential for recovery is always there. The general historical trend demonstrates that. What do you tell people about the value of altcoins, or anything that isn’t Bitcoin or Ether? There are a portion of crypto market participants that like to argue that Bitcoin is the only asset that matters and the rest are worthless. I think Bitcoin absolutely has systemic advantages as a function of being the first, the largest, the most well-known token. But to some extent, by that logic, as the first big search engine, Yahoo! would be the only one that matters. We’re so early in the life span of crypto that picking a singular winner based on its existing network feels like a weak argument to me. Of course there are different risks associated with Bitcoin, Ethereum, and the thousands of tokens, but the truth is we simply don’t know what will be the winners a decade from now. Does that mean you recommend investing in those other coins too? If you believe this asset class will continue to exist (and you have to believe that, if you’re willing to put your money into it), for the long-term horizon, I believe you have to diversify. If you do that well, you may be able to reduce your overall portfolio risk. How do you recommend people learn about all of the other coins? It seems like a daunting task. It is, and while we do advocate for people learning about crypto, we don’t think you need to become an expert to invest. There are currently 17,000 tokens in existence. You can’t learn about all of them—and many aren’t worth learning about—but what you can do is check out our guide to the 54 (and growing) tokens we currently invest in. For each one, we give you a brief background and tell you why we think they matter. It’s our way of simplifying the learning process and helping you decide what to invest in. We also publish blogs covering crypto investing topics that only take a few minutes to read. How do you respond to people who are negative about crypto, or those who call it a bubble? It’s a speculative and emerging asset class that’s only existed for a decade, but that doesn't necessarily make it a bubble. That can create opportunity with commensurate risk. In some regard, all assets are speculative in nature. You wouldn’t buy stocks if you didn’t think they were going to appreciate, would you? The market goes through cycles. It has boom and bust cycles that repeat just like they do in any other market. But also, look at the debate that took place over the Senate Infrastructure Bill. If this is only a bubble, the Senate wouldn’t have argued so much about it, holding up more than $3 trillion in spending. Crypto is no longer “fake” internet money. This is a real thing with tangible markets, and it’s not going away. It’ll still be volatile, of course, but it’s not going away. Is crypto for everyone? I don’t think so. Like I said, it’s a volatile asset class, and if you expect it to consistently go up month after month and quarter after quarter, that’s just not what this is. It’s not a get rich quick opportunity either (although it certainly has been lucrative for some investors). Investing in crypto is investing in emerging technology. It has market cycles that you need to be aware of. You participate knowing that’s part of the experience. Some people aren’t into that, and that’s okay. Do you need a strong stomach for crypto? If you go into this with a diversified portfolio and the knowledge that a small percent of your net worth can experience outsize gains—and you also are in a position that losing your investment isn’t catastrophic—crypto shouldn’t feel nauseating. If it does, you maybe shouldn’t be in it, and that’s ok. How long did it take you to understand the market? It’s hugely complicated. It took me three months of full-time work before I had a general baseline understanding of everything. Even now, I’m in this all day and I still don’t understand everything that’s happening. That’s why it’s an intellectually engaging industry to work in. -
What’s The Best Crypto to Buy Now? (Hint: There’s Not One)
What’s The Best Crypto to Buy Now? (Hint: There’s Not One) Here are three reasons why you shouldn't try to find the “best” cryptocurrency to buy now. (And what you can do instead.) If you decide to go on a Google search hunt for the best cryptocurrency to buy this year, you may find yourself down a rabbit hole in an unfamiliar and uncomfortable part of the internet. (Don’t worry, we’ve all been there at some point.) And if you don’t end up there, you may find yourself on one of the many generic investing websites, all offering you similar “top cryptocurrencies to buy in 2022” lists. You’ll find the usual suspects here, mostly based on market capitalization or even personal preference of the writer. It’s common for these lists to include Bitcoin, Ether, Solana, Cardano, Binance Coin, Polkadot, and Avalanche. All fair examples but no need to do a Google search at this point. Instead of attempting to discover the next best cryptocurrency or token, we favor a different mental model. Ask yourself this question: What’s the best area of crypto to invest in, not now, but over the next three years? (Or whatever time horizon you are investing within.) You’ll see that trying to find the needle in the haystack—and it’s an incredibly large haystack—is probably not the best route to take. Rather, we recommend a more long-term, wide-reaching approach to selecting your investments. Three Reasons Not to Find the "Best" Crypto To sum it up, here are three reasons why you shouldn't try to find the “best” cryptocurrency to buy now. (And what you can do instead.) 1. You’re probably not a professional crypto investor. (And that’s perfectly OK.) If you are like nearly everyone, you’re not a professional crypto investor. Absolutely fine. Similar to any other asset class, non-professional crypto investors are at a disadvantage when it comes to technical resources, market data, and general industry knowledge. For example, at Makara, we have people whose job it is to research individual crypto assets and analyze the pros and cons of including them on our platform. So instead of pretending to be a crypto day trader in search of a new token that’ll take you to the moon, we recommend staying on planet earth. One way to do this is to learn about broad sectors in crypto and decide for yourself which areas you think may have the most growth potential. Among other things, we’re talking about the metaverse, decentralized finance, and Web 3.0. You could take it a step further and read up on NFTs but you may just be tempted to right-click-save on a picture of an ape that for some strange reason you can’t stop staring at—avoid the temptation, for now. Read up on crypto sectors, and if you’re feeling up to it, try explaining them to your friends or family to see if you grasp the important notes. This approach will give you a wider understanding of the crypto industry and pairs well with our next two recommendations. 2. You don’t have enough time. (Join the club!) Making wise investment decisions takes time. One of the best investors to ever live, Warren Buffet, reads 80% of his day. We’re going to guess you can’t spend 80% of your day reading about crypto. So how do you make up for this? As we said, educate yourself about crypto industry sectors instead of searching for individual assets. But don’t stop once you can explain what the metaverse is and why it could change the future. Yes, you are short on time, but if you have done the work to understand sectors in crypto and are interested in investing, you have two very important questions to ask yourself: How much do I want to allocate into crypto? And what is my time horizon? These are very personal questions. And with the little time you do have, ones worth thinking about. Knowing the amount you are comfortable investing and when you need to withdraw the funds will help you better understand the risks and make a decision that lets you sleep at night. We like sleep. 3. You’re increasing your risk. (Not a good thing.) Investing in one cryptocurrency is not quite comparable to putting all of your eggs in one basket. It’s more like having one egg. One cryptocurrency, like one egg, can be fragile, or in financial language, volatile and prone to losses. It lacks any diversification within the crypto asset class. Diversification is a complex subject, but generally speaking, the goal of diversification is to invest in uncorrelated assets to reduce the risk of losses in a portfolio while enhancing its expected return. Moral of the story: we recommend diversification. Consider how your crypto investments fit into your larger diversified portfolio of uncorrelated assets. Within crypto, you can consider spreading your investments across multiple assets and even multiple sectors within crypto. One way of thinking about it is since predicting the future is near impossible, diversification sets you up for various outcomes. We built crypto baskets at Makara to give you the choice to invest across the crypto asset class in the metaverse, Web 3.0, or decentralized finance. We even have a basket encompassing all assets on the platform called the Universe Basket. Your To-Do List for Finding the Best Crypto Assets Step 1: Read up on broad crypto sectors. Step 2: Know how much you want to invest and for how long. Step 3: Select diversified investments. Rinse and repeat. -
What Are The Most Common Asset Classes For Investors?
What Are The Most Common Asset Classes For Investors? Every type of asset gains or loses value differently, so it helps to know what those types are and how they work. In 1 minute Asset classes are investments that share the same risk factors, influences, and regulations. The most common asset classes are stocks, bonds, and cash. Stocks: Stocks are shares of a company, and they gain or lose value based on the company’s performance and potential. Bonds: Bonds are like loans—usually loans to a company or government—which accrue interest over time. Cash: Think bank accounts. Cash investments are usually short-term loans with low risk and low returns. They’re also federally insured. Betterment helps you automatically select the mix of assets that can help you meet your goals, and bundles them into funds. Tell us about your financial goals, and we’ll show you a roadmap for how to reach them. Got more time? Keep learning about asset classes below. In 5 minutes In this guide, we’ll: Explain what an asset class is Explore the most common asset classes Look at mutual funds and ETFs What is an asset class? An asset class is a name for a group of assets that share common qualities and behave similarly in the market. They’re governed by the same rules and regulations, and gain or lose value based on the same factors and circumstances. Different asset classes have relatively little in common, and tend to have fluctuations in value that are imperfectly correlated. There are eight main asset classes: Equities (stocks) Fixed income (bonds) Cash Real Estate Commodities Cryptocurrencies Alternative investments Financial Derivatives Within these groups, there are several assets people commonly invest in. The most common types of assets for investors. The three financial assets you may hear about the most are stocks, bonds, and cash. A strong investment portfolio likely often includes a balance of these assets, or combines them with others. Let’s take a closer look at each of these. Stocks A stock is a type of equity. It’s basically a tiny piece of a company. When you invest in stocks, you become a partial “owner” of the companies that issued those stocks. You don’t own the building, and you can’t go bossing around the employees, but you’re a shareholder. Your stock’s value is directly tied to the company’s profits, assets, and liabilities. And that means you have a stake in the company’s success or failure. Stocks are volatile assets—their value changes often—but over time they tend to perform better than other assets (such as bonds and cash). Choosing stocks from a wide range of companies in different industries is one of the smartest ways to diversify your portfolio. Bonds A bond represents a share of a loan. Its value comes from the interest on the loan. Bonds are typically more stable than stocks. Lower risk, lower reward. Bonds belong to the “fixed income” asset class, and tend to depend on different risk variables than stocks. If a company has a bad quarter, that’s probably not going to affect the value of your bond. Unless they have a really bad quarter, and default on their loan. When stock markets have a bad month, investors tend to flock to safer asset classes and bonds therefore will likely outperform. Other than that, the main things to consider with bonds are interest rates and inflation. When interest rates increase or decrease, it directly affects how much interest you accrue. And since bonds generate lower returns than stocks, they leave you more vulnerable to inflation, too. Cash With cash investments, you’re basically loaning cash (often to a bank) in exchange for interest. This is usually a short-term investment, but some cash investments like certificates of deposit (CDs) can last for a few years. These investments are pretty low-risk because you can be confident they will generate a return, and they’re actually insured by the FDIC. Cash investments offer higher liquidity meaning you can more quickly sell these assets when you need the money. As such, the return you get is typically lower than what you’d achieve with other asset classes. Investors therefore tend to park the money they need to spend in the near-term in cash investments. Other common assets Those are the big three. But investors also invest in real estate, commodities, alternative asset classes, financial derivatives, and cryptocurrencies. Each of these asset classes come with their own set of risk factors and potential advantages. What about investment funds? An investment fund is a basket of assets that can include stocks, bonds, and other investments. The most common kinds of funds you can invest in are mutual funds and exchange-traded funds (ETFs). Mutual funds and ETFs are similar, but there’s a reason ETFs are gaining popularity: they’re usually cheaper. ETFs tend to be less expensive to manage and therefore typically have lower expense ratios. Additionally, mutual funds charge a fee to cover their marketing expenses. ETFs don’t. Mutual funds are also more likely to be actively managed, so they can have more administrative costs. Most ETFs are funds that simply track the performance of a specific benchmark index (e.g., the S&P 500), so there’s less overhead to manage ETFs. ETFs have another advantage: you can buy and sell them on the stock exchange, just like stocks. You can only sell a mutual fund once per day, at the end of the day. That’s not always the best time. Being able to sell at other times opens the door to other investment strategies, like tax-loss harvesting. Want to learn more about investment strategies? Check out the ones we use at Betterment. [Button] Go How to choose the right assets When you start investing, it’s hard to know what assets belong in your investment portfolio. And it’s easy to make costly mistakes. But if you start with a goal, choosing the right assets is actually pretty easy. Say you want $100,000 to make a down payment on a house in 10 years. You have a target amount and a deadline. Now all you have to do is decide how much risk you’re willing to take on and choose assets that fit that risk level. For most investors, it’s simply a matter of balancing the ratio of stocks and bonds in your portfolio. -
How to Make a Tax-Smart Investment Switch
How to Make a Tax-Smart Investment Switch Calculate the value of realizing gains to move to a potentially better investment. A customer once called us to discuss moving significant assets from another provider to Betterment. He asked if he would have to pay a one-time tax cost to liquidate, and considering that cost, would the switch still be worth it? We thought we'd share with everyone a way to figure out the cost and benefits of switching. Depending on your particular circumstances, the answer is likely yes to both questions—selling off a long-established portfolio may trigger taxes, but in the long term, it can be worth it. As an example, you might want to move out of an actively managed mutual fund. Research has shown that a portfolio of actively managed funds is expected to underperform by 1.01% a year on average, after fees, compared to an all index-fund portfolio. Or perhaps you're interested in lowering your fees over the long term or diversifying your investments from a single stock to a multi-asset class portfolio. While nothing in this piece should be construed as tax advice, since individual circumstances can vary greatly, the following should serve as a general illustration of the cost and benefit of transitioning to a potentially better investment. Informed Trade-Offs The key here is making an informed trade-off—you may trigger a tax bill today by selling your current holdings, but if you're in it for the long haul, moving to a better portfolio consisting of all index ETFs should make up for that tax cost. The real question to ask yourself when looking to move your investments to Betterment is: How long do I intend to hold this investment for? If you’re a short-term investor and plan to hold assets for a couple of years, or less, there's not much to gain from transitioning to a more efficient portfolio (although it should be noted that under this scenario, you'll realize the capital gains very soon in any case.) And as a general rule, you should only consider moving appreciated investments that you've held for more than a year in order to qualify for long-term capital gains on liquidation. If your investments have not appreciated since you bought them, or if they are held in an IRA or 401(k), you can generally transition them tax-free.1 Tax Cost vs. Excessive Fees The process by which we pay tax versus fees on our investments subtly biases us to overestimate the impact of taxes, and underestimate the impact of fees. Fees are generally taken out of returns before they ever hit our accounts—it's money we never even see. Tax on realized capital gains is assessed for an entire year, and results in a clear and visible liability, paid out of funds that are already in your possession. It's no wonder that irrational tax aversion is a well-documented, widespread phenomenon, whereas millions of people unwittingly go on paying unnecessarily high fees year after year. Your key decision boils down to comparing the long-term benefit of switching to a potentially better investment and paying more upfront tax, versus staying put in a portfolio of less optimal investments with higher expenses (that might also be a drain on your time, which is worth something). It's also important to keep in mind that unless you gift or bequeath your portfolio, you will one day pay tax on these built-in gains. Tax deferral is worth something, but how much? The 3 Key Financial Drivers to Consider 1. You could be invested in better assets. Take a hard look at your investor returns in your current investments. Could they be better? If you’re invested in actively managed funds, you may be losing, on average, 1.01% in returns, compared to an all index-fund portfolio, research shows. Betterment’s portfolio is made up entirely of index-tracking ETFs. 2. Automation and good behavior drive returns. We automatically take care of maintaining your investments for you—including rebalancing, dividend reinvestment, diversifying, tax efficiency, free trades and more. If you’re handling your own investments, consider what you're missing (and also how you're spending your time.) We perform automatic, regular rebalancing, which is expected to add 0.4% to returns, on average; a global, diversified portfolio is expected to add 1.44% in returns as compared to a basic two-fund portfolio and the average Betterment customer has enjoyed a behavior gap that's narrower by 1.25% as compared to the average investor. All told, including the demonstrated benefit of index funds—these advantages are expected to contribute to returns over the long run. 3. If you're paying what a typical mutual fund charges, you could be paying much less in fees. The average expense ratio for a hybrid (stock and bond) mutual fund is 0.79%.2. Betterment’s underlying ETF portfolios have an average expense ratio of 0.06% to 0.17%, depending on your allocation. Note that the range is subject to change depending on current fund prices. Our management fee is either .25% or .40%, depending on your plan. Your all-in cost at Betterment is between 0.31% and 0.57%. As smart investors know, every basis point matters.3 Taxes are a cost, but generally a cost you'll eventually pay anyway. Meanwhile, the cost of being in a sub-optimal investment over the years can far outweigh any benefit of tax deferral. Need a second opinion? If you’re still not sure if transferring your taxable portfolio is worth the upfront costs, we can weigh in. If your taxable portfolio holds more than $250,000 in assets, stop stressing and simply reach out to our licensed transfer specialists at concierge@betterment.com. The team can review the specifics of your portfolio and provide you with a recommendation on how to best move—or not move—your assets to Betterment. 1 The discussion here only applies to taxable investment accounts. All types of IRAs (traditional and Roth) and 401(k)s don’t typically trigger taxes when rolling over from one provider to another. (An exception is converting from a traditional IRA to a Roth, which will trigger taxes. However, there are smart ways to lower these, too.) 2 2021 Investment Company Fact Book 3 We've updated our pricing structure since this article was published. Learn more at betterment.com/pricing. -
How Much Could You Be Losing To Fees?
How Much Could You Be Losing To Fees? Unexpected or hidden fees can damage your long-term investment returns. Sync your outside accounts with Betterment now and see how much you’re being charged by other investment providers. When you invest in valuable items, it’s easy to overlook the hidden fees. Buying a house certainly requires property tax and insurance payments, but you may quickly discover hidden fees in your investment—such as home repair and maintenance costs—of which you were never aware nor did you expect. Purchasing a car results in a similar scenario, in that taxes and insurance are rarely the only expenses. Repair, cleaning, maintenance, and miscellaneous fees can catch you off guard. You’ll soon realize that it’s more expensive than you ever thought to manage these assets. The same is true with investment accounts. At Betterment, we think all investment accounts should be clearly and transparently priced, without any hidden fees. Now, we can help you discover if you’re paying high advisory or hidden fund fees across all of your investments. Here’s a deeper dive into the types of fees you may encounter in your investments with outside fund providers. Understanding Fund Fees Expense Ratios When investing in any mutual fund or exchange-traded fund (ETF), the investor pays fees that cover the management, administration, and operations of the fund. These fees are summarized in the expense ratio. This fee may also include marketing costs which go to the salesperson, known as 12b-1 fees. The expense ratio is visible in the fund’s prospectus, but in general people rarely read that long document. It often goes unnoticed because the fee is not explicitly charged from the balance, but is instead built into the fund’s daily pricing. Contrary to general assumptions, paying higher expense ratios does not guarantee higher returns in an investment portfolio. Since paying higher fees does not necessarily equal high returns, choosing funds with a lower expense ratio is a simple yet generally sound investment strategy. Advisory Fees If you hire an advisor to choose and manage your investments, including one such as Betterment, you’ll most likely pay for the service received. This is known as an “advisory fee.” If you pay advisory fees with an outside investment provider, you can include the fees after you sync your outside accounts with Betterment. We then summarize how much you are paying in fees per year, and also take that number into account when providing retirement advice. Some advisors do not charge fees in an overly transparent manner but earn revenues in other ways. This can include the 12b-1 fees mentioned above, which are built into the expense ratio of the fund, or through load charges, explained below. Lesser-Known Fees Aside from expense ratios and advisory fees, some investment funds have even less transparent costs. One reason Betterment chooses ETFs for our portfolios is because they do not contain the fees mentioned below1, and they are often tax-efficient. On the other hand, mutual funds can have additional fees and revenue-sharing relationships, due to the level of trading and activity involved with the fund’s management. When investing in mutual funds, they typically have the following costs which are borne of the investor, but not included in the expense ratio. These include: Sales load fee: A sales charge imposed by “Class A” or “Class B” mutual funds when you purchase shares. “Class C” shares can have a load fee when you withdraw your money from the fund. These loads are commissions that pay the professional adviser or broker who sold you the fund. Trading fee: Trading fees when you buy or sell stocks in a brokerage account, or when the manager of a mutual fund pays to make trades within the fund. These expenses are taken out of the daily pricing of the fund, but not included in the expense ratio. These fees are hard to estimate, but in general a fund that has a high turnover, like an actively managed fund, will have higher trading fees. Redemption fee: Also referred to as a “market-timing fee,” or “short-term trading fee,” mutual funds charge this fee to discourage investors from making short-term “round trip” transactions (i.e., a purchase, typically a transfer, followed by a sale within a short period of time). 4 Steps to Minimize Investment Fees As a smart investor, there are four steps you can take to help minimize your investment fees. Know where you stand. Look up the expense ratios for all of your investments, or simply sync your outside accounts with Betterment to see a summary of the total advisory and fund expenses you are currently paying. Choose low cost funds. Typically, index ETFs are cheaper than mutual fund equivalents. They generally have no loads or marketing expenses. They also have lower turnover, which means lower internal trading costs and low taxes. Avoid trading costs. If you envision lots of trading activity across your investments, try choosing a platform that has no trading costs. Trading costs can be a constant drag on returns, especially when you use smart strategies like rebalancing and tax loss harvesting. Betterment includes both smart rebalancing and Tax Loss Harvesting+ (TLH+) benefits at no additional cost for customers. Select a low cost advisor. If you have investments with other providers, inquire regarding what fees outside of expense ratios are being charged. You can then enter these additional fees to appear on your synced non-Betterment accounts. Betterment is the largest independent online financial advisor, and we also deliver enhanced value with transparent pricing and lower fees than traditional financial services. When you sync your accounts, not only can you see all of your wealth in one place—we’ll also help you discover which outside investments are charging you high fees so that you can take action accordingly. Get started with opening a Betterment account today. For existing Betterment customers, get started syncing your accounts now. 1Some brokerages charge trading fees for ETFs. Trading fees are included in Betterment’s flat advisory fee. -
How Much Crypto Should I Own?
How Much Crypto Should I Own? What’s the right amount to keep in a portfolio? If investors want to dip their toes into crypto, we recommend aiming for this allocation. Many of us have followed the dramatic rises and precipitous falls of bitcoin, and cryptocurrencies in general, over the past few years. Some may have written them off entirely after 80% declines in 2018, only to see them roar back into investors’ collective consciousness in 2020. Certainly sentiment has shifted over a short two years—more institutional investors are taking a hard look at crypto and previous naysayers have softened their view. This all leads to one question: How much cryptocurrency should I own? Math to the rescue. It goes without saying that this is a hard question to answer. But, we can borrow a page from modern quantitative finance to help us arrive at a potential answer. For years, Wall Street “quants” have used a mathematical framework to manage their portfolios called the Black-Litterman model. Yes, the “Black” here is the same one from the famous Black-Scholes options pricing formula, Fischer Black. And “Litterman” is Robert Litterman, a long-time Goldman Sachs quant. Without getting into too much detail, the model starts with a neutral, “equilibrium” portfolio and provides a mathematical formula for increasing your holdings based on your view of the world. What’s amazing is that it incorporates not just your estimate about how an investment might grow, but also your confidence in that estimate, and translates those inputs into a specific portfolio allocation. Your starting point: 0.50% The Black-Litterman model uses the global market portfolio—all the asset holdings in the world—as its starting point for building a portfolio. This means that, if you don’t have any other views on what investments might perform better or worse, this is the portfolio you should consider holding. In early 2021, the global market for stocks totaled $95 trillion and the global bonds market reached $105 trillion. The cryptocurrency market as a whole was valued at roughly $1 trillion. This means that cryptocurrency represents 0.50% of the global market portfolio. The Global Market Portfolio In Early 2021 Source: Betterment sourced the above cryptocurrency data and stock and bond data from third parties to produce this visualization. Just as there are plenty of arguments to hold more cryptocurrency, there are also many arguments to hold less. However, from the model’s standpoint, 0.50% should be your starting allocation. Now, add your views. This is where the mathematical magic comes into play. For any given growth rate in cryptocurrency (or any investment for that matter), the Black-Litterman model will return the amount you should hold in your portfolio. What’s more, you can specify your level of conviction in that assumed growth rate and the model will adjust accordingly. In the below chart are the portfolio allocations to bitcoin derived from the Black-Litterman model. This chart can serve as a useful, hypothetical guideline when thinking about how much cryptocurrency you might want to hold. How to use it: Select how much you think bitcoin will overperform stocks, from +5% to +40%. Each return expectation corresponds to a line on the chart. For example, if you think that bitcoin will outperform stocks by 20%, this corresponds to the purple line. Now, follow the line left or right based on how confident you are. If you’re at least 75% confident (a solid “probably”), the purple line lines up with a 4% allocation to bitcoin. Graph represents a hypothetical rendering of confidence of return value based on inputs to the Black-Litterman model. Image does not represent actual performance, either past or present. One of the most interesting things to note is how high your return estimate needs to be and how confident you need to be in order to take a sizable position in bitcoin. For example, for the model to tell you to hold a 10% allocation you need to be highly confident that bitcoin will outperform stocks by 40% each year. Also of note, it does not take much to drive the model’s allocation to 0% allocation, ie: no crypto holdings. If you don’t think that there’s a 50/50 chance that bitcoin will at least slightly outperform, the model says to avoid it entirely. How we got here. The inputs to the Black-Litterman model tell an interesting story in and of themselves. The main inputs into the model are global market caps, which we discussed earlier, asset volatility, and the correlation between assets. It goes without saying that cryptocurrencies are risky. Over the last five years, bitcoin’s volatility was six times that of stocks and 30 times that of bonds. At its worst, the digital coin saw an 80% drop in value, while stocks were down 20%. Other cryptocurrencies fared even worse. Source: Betterment sourced the above ACWI data and Cryptocurrency data from third party sources to create the above visualization. Visualization is meant for informational purposes only and is not reflective of any Betterment portfolio performance. Past performance is not indicative of future results. If an asset is volatile, and one is not able to diversify that volatility away, then investors will require a higher rate of return on that investment, otherwise they will choose not to invest. The fact that bitcoin is so volatile, but has such a small number of investors (relative to stocks or bonds) suggests that many investors still do not see the potential returns worth the risks. On the other hand, cryptocurrencies are at their core a new technology, and new technologies always have an adoption curve. The story here may be less about expected return versus risk and more about early adoption versus mass appeal. The final ingredient in the model is bitcoin’s correlation with stocks and bonds. Bitcoin has some correlation with both stocks and bonds, meaning that when stocks go up (or down), bitcoin may do so as well. The lower the correlation, the greater the diversification an asset provides to your portfolio. Bonds have a low correlation with stocks, which makes them a good ballast against turbulent markets. Bitcoin’s correlation is higher, meaning that it can provide some diversification benefit to a portfolio, but not to the same degree as bonds. Cryptocurrencies can be a component of your financial plan—but it shouldn’t be the only thing. While it can’t tell you if bitcoin will be the next digital gold, this mathematical model can help you think about what kind of allocation to crypto might be appropriate for you and what assumptions about risk and return might be underlying it. Even though Betterment currently doesn’t include cryptocurrency in our recommended investment portfolios, you can learn more about how to invest appropriately in it using our cryptocurrency guide. Since crypto should only comprise a small percentage of your overall portfolio, you should still have a diversified portfolio and long-term investment plan that will help you meet your financial goals. Betterment can help you plan for the short and long term, recommending the appropriate investment accounts that align with your financial goals and allowing you to select your preferred risk-levels. You can also align your investments with your values by using one of our three socially responsible investing portfolios. -
Understanding Crypto Fundamentals
Understanding Crypto Fundamentals Cryptocurrency is a complicated technology, but it’s also accessible. It can be understood by anyone, regardless of your background. At this point, it’s highly likely you’ve at least heard the many buzzwords associated with cryptocurrency. Blockchain, Bitcoin, or Ethereum ring a bell? But how many times has someone also said, “You should definitely invest in crypto” and then done a poor job of describing what any of it actually means? I’m all for movements and trends that create engagement within the investing space, but most of us require more before we feel comfortable taking action. My hunch is that some of the qualities that help make an investor successful—being thoughtful and disciplined, for example—can also be our Achilles heel when it comes to crypto and other speculative investments. And while I’m not suggesting that we set our principles aside and immediately add crypto to our portfolio, (heck, only 15% of women are actually investing in it and we’re the better investors, aren’t we?), understanding the fundamentals should help unlock the door to the possibility. At the very least, I hope it prepares you for the next time crypto is inevitably brought up in conversation. So let’s master the three main areas, eh? What it actually is. Considerations for investing. And how to do so, if you so wish. Section 1: So, what’s crypto, anyway? First things first, it’s important to understand a few key definitions. Only then can we piece them together to try and make sense of it all. Three key terms: Cryptocurrency “Crypto”: a form of payment for goods and services that can only be exchanged virtually (digital currency). It’s also decentralized, meaning the transaction doesn’t have to be made through an official financial institution, such as a bank. Blockchain: the technology behind crypto that enables virtual records of all digital transactions to be created and stored securely across computers. This helps verify ownership and prevents fraud. Bitcoin: one of the MANY types of cryptocurrencies that exist. Tied together, crypto is basically a decentralized form of currency that relies on blockchain technology to facilitate secure and strictly digital transactions. Bitcoin, while by far the most popular cryptocurrency, is really just one of many that exist. Bitcoin can be acquired and used to exchange goods and services and/or as an investment opportunity. Still confused? Analogy time. It’s kind of like when you go to a carnival and you use tickets instead of cash. The ticket is your Bitcoin (or another crypto, like Ether) and it carries a perceived value that can be exchanged for something else: Say, a ferris wheel ride. Your primary motivation for having the tickets could be purely transactional, like paying for the fun night at the carnival. But what happens if you wind up with leftover tickets at the end of the night, either intentionally or unintentionally? By not timely exchanging those tickets for other goods and services, it’s expected that their value could change. Over time, the same leftover tickets could potentially buy you 2x the ferris wheel rides, for example, or the same ride could require more tickets than before. To tie it back to cryptocurrency, what continues to attract investors is the idea that the value of cryptocurrency could increase over time. Section 2: To invest or not to invest? The considerations associated with investing in the digital currency space are unique and complex. Does one invest in a single cryptocurrency? A mixture of the 1,000+ possible currencies? Or, is it actually the technology behind cryptocurrency that has the most potential? And exactly how much exposure should one have? If you were hoping for a straightforward answer, I'm sorry to disappoint. Take Bitcoin, for example. Satoshi Nakamoto created Bitcoin in 2009, in response to the financial crisis of 2008. His primary intention was for Bitcoin to act as an alternative to your traditional, bank-controlled currency. Fast forward to today and Bitcoin is still far from being a convenient, 1:1 replacement for cash. Instead, retail investors are flocking to it for its growth potential, betting its value will continue going up. And even though Bitcoin is far and away the single largest cryptocurrency—and the fastest ever asset class to reach a $1T market cap thanks to a $500B surge in 2021 alone—its historical price fluctuations and inherent volatility often make it too risky to be trusted as a standalone investment. Bitcoin’s extreme price fluctuations in April should be a caution sign to all investors. After cracking $60,000, a 15% flash crash had Bitcoin’s price as low as $50,900, and as of end of month April, it was still down about 8%. And if you’re looking for a sound reason as to why the crash happened...good luck. There is no true consensus. So, even if you believe in the technology and conclude crypto’s here to stay, one thing is certain: Right now, this is not a stable asset class and buying Bitcoin is absolutely not the same as holding a regulated currency, like U.S. dollars. That said, even if stability and a disciplined investment approach is important to you, there could still be room for crypto in your strategy. Like anything else, having some exposure is reasonable. You just want to be sure it’s in balance with your broader strategy, explicitly categorized as “play money”, and not being counted towards any specific goal or future need. Until there’s an easier way to actually exchange your crypto for goods and services (at a steady price), you should be buying it primarily for its growth potential. Read more on Betterment's advice for investing in crypto responsibly. Section 3: I think I’m ready to buy. So, you’re ready to join the club. You’ve decided that based on your financial goals and strategy, you’re willing to invest some of your excess cash in crypto. Great. Like the many currencies and tangent technologies, there are several platforms to choose from, possibly even through one of your existing accounts. Unless you have the ability to easily track and monitor your crypto, keeping it separate from your established portfolio may help you better maintain your core strategy moving forward. As you evaluate your options, here are some additional considerations to keep in mind. Safety and security: Use a centralized exchange, or one that’s required to register and follow standard “know your customer” rules (at least when you’re first starting out). Cost: Depending on the platform, there can be trade specific fees, ongoing management fees, and additional costs to send your currency to someone else. General platform functionality: Do you want to be able to simply buy and sell currency? Or do you also want to be able to exchange your currency for additional goods and services and send it to other people? Since this asset class is so volatile, what is your chosen platform’s track record of uptime? Nobody wants their platform to be down while they are trying to make a trade. Companies like Coinbase are often touted as good enough options for beginners and have seemingly avoided the fraud and funny business that other exchanges have fallen victim to. They also have a lot of resources and tools you can access as you get your feet wet. Consider using them as a jumping off point for further exploration. Be an informed crypto investor. So, while this asset class is relatively new and is constantly evolving, it’s important to get familiar with the basics. It’s clear that cryptocurrencies aren’t going anywhere, and the sooner you have the tools to understand what cryptocurrency is—and the consideration related to investing in it—the more empowered you’ll feel participating in the ongoing conversation, and ultimately investing (responsibly), if you so choose. -
Optimizing Performance in Lower Risk Betterment Portfolios
Optimizing Performance in Lower Risk Betterment Portfolios In this methodology, we provide insight into how we optimize the performance of the lower risk bonds in Betterment's portfolios. TABLE OF CONTENTS The Role of Ultra Low-Risk Assets in a Bond Portfolio How we optimize ultra-low-risk bonds to target a higher yield Why Two Low-Volatility Funds Result in Our Ultra-Low-Risk Asset Allocation Using 30-day historical yields to inform future yields Continued bond portfolio research In this methodology, we provide insight into how we optimize the performance of the lower risk bonds in our 100% bond portfolio. Primarily, Betterment’s optimization method involves the inclusion of short-term, investment-grade bonds in lower-risk allocations of the Betterment Portfolio Strategy. Why are we exploring this part of how we manage the Betterment Portfolio Strategy? First, over time, we’ve improved the mix of bonds in our portfolios to control risk without compromising expected performance—the main focus of this methodology. Second, many investors may not yet know about the important role of ultra-low-risk bonds in the portfolio we recommend. When investors opt for a 100% bond, 0% stock allocation in their Betterment portfolio, the only assets in the portfolio are bonds with ultra-low-risk profiles. The Role of Ultra Low-Risk Assets in a Bond Portfolio We have constructed the Betterment Portfolio Strategy—our set of recommended portfolios—to fulfill our five investing principles that guide our advice for you. One of our key investing principles is maintaining diversification. Effective diversification means taking as little risk as possible to achieve your growth target. For portfolios with lower risk levels, adding in ultra-low-risk bonds can help reduce risk without adversely affecting returns. We consider U.S. short-term Treasuries and other US. short-term investment-grade bonds to be ultra-low-risk (although all investments carry some measure of risk). At every risk level, Betterment invests in a portfolio that we expect to have a higher rate of return relative to its risk. These portfolios seek the “efficient frontier,” otherwise known as the theoretical boundary of highest-returning portfolios at any given level of risk. By further diversifying bond holdings with ultra-low-risk assets, the Betterment Portfolio Strategy pursues higher expected returns with less risk than portfolios that do not include these low-risk assets. Graphically, you can see below that among the highest returning portfolios for lower risk levels (i.e., levels of volatility) are portfolios that include ultra-low-risk bonds (the black line). Additionally, certain low risk portfolios could not be achieved at all without adding ultra-low-risk assets. As you can see below, portfolios constructed without ultra-low-risk bonds (the blue line) are unable to achieve a volatility lower than approximately 7%. Figure 1. Betterment’s efficient frontier including ultra-low-risk bonds Expected returns are computed by Betterment using the process outlined in our methodology optimizing the Betterment Portfolio Strategy. Volatilities are calculated by Betterment using monthly returns data provided by Xignite. At a certain point, including ultra-low-risk bonds in the portfolio no longer improves returns for the amount of risk taken. This point is called the ‘tangent portfolio.’ For the Betterment portfolio strategy, the tangent portfolio is our 43% stock portfolio. Portfolios with a stock allocation of 43% or more do not include ultra-low-risk bonds. When a portfolio includes no stocks—100% bonds—the allocation suggests an investor has no tolerance for market volatility, and thus, our recommendation is to put the investor’s money completely in ultra-low-risk bonds. How we optimize ultra-low-risk bonds to target a higher yield As you can see in the chart below, we include our U.S. Short-Term Investment-Grade Bond ETF and our U.S. Short-Term Treasury Bond ETF in the portfolio at stock allocations below 43% for both the IRA and taxable versions of the Betterment Portfolio Strategy. https://d1svladlv4b69d.cloudfront.net/src/d3/allocation-mountain-chart/aa-chart.html At 100% bonds and 0% stocks, a Betterment portfolio consists of 80% U.S. short-term treasury bonds and 20% U.S. short-term investment-grade bonds. If an investor were to increase the stock allocation in their portfolio, the allocation to ultra-low-risk bonds decreases, though the relative proportion of short-term U.S. treasuries to short-term investment-grade bonds remains the same. Above the 43% stock allocation threshold, these two assets are no longer included in the recommended portfolio because they decrease expected returns given the desired risk of the overall portfolio. Fund selection In line with our fund selection process, we currently select JPST – JPMorgan Ultra-Short Income ETF to gain exposure to the U.S. short-term investment-grade bonds and we’ve selected SHV – iShares Short Treasury Bond ETF to gain exposure to U.S. short-term treasury bonds. To summarize the fund selection process, we start with the universe of bond ETFs with average maturities of less than 3 years, given the relationship between maturity length and risk. We further reduce the set of candidates by ruling out ETFs with unfavorable risk characteristics, including those with excessive interest-rate risk or high overall volatility. We then filter for funds with sufficient liquidity, so that we can maintain low costs for investors. Finally, we select the fund with the lowest combination of expense ratio and expected trading costs: JPST. The same process led to our selection of SHV. Why Two Low-Volatility Funds Result in Our Ultra-Low-Risk Asset Allocation Short-term US treasuries and investment-grade bonds are both inherently low-risk assets. As can be seen from the chart below, short-term U.S. treasuries (SHV) have low volatility (any price swings are quite mild) and smaller drawdowns (the length and magnitude of periods of loss are muted). Though slightly more volatile than short-term treasuries, the same can be said for short-term investment grade bonds (JPST). Figure 2. SHV and JPST The above chart shows the historical growth of $1 invested in each investment option from 9/30/2013 (the first date both funds SHV and NEAR (which is used as a historical proxy for JPST) were in existence) to 5/23/2018. Performance is net of fund-level fees and does not include any management fees from Betterment. Dividends are assumed to be reinvested. The composite is assumed to be rebalanced daily at closing prices. JPST fund inception as in May, 2017. For returns data in May, 2017 and earlier, we use returns from a comparable fund, NEAR. JPST replaced NEAR as our U.S. short-term investment-grade bond fund in Dec, 2019. Data: xIgnite. It’s also worth noting that these two asset classes do not always go down at exactly the same time. By combining these two asset classes, we are able to produce a two-fund portfolio with a higher potential yield and the same low volatility. In fact, combining these asset classes resulted in smaller historical drawdowns in performance that lasted for fewer days than was the case for either asset class individually. As you can see from the chart below, the combination of U.S. short-term treasury bonds and U.S. short-term investment-grade bonds used for the Betterment 100% bond, 0% stock portfolio (blue) generally had shorter, less severe periods of down performance than either fund by itself. Figure 3. Drawdowns in performance The above chart shows the largest drawdowns in performance from Sept 30, 2013—the first date both funds SHV and NEAR, which is used as a historical proxy for JPST—were in existence) to 11/14/2019. Performance is net of fund-level fees and does not include any management fees from Betterment. Dividends are assumed to be reinvested. The composite portfolio (blue) is assumed to be rebalanced daily at closing prices to maintain a 80% SHV, 20% JPST weighting. JPST fund inception was in May, 2017. For returns data in May, 2017 and earlier, we use returns from a comparable fund, NEAR. JPST replaced NEAR as our U.S. short-term investment-grade bond fund in Dec, 2019. Data: xIgnite. Using 30-day historical yields to inform future yields A reasonable question about this methodology is how to interpret the potential returns of the composite looking forward. As with other assets, the returns for ultra-low-risk bonds include both the possibility of price returns and income yield. Generally, price returns are expected to be minimal, with the primary form of returns coming from the income yield. Below you can see that the prices for the composite of 80% SHV and 20% JPST tends to stay fairly constant, while the price with dividends grows through time. This shows that the yield (paid by the funds through monthly dividends) is responsible for almost all of the growth in these funds. Figure 4. Growth of $100 in the Betterment 0% stock portfolio The above chart shows the historical growth of $100 invested in a portfolio that consists of 80% SHV and 20% JPST. Data is from 6/1/2017 (the first full month both funds SHV and JPST were in existence) to Nov. 14, 2019. Performance is net of fund-level fees and does not include any management fees from Betterment. Dividends are assumed to be reinvested. The portfolio is assumed to be rebalanced daily at closing prices. Data: xIgnite. Looking at 30-day SEC yield—a standardized calculation of yield that includes fees charged by the fund—we can get a good sense of the expected performance for these low-volatility assets. Why can we believe this? First, performance is determined by both yield and price change, and because there is low price volatility in these assets, yield is the primary component of performance. We use the SEC 30-day historical yield as an expectation of annualized future yield because it’s the most recent 30 days of yield performance, and we generally expect future yield to be similar to the last 30 days, although past performance does not guarantee future results. We expect this to be the case because the monthly turnover in these funds is relatively low. However, the yield can be expected to change—either up or down—as market conditions, including interest rates, change. The yields you receive from the ETFs in Betterment’s 100% bond portfolio are the actual yields of the underlying assets after fees. Betterment does not adjust the yield you earn according to our discretion, as a bank savings account could. A bank may choose not to adjust its interest rate higher as prevailing rates rise, or may cut its interest rate. Because we are investing directly in funds that are paying prevailing market rates, you can feel confident that the yield you are receiving is fair and in line with prevailing rates. Below we can see that over the 30 days ending Nov. 14, 2019, SHV had an annualized yield of 1.59%, net of fund fees, which is dispersed to shareholders on a monthly basis. Over the same period, JPST yielded 2.12%. The 100% bond portfolio, composed of 80% SHV and 20% JPST, has yielded 1.70%. Table 1: Risk and Yield Ultra low-risk bond baseline (SHV) Additional candidate fund (JPST) SHV 80% + JPST 20% SEC 30-day yield (includes fund expense ratios) 1.59% 2.12% 1.69% Annual Volatility 0.30% 0.38% 0.30% Deepest drawdown return -0.12% -0.34% -0.12% Expense ratio 0.15% 0.18% 0.16% SEC 30-day yields are as of Nov. 14, 2019. Annual volatility and drawdown return are calculated from Sept. 30, 2013 —the first date both funds SHV and NEAR, which is used as a historical proxy for JPST—were in existence) to Nov 14, 2019. For returns data in May, 2017 and earlier, we use returns from a comparable fund, NEAR. JPST replaced NEAR as our U.S. short-term investment-grade bond fund in Dec, 2019.SEC 30-day yields, annual volatility and drawdown are net of fund fees and do not include Betterment’s management fee. Data from Xignite and Betterment calculations. Bond portfolio research never stops. By combining multiple low-risk assets, we seek to deliver higher expected returns, through higher yields, while keeping risk in check. The diversification benefits of U.S. short-term treasuries and investment-grade bonds allow us to construct low-risk portfolios with shorter and less severe downturns. As always, we iterate on our portfolio optimization methods. We update our changes in this overview of our financial advice as we develop improved ways of helping you reach your financial goals. -
How Much Are You Losing To Idle Cash?
How Much Are You Losing To Idle Cash? Uninvested cash may feel more readily available compared to when it's invested, but there can be better ways to manage your funds. Find out how. So far, we’ve told you about the consequences of having uninvested cash in your investment portfolio. But cash is king, and so even the most savvy investors still keep money in places like checkings and savings accounts in order to have easy access to those funds, which then can be used for day-to-day expenses. Here at Betterment, we want you to do better. What Is “Idle Cash”? Idle cash is money that is not invested in anything and is therefore not earning investment income. It’s money that is not actually participating in the economy-- not being spent on anything and not increasing in value. Therefore, it can’t earn you anything. Ultimately, keeping idle cash on hand is simply not as beneficial as you may think. In fact, these funds are frequently considered wasted, as they typically cannot keep up with the effects of inflation. In the U.S., the inflation rate that the Federal Reserve targets is 2% annually-- given that your idle cash likely does not increase in value, its purchasing power actually decreases as time passes. That’s right—uninvested funds gradually lose value, since they are unable to keep up with the rate of inflation, which means that as time goes on, the $100 under your mattress can eventually only buy $98 worth of things, then $96, then $94, and so on. And that’s just inflation—the opportunity cost of keeping cash that you otherwise could invest in the market is even worse. Why do people keep uninvested cash? Despite the fact that keeping idle cash can be detrimental to a successful, long term savings plan, there are still plenty of reasons for people to keep cash on hand. Accessibility and liquidity are huge factors—investors want to be able to pay their bills from their checking accounts with the click of a button, for example—as is safety and security, and the fact that savings accounts from member banks are FDIC-insured. The current reality is that among the checking and saving accounts out there, the return on deposited funds is very low. In fact, the FDIC announced that as of February, the average yield on a savings account is 0.09% APY—in a 2% inflation environment, this is still a purchasing power losing investment. The yield on checking accounts is even worse—most of these products have very low interest rates. How much uninvested cash can I get away with keeping? While a small portion of uninvested cash may seem insignificant, it can be disadvantageous for at least two reasons: Preventing it from keeping up with inflation rates means your cash loses value over time, and You fail to benefit from money that can compound over time and garner even higher returns. Typically you shouldn't reinvest cash if it costs you more to actually invest it than what you would earn, due to, for example, broker commissions. However, at Betterment, the absence of trading commissions, as well as our ability to support fractional shares, help ensure that every last cent of your cash is being put to work for you. If we assume an average trading cost of $7 per trade (typical of discount brokerages) and you don’t want to reduce your returns by more than 1%, then you should have, at most, $700 of cash. Even though we recommend having no cash at all because any amount may reduce your returns, for practical reasons we believe portfolios have too much cash when they exceed $700 in cash. How should I manage the rest of my cash instead? There are many schools of thought as to how cash can be managed, but the most common objectives are the following: Yield (without meaningful risk) and liquidity-- simultaneously making sure that your cash does not waste away due to the effects of inflation while mitigating potential high risk. That you are able to access your cash within a reasonable amount of time. 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
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
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
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
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.”
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