Understanding Betterment’s Portfolio Strategy
Here at Betterment, we invest in low-cost, globally diversified funds. Learn more about what we invest in and what it means for your portfolio.
TABLE OF CONTENTS
The Betterment Portfolio
- What funds are in my portfolio?
- Why has Betterment selected this portfolio?
- Can I invest in an individual stock or fund (ie., S&P 500 index or Apple)?
- What are the current overlaps of the same stocks held within different ETFs?
- If I live in California or New York, can I have state-specific municipal bonds in my taxable investment portfolio?
How It Works
- How will my portfolio be allocated?
- How and when will my portfolio be rebalanced?
- Will my portfolio beat the market?
- Can my investments lose value?
What are ETFs?
An exchange-traded fund (ETF) is a security that usually tracks an index, a commodity, or a basket of assets—much like an index fund—but trades like a stock on an exchange. Most ETFs track fairly closely to the indexes that they follow, such as the S&P 500 or the Dow Jones Industrial Average. ETFs are bought and sold like stocks throughout the day, and therefore experience continually changing prices. Betterment uses ETFs in both our stock and bond portfolios because of the liquidity, diversification, and low management fees. For more information on the ETFs you are invested in through Betterment, please visit our portfolio page.
What’s an expense ratio?
Expense ratios are fees that exchange-traded funds (ETFs), mutual funds, closed-end funds, and money market funds charge their shareholders. This fee is called a “ratio” because it is quoted as a percentage of assets per year, e.g. 0.85%. The expense ratio includes the administrative, operating, and legal costs involved in managing the fund, and sometimes even marketing costs (called 12b-1 fees) to distribute the fund.
The expense ratio is important to consider when you invest in a fund. Even though you will never see a deduction of this fee from your account, you’re still paying it. It’s built into the price of the fund, so it accrues daily, and is proportional to your investment in the fund. Therefore, this expense directly impacts your return in the fund—and ultimately your wealth.
For that reason, it’s important to compare the expense ratios of funds from different providers within an asset class. Additionally, some asset classes are inherently more expensive than others. For example, U.S. stock funds generally have a lower expense ratio than international stock funds, whose assets are more expensive to obtain. The strategy of the fund will affect its expense ratio as well. For example, passively managed index funds will have lower expense ratios than actively managed funds, despite their typically better net-of-fee performance.
ETFs vs Mutual Funds
An exchange-traded fund (ETF) is a security that generally tracks a broad-market stock or bond index, or a basket of assets—just like a mutual fund—but trades like a stock on a listed exchange. By design, index ETFs closely track their benchmarks, such as the S&P 500 or the Dow Jones Industrial Average.
By contrast, most mutual funds are actively managed, and attempt to beat their benchmarks. The performance of the fund can be highly dependent on the portfolio manager making the decision to invest in one stock versus another stock, and can vary from year to year.
ETFs are bought and sold like stocks throughout the day, and are heavily traded amongst many different parties. This liquidity reduces transaction costs, and also makes it easier to trade for on-demand activities like creating or rebalancing a portfolio.
In contrast, mutual funds only trade once a day, and the fund administrator is the only counter-party for buyers and sellers. Mutual funds also have internal trading fees which are not disclosed on top of the stated fee, which are estimated to range from 0.11% of assets to 2%, with an average of 1.44%. So, while many passive index mutual funds’ undisclosed trading fees are likely quite low, they are not zero, which is something to consider when doing a pure cost comparison.
Typically, ETFs have lower expense ratios than mutual funds, despite their typically better net-of-fee performance. This is one of the main reasons—along with better tax efficiency and no minimum balances—that Betterment utilizes exchange traded funds in our portfolio.
ETF managers make money by deducting the annual expenses from the dividends they pay out through the year, and they tell you in advance how much that will be. There are no costs to buy or sell ETFs, and no hidden expenses. If you were to trade through a broker, the broker would usually charge you a commission to execute the transaction. Here at Betterment, we do not charge you any fees outside of our flat advisory fee when we buy and sell ETFs on your behalf.
On the other hand, open-end mutual funds have purchase and redemption fees. These fees range from 0.25% to 2% and are charged by the fund to buy or sell shares within a specified (usually short) period of time. Purchase and redemption fees differ from a commission because the money goes back into the fund rather than to a broker. These fees are meant to discourage short-term market timing.
Some mutual funds have different share classes, each with their own expense ratio and minimum investment.
It’s easy to quickly get deep into the weeds here, but strictly speaking, even a “tax efficient” mutual fund is not necessarily as tax efficient as an ETF.
When you own a share of an ETF, you hold a single security directly for tax purposes, and you’re in control of events that trigger tax consequences. An example of a tax event would be selling the share.
However, when you own a share of a mutual fund, a number of circumstances you have no control over can trigger taxable events for you. The fund manager may choose to sell some underlying securities to rebalance or otherwise readjust the index, or investors other than yourself can withdraw, forcing the manager to sell in a way that can have tax consequences for you, even though you haven’t sold anything. A manager of a “tax efficient” fund presumably seeks to minimize such outcomes, but it may not always be under their control.
What funds are in my portfolio?
The Betterment Portfolio is comprised of a combination of globally-diversified stock and bond ETFs that aim to efficiently capture the broad U.S. stock market, as well as international developed and emerging markets. We selected these ETFs based on their liquidity, diversification, and low management fees.
Your money is invested in thousands of companies through fractional shares. Exactly how much of your portfolio is made up of which stocks and bonds depends on your portfolio’s exact target allocation, so some funds in our portfolio strategy only appear in certain stock-to-bond allocations. For example, if your portfolio is set to 100% bonds, you will not see any of the stock ETFs that are included in the Betterment Portfolio.
While logged in, choose a specific investing goal and then go to the Portfolio Analysis tab to see your specific asset classes and the underlying ETFs for that goal.
Why has Betterment selected this portfolio?
The Betterment Portfolio is professionally constructed using a two-part process: asset allocation and fund selection. Together, they determine the ETFs that make up your portfolio.
Betterment constructs globally-diversified, strategic asset allocation portfolios appropriate for an investor’s goals and time horizon. Each portfolio is selected as the result of a systematic portfolio optimization process that simultaneously balances forecasts for long-run expected returns for each asset class against both historical and forward-looking downside behavior for the portfolio as a whole.
In forecasting expected returns, we utilize the Black-Litterman Global Portfolio Optimization model to appropriately marry market expectations extracted from historical performance and current price levels with Betterment’s views on long-run asset class behavior and correlations. The result is a portfolio that provides an optimal blend of asset class exposures across different economic regions, investment styles, and security types to deliver the best possible risk-adjusted returns for every level of risk.
The long-term performance of a portfolio can be negatively impacted by changes in interest rates and inflation. Our fully diversified global portfolio helps smooth out the impact of these factors since different areas of the world experience them at different times and with varying severity. Our portfolio also avoids a common behavioral error of investors called home-bias, or the tendency to own companies from the country you live in.
Can I invest in an individual stock or fund (ie., S&P 500 index or Apple)?
No, you cannot invest in an individual stock or fund at Betterment. We aim to invest in a globally-diversified portfolio (which includes over 5,000 companies) made up of low-cost and liquid ETFs. The portfolio was chosen to help provide optimal returns at every level of risk, and is rebalanced as the market fluctuates and as you grow closer to your goal’s end date, if you have a time horizon set.
We believe in passive investing. The majority of the evidence shows that active management, whether by individual investors or fund managers, can cause more harm than good in net-of-fee returns. This is why we invest in low-cost, passive investments and seek to match the market’s performance.
We do offer some alternatives to the Betterment Portfolio, including strategies for those interested in socially responsible investing, targeting income generation, and quantitative factor investing. Each portfolio is available at the individual goal level, and adjusts its recommended allocation or target income based on your preferences and time horizon. You can have multiple portfolio strategies within your Betterment account, tailored for your different financial goals.
For our advanced investors, the most customization we offer are flexible portfolios, which allow you to adjust the weight of each asset class within the Betterment Portfolio.
What are the current overlaps of the same stocks held within different ETFs?
Generally, the only stocks which will have overlap are value stocks and small-cap stocks.
We’ve employed evidence-backed optimizations that tilt a recommended portfolio toward value stocks and investments with a smaller market capitalization. To achieve this tilt, we use a whole U.S. stock-market ETF for our core holding, and then invest in three additional value-based ETFs for large-cap, mid-cap, and small-cap value equity exposure, respectively.
Stocks which fall into these three ETFs will have double exposures, which is exactly what we want–to be overweight in them compared to the broad market.
If I live in California or New York, can I have state-specific municipal bonds in my taxable investment portfolio?
The standard Betterment portfolio for taxable accounts utilizes a national municipal bond ETF to provide exposure to national municipal bonds. For customers with a minimum balance of (or intent to fund) at least $100,000, Betterment offers state-specific municipal bond ETFs for California and New York residents in lieu of the national municipal bond ETF. These ETFs provide exposure to California municipal bonds and New York municipal bonds, respectively.
State-specific municipal bonds are generally advantageous for those in high-income tax brackets. For more background on when it might make sense to invest in local municipal bonds, please see the following article: Muni Bond Exposure: When Does It Make Sense to Go Local?
To switch out national municipal bond ETFs in your portfolio to state-specific bond ETFs, please contact us at email@example.com. We generally recommend making this switch before you fund your account, but if your account is funded, we will sell you out of the national municipal bond ETF over time in a way that attempts to minimize realizing any taxable gains for you.
How will my portfolio be allocated?
When you deposit money with Betterment, every dollar is seamlessly invested in up to 14 different asset classes, depending on your selected asset allocation.
You decide your ideal allocation of stocks vs. bonds, which is dependent on the amount of risk you want to take and how much time you plan on investing for. We’ll provide recommendations based on your goals and your timeframe, and we’ll automatically rebalance your portfolio over time to keep you on track to meet your financial goals. When setting up your account, the more accurate the information you enter about your goals, the better our advice can be optimized for you.
You can also see the full breakdown of the ETFs at each allocation, or if you already have an account, you can log in and view your portfolio breakdown.
How and when is my portfolio rebalanced?
Why Rebalancing Is Necessary
Over time, the value of individual ETFs in a diversified portfolio moves up and down, drifting away from their target weights. For example, over the long term, stocks generally rise faster than bonds. The stock portion of your portfolio may go up in value faster relative to the bond portion–if you don’t rebalance.
The difference between the target weights for your portfolio and the actual weights in your current portfolio is called drift.
Rebalancing is what corrects drift, bringing your portfolio back to its target allocation.
Measuring Portfolio Drift
We define portfolio drift as the total absolute deviation of each asset class from its target, divided by two. Here’s a simplified example, with only four assets:
A high drift reduces the efficiency of your portfolio and may expose you to more (or less) risk than you intended when you set the target allocation.
Taking actions to reduce this drift is called rebalancing, which Betterment automatically does for you in several ways—depending on the circumstances—and always with an eye on tax efficiency. Our methods for rebalancing are:
- Cash Flow Rebalancing: suggested when drift reaches 2%
- Sell/Buy Rebalancing: automatically triggered when drift reaches 3%*
- Allocation Change Rebalancing: corrects drift when you manually change your target allocation
*Note that Dimensional Fund Advisor portfolios used by our Betterment For Advisors platform has an alternate sell/buy rebalancing drift threshold of 5%, and the drift is calculated based on fund-level drift rather than asset-class drift.
We’ll go into detail about each of these rebalancing methods below.
Cash Flow Rebalancing
This method involves either buying or selling—but not both at the same time—and is preferable when cash flows into or out of the portfolio are happening anyway. Every cash flow (e.g. deposit, dividend reinvestment, or withdrawal) is used to rebalance your portfolio. Fractional shares allow us to allocate these cash flows with precision to the penny.
Inflows: You are rebalanced whenever you make a deposit, including when you auto-deposit or receive dividends in your account. We use the inflow to buy the asset classes you are currently underweight in, reducing your drift. The result is that the need to sell in order to rebalance is reduced. With sufficient inflows, the need to sell is eliminated completely. No sales means no capital gains, which means no taxes will be owed.
This method is so desirable that we’ve built it directly into your Portfolio tab. Whenever your drift reaches 2% or higher, we calculate the deposit required to reduce your drift, and make it easy for you to make the deposit.
Outflows: Outflows (e.g. withdrawals) are likewise used to rebalance, by first selling asset classes which are overweight. Once we have sold all assets classes that you are overweight in, we sell all asset classes equally to keep you balanced. We employ a sophisticated lot selection algorithm called TaxMin within asset classes to minimize the tax impact as much as possible in taxable accounts.
In the absence of cash flows, or when they are not sufficient to keep your portfolio’s drift within a certain tolerance, we rebalance by selling and buying. We sell just enough of the overweight asset classes, and use the proceeds to buy into the underweight asset classes to reshuffle the assets in the portfolio and reduce the drift.
Sell/Buy rebalancing is automatically triggered whenever the portfolio drift reaches 3%. Our algorithms check your drift approximately once per day, and rebalances if necessary.
It’s possible for your drift to stay above 3% if you have no long-term lots to sell (usually due to the account being less than a year old) and there is an absence of cash flows.
That’s because with any sell trade, TaxMin selects the lowest tax impact lots, but will stop before selling any lots that would realize short-term capital gains, which are taxed at a higher rate than long-term capital gains. This way, we can achieve higher after-tax outcome by simply waiting for those lots to become long-term before rebalancing, if it’s still necessary at that point.
If you’d like to turn off automated sell/buy rebalancing so that we only rebalance your portfolio in response to cash flows (e.g. deposits, withdrawals, or dividend reinvestments) and not by reshuffling assets already in the portfolio, please email us.
Allocation Change Rebalancing
Manually adjusting the target allocation will also trigger a rebalance. This sells securities and could possibly realize capital gains. Moreover, if you change your allocation even by 1%, you will be rebalanced entirely to match your new desired target allocation, regardless of tax consequences. As with all sell trades, we will utilize TaxMin to reduce the tax impact as much as possible, and you will see a Tax Impact Preview before finalizing the change.
Will my portfolio beat the market?
Investors in every country are apt to follow their local stock market as a benchmark. The British follow the FTSE, Germans watch the DAX, and the Japanese pay attention to the Nikkei. American investors are drawn to use the S&P 500 as a benchmark because it’s familiar and is the most widely reported index in U.S. news. What Americans are less likely to hear is that the S&P 500 represents only a portion (about 80%) of the U.S. stock market and 36% of the world’s total stock market. While U.S. investors know when their portfolio is underperforming the S&P 500, they don’t know when they’re underperforming international indices.
The Betterment Portfolio is not designed to beat the market, which is difficult to do with any certainty and involves a lot of risk. Investing for the long-term is made less risky through a well-diversified portfolio like ours, which includes, but is not limited to, U.S. large cap stocks, which is the index measured by the S&P 500. There will always be parts that overperform and underperform, but we selected this specific mix of securities to help prevent your performance from experiencing extreme up or down changes, the way a more concentrated portfolio would do.
Can my investments lose value?
Betterment is a strong believer in passive investing. The majority of the evidence shows that active management, whether by individual investors or fund managers, causes more harm than good in net-of-fee returns. We invest in low-cost, passive investments which always seek to match the market’s performance.
However, like all market investments, the securities you own in your account are subject to market risk. Fluctuations in the market are normal and hard to predict over the short term, but it’s because of the volatility that you have an opportunity to seek a higher return in the long-term than you might get from a bank account.
The most important things we recommend you do as an investor are to:
- Set up your account to accurately reflect your goals;
- Use our recommended stock allocations; and
- Stay the course.
Our historical data shows that over the long-term, your investment is likely to increase.
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