Betterment has established a reputation for creating investment portfolios that help individuals maximize their financial potential. The company’s approach is rooted in real-world evidence and systematic decision-making, ensuring that each portfolio is tailored to meet specific investment objectives. At the heart of Betterment’s strategy lies the Core portfolio which serves as the foundation for all globally-diversified portfolios. From this core, Betterment applies targeted adjustments to create portfolios that align with various investment goals, such as value-focused strategies, innovative technology exposures, or socially responsible investing (SRI) criteria.
The process of building an investment portfolio involves two critical tasks: asset class selection and portfolio optimization. Betterment’s methodology for these tasks is informed by extensive research and industry best practices. The company’s fund selection process, while crucial, is covered separately and complements the portfolio construction methodology.
Global diversification and asset allocation
An optimal asset allocation aims to achieve the maximum return for a given level of risk, with risk measured in terms of volatility. Betterment’s asset allocation strategy is based on Modern Portfolio Theory (MPT) developed by economist Harry Markowitz. MPT posits that assets should be evaluated based on their contribution to the
Betterment’s approach to asset allocation begins with a universe of investable assets, representing the global market portfolio. The company evaluates available exchange-traded funds (ETFs) to capture the exposures of various asset classes. Betterment’s portfolios include a mix of stocks and bonds with specific allocations to U.S., international developed market, and emerging market assets. This diversification strategy helps manage risk and enhance potential returns.
Asset classes excluded from Betterment portfolios
While MPT suggests including all available asset classes, Betterment excludes certain classes due to their cost and lack of data. For instance, the company does not include commodities or natural resources asset classes, as they have a low contribution to a global stock/bond portfolio’s risk-adjusted return. Additionally, real estate investment trusts (REITs) are not explicitly included, as their addition would overweight real estate exposure relative to the
Portfolio optimization
Betterment fine-tunes its clients’ investments to maximize return potential for an appropriate level of risk. This effort is based on established industry techniques and rigorous research. Unlike many asset managers that offer a limited set of model portfolios, Betterment provides customers with 101 different stock-bond risk levels, offering more granularity and control over risk exposure.
The portfolio optimization process involves estimating variables such as expected returns, covariances, and volatilities. These variables, known as capital market assumptions (CMAs) provide quantitative inputs for deriving favorable asset class weights. Betterment uses the Capital Asset Pricing Model (CAPM) and a utility function to optimize portfolios for higher returns given the risk an investor is willing to accept.
Constrained optimization for stock-heavy portfolios
For portfolios with a higher allocation to stocks, Betterment employs a constrained optimization approach. This method generates several thousand random samples of 15 years of expected returns based on the latest CMAs. The company then finds a set of allocation weights that provide the best risk-return trade-off, expressed as the portfolio’s Sharpe ratio. Constraints are imposed to ensure the portfolio weights align more closely with a custom benchmark, mitigating the risk of disproportionate allocations to certain asset classes.
Constrained optimization for bond-heavy portfolios
For portfolios with a higher allocation to bonds, the optimization approach differs. Expected returns are maximized for target volatilities assigned to each risk level. Manually established constraints manage risk relative to the benchmark, with a declining trend in emerging market stock and bond exposures as stock allocations decrease. This approach reflects the view that more conservative investors should have increased exposure to short-term Treasury, short-term investment-grade, and inflation-protected bonds.
Tax management using municipal bonds
For investors with taxable accounts, portfolio returns can be improved on an after-tax basis by utilizing municipal bonds. The interest from municipal bonds is exempt from federal income tax, making them an attractive option for taxable accounts. Betterment incorporates municipal bonds within the bond allocations of taxable accounts, improving the Additionally, investors in states with high tax rates, such as New York and California, can opt for state-specific municipal bonds to further save on state taxes.
Innovative portfolio strategies
Betterment offers several innovative portfolio strategies tailored to specific investment objectives. These include the Value Tilt portfolio which maintains global diversification while including a sleeve within the stock allocation of large-, mid-, and small-capitalization U.S. value funds. The Innovative Technology portfolio provides increased exposure to thematic trends such as artificial intelligence, alternative finance, clean energy, manufacturing, and biotechnology.
Additionally, Betterment introduced its first Socially Responsible Investing (SRI) portfolio in 2017, expanding to include three distinct portfolios: Broad Impact, Social Impact, and Climate Impact. These SRI portfolios are built on the same foundational principles as the Core portfolio but incorporate socially-responsible ETFs that align with specific Environmental, Social, and Governance (ESG) and shareholder engagement mandates.
Together, these processes and principles put Betterment’s philosophy into action, helping each customer maximize value while invested and when they take their money home.
