Boris here, Operations Manager at Betterment. I became a Betterment customer years before I came to work here, so I've thought through all these issues at length, and in particular tax efficiency, since I'm an attorney who's practiced tax law in the past. I wanted to address a couple of points you raise.
Funds vs. ETFs
It's easy to quickly get deep into the weeds here, but strictly speaking, even a "tax efficient" fund (which could mean a number of things) is not necessarily as tax efficient as an ETF.
- When you own a share of an ETF, you directly hold a single security directly for tax purposes, and you're in control of events that trigger tax consequences (primarily, selling it).
- When you own a share of a 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 his control either.
Another reason ETFs are generally preferable is that mutual funds, even Vanguard's low cost funds, like their Target Retirement Funds, have trading fees which are not disclosed on top of the stated fee. Here's a good WSJ primer on this issue:
Vanguard's undisclosed trading fees are likely quite low, but they are non-zero, so that's something to consider when doing a pure cost comparison. Through Betterment you hold exclusively ETFs, including many from Vanguard (a company we greatly admire), and we cover all trading fees. The ETF fee and our stated fee is all there is.
Tax Efficient Rebalancing
Ultimately, tax efficiency depends less on what you hold in your portfolio (assuming fund managers that make tax efficiency a priority) and more on how you move in and out of your portfolio. As long as you don't sell, you don't get taxed, but we all know that rebalancing is an essential element to a sound investment strategy, which means that you will, in fact, need to sell on a regular basis.
This is one of the areas where Betterment provides tremendous value.
- First, we automatically rebalance you every quarter, as well as any time your allocation deviates by more than 5%.
- Second, we have additional algorithms running under the hood to maximize tax efficiency at every possible turn.
It's possible to do the first manually (with constant monitoring and time spent - more on that below). It's virtually impossible to do the second as well as Betterment does automatically. I've tried. You cannot emulate sophisticated, relentless 24/7 software by reading a couple of books. Let me elaborate:
A primary (though not only) goal of tax efficient management is to avoid short term capital gains (i.e hold for at least a year). To achieve this, Betterment's software is constantly looking for ways to avoid selling when it can be avoided. Every time you make a deposit (and we encourage regular auto-deposits), we buy a little bit more of the basket that's underperforming, rather than investing your deposit pro rata according to your target allocation. When you get interest or dividends, we do the same when reinvesting them. If you need to make a withdrawal, again, we don't sell pro rata, but sell more of the overperforming basket, seeking to minimize future selling. This typically amounts to dozens of additional calculations annually, often with seemingly insignificant amounts at stake, but it all adds up over the years. Nobody out there does anything like this, and certainly not for what we charge.
Our Fee vs. "Do It Yourself"
Let's assume for a moment that you can manually replicate what we do (and not only that, but that you will - another big if). We understand the importance of low costs - it's one of our mantras here (did I mention we love Vanguard?) However, minimizing fees is not the sole consideration - for any transaction, one should examine the value proposition. Most of us can probably take some plumbing courses and then never have to call a plumber again for the rest of our lives, choosing to DIY. Yet most of us choose not to spend hours with our heads under the sink - and not because we're lazy. Our time is worth something too.
Let's run some numbers. As you know, our fee is 15 bps on balances over $100,000. Once you're out of residency, your taxable account will get there in no time. That's $150 a year (less than 50 cents a day) to manage $100k. Let's say that a DIY tax efficient rebalancing strategy takes you ten hours a year. How much is ten hours worth to a professional pulling 60 hour weeks? Does it make sense to pay yourself $15 dollars an hour to eat up your precious free time, when you make $100+/hr at work? When you could be enjoying yourself, playing with your kids? At some point, I hope we can all agree that the answer is no.
I haven't even touched on all the other advantages our product confers (though I have to say, given my background, tax efficiency is one of my favorites). Betterment's built a product that lets you get on with your life by providing a next generation service at an extremely good value.
At some point, index funds didn't exist. Not too long ago, neither did ETFs. The preference for these is now conventional wisdom. Some day, not too long from now, people will be chuckling at how they used to sit around with calculators, trying to optimally rebalance their portfolios by hand, like we used to defrost our own freezers. By all means, we should educate ourselves and understand what's going on, but for the price of 1/4 (YMMV) of a cup of coffee a day, let's enjoy our lives instead!
We're thrilled to have you as a customer, and I'm happy to answer any other questions you may have.