Investment Portfolios

The latest update to our Core portfolio strategy Learn more about the changes we believe will help improve long-term risk-adjusted returns. Betterment serves as a fiduciary, acting in our clients’ best interests. We monitor our portfolios and review the underlying investments on a regular basis to optimize portfolios and help you achieve your investment goals. As part of this process, we’ve made changes to our Core portfolio strategy that we believe will help improve long-term risk-adjusted returns. How we evaluate and manage our portfolios The Betterment Investment Committee monitors and reviews the underlying inputs used to construct our portfolios, including running simulations to gauge expected long-term performance. Our capital market assumptions (CMAs) represent our long-term expectations for the return and risk of various asset classes. These CMAs help inform how we allocate across different asset classes in our portfolios, and power our platform’s advice tools What’s changed in the Core portfolio? Our updated CMAs indicate a shift in the expected risk-return profile of certain asset classes, suggesting a reallocation of target exposures with the Core portfolio going forward. Here’s what that means: Within our equities basket Dialed down exposure to emerging markets stocks while increasing exposure to U.S. stocks. With increasing geopolitical risks, we believe this shift can help reduce potential losses, especially for portfolios holding fewer stocks relative to bonds. This change also brings us closer to MSCI All Country World Index (MSCI ACWI, our stock allocation benchmark as described below) Reduced the emphasis on U.S. value stocks (“value tilt”), shifting toward U.S. stock exposure weighted by market capitalization. Over time, we’ve observed gradual compression in the value factor premium as markets have become more efficient. We expect this adjustment to help reduce risk and more closely align the Core portfolio with our custom benchmark indices (described below). Within our fixed income basket Reduced exposure to both emerging markets and international developed bonds, while increasing exposure to U.S. bonds. Similar to our stock allocations, we expect this to mitigate potential downside risk for more conservative allocations. Increased allocations to inflation-protected U.S. bonds. This update will help shield clients with more conservative portfolios from potential erosion risk on savings—providing protection against market drawdowns, rising interest rates, and other macroeconomic events that could have negative short-term consequences. This change can be particularly relevant for customers in retirement, since inflation can meaningfully eat away at the value of your money over time. Developing a “benchmark aware” portfolio strategy In an evolution of our investment process, we’ve also updated our Core portfolio construction methodology to become more “benchmark aware.” This means we now calibrate our exposures based on a custom benchmark. The custom benchmark we have selected is composed of (1) the MSCI All Country World Index (MSCI ACWI), (2) the Bloomberg Global Aggregate Bond index, and (3) at low risk levels, the ICE US Treasury 1-3 Year Index. This custom benchmark has varying risk levels that correspond to the Core portfolio allocations we support for a variety of investor risk tolerances. Introducing the Value Tilt portfolio strategy For customers who favor the potential benefits and associated risks in value investing, we’re introducing a new portfolio option: Value Tilt. The Value Tilt portfolio strategy maintains the same historical track record as the Core portfolio strategy, up until the 2024 changes where this becomes a new strategy. While this portfolio includes the same thematic asset allocation changes as the Core portfolio strategy, it maintains explicit weighting towards U.S. value stocks. An expansion of our portfolio options, Value Tilt is available for all goals, new and old. You can select it within your account. What does all this mean for you? No action is required from you to transition to the updated Core portfolio allocations. We’ll manage your Core portfolio tax-efficiently and put your cash flows (such as deposits, withdrawals, dividends, contributions, and distributions) to work to assist with the transition, moving your portfolio towards the updated target allocation. Our algorithms will automatically work to reduce any drift between your positions and the updated target allocation, by (1) first purchasing those funds where your portfolio is underweight when investing dividends and deposits and (2) first selling those funds where your portfolio is overweight, when generating cash for withdrawals. If you’ve enabled tax loss harvesting, we’ll use those opportunities to reduce drift as well. We do not expect any tax impact in IRAs, 401(k)s, and HSAs. Considering potential tax impact For taxable goals, while the trade-off between expected returns and tax impact is unique to each client (and depends on factors such as your investing time horizon and financial situation), most customers should see minimal changes to their taxes as a result of this transition. That’s because we’re taking a gradual approach with the portfolio migration and using cash flows to transition taxable accounts. If you would rather be invested in one of our other managed ETF portfolio strategies or wish to have value exposure in your portfolio, you have the option of selecting any of these strategies, along with the Value Tilt portfolio, on our platform. Betterment is regularly monitoring your investments so that you don’t have to. Learn more about our investment philosophy and process.

The Betterment Core portfolio strategy We continually improve our portfolio construction methodology over time in line with our research-focused investment philosophy. TABLE OF CONTENTS Introduction Global Diversification and Asset Allocation Portfolio Optimization Tax Management Using Municipal Bonds The Value Tilt Portfolio Strategy Innovative Technology Portfolio Strategy Conclusion Citations I. Introduction Betterment builds investment portfolios designed to help you make the most of your money so you can live the life you want. Our investment philosophy forms the basis for how we pursue that objective: Betterment uses real-world evidence and systematic decision-making to help increase our customers’ wealth. In building our platform and offering individualized advice, Betterment’s philosophy is actualized by our five investing principles. Regardless of one’s assets or specific situation, Betterment believes all investors should: Make a personalized plan. Build in discipline. Maintain diversification. Balance cost and value. Manage taxes. To align with Betterment’s investing principles, a portfolio strategy must enable personalized planning and built-in discipline for investors. The Betterment Core portfolio strategy contains 101 individualized risk levels (each with a different percentage of the portfolio invested in stocks vs. bonds, informed by your financial goals, time horizon and risk tolerance), in part, because that level of granularity in allocation management provides the flexibility to align to multiple goals with different timelines and circumstances. In this guide to the Betterment Core portfolio strategy construction process, our goal is to demonstrate how the methodology, in both its application and development, embodies Betterment’s investing principles. When developing a portfolio strategy, any investment manager faces two main tasks: asset class selection and portfolio optimization. Fund selection is also guided by our investing principles, and is covered separately in our Investment Selection Methodology paper. II. Global Diversification and Asset Allocation An optimal asset allocation is one that lies on the efficient frontier, which is a set of portfolios that seek to achieve the maximum objective for any given feasible level of risk. The objective of most long-term portfolio strategies is to maximize return for a given level of risk, which is measured in terms of volatility—the dispersion of those returns. In line with our investment philosophy of making systematic decisions backed by research, Betterment’s asset allocation is based on a theory by economist Harry Markowitz called Modern Portfolio Theory.1 A major tenet of Modern Portfolio Theory is that any asset included in a portfolio should not be assessed by itself, but rather, its potential risk and return should be analyzed as a contribution to the whole portfolio. Modern Portfolio Theory seeks to maximize expected return given an expected risk level or, equivalently, minimize expected risk given an expected return. Other forms of portfolio construction may legitimately pursue other objectives, such as optimizing for income, or minimizing loss of principal. Asset Classes Selected for Betterment’s Core Portfolio Strategy The Betterment Core portfolio strategy’s asset allocation starts with a universe of investable assets, which for us could be thought of as the “global market portfolio.”2 To capture the exposures of the asset classes for the global market portfolio, Betterment evaluates available exchange-traded funds (ETFs) that represent each class in the theoretical market portfolio. We base our asset class selection on ETFs because this aligns portfolio construction with our investment selection methodology. Betterment’s portfolios are constructed of the following asset classes: Equities U.S. equities International developed market equities Emerging market equities Bonds U.S. short-term treasury bonds U.S. inflation-protected bonds U.S. investment-grade bonds U.S. municipal bonds International developed market bonds Emerging market bonds We select U.S. and international developed market equities as a core part of the portfolio. Historically, equities exhibit a high degree of volatility, but provide some degree of inflation protection. Even though significant historical drawdowns, such as the global financial crisis in 2008 and pandemic outbreak in 2020, demonstrate the possible risk of investing in equities, longer-term historical data and our forward expected returns calculations suggest that developed market equities remain a core part of any asset allocation aimed at achieving positive returns. This is because, over the long term, developed market equities have tended to outperform bonds on a risk-adjusted basis. To achieve a global market portfolio, we also include equities from less developed economies, called emerging markets. Generally, emerging market equities tend to be more volatile than U.S. and international developed equities. And while our research shows high correlation between this asset class and developed market equities, their inclusion on a risk-adjusted basis is important for global diversification. Note that Betterment excludes frontier markets, which are even smaller than emerging markets, due to their widely varying definition, extreme volatility, small contribution to global market capitalization, and cost to access. The Betterment Core portfolio strategy incorporates bond exposure because, historically, bonds have a low correlation with equities, and they remain an important way to dial down the overall risk of a portfolio. To promote diversification and leverage various risk and reward tradeoffs, the Betterment Core portfolio strategy includes exposure to several asset classes of bonds. Asset Classes Excluded from the Betterment Core Portfolio Strategy While Modern Portfolio Theory would have us craft a portfolio to represent the total market, including all available asset classes, we exclude some asset classes whose cost and/or lack of data outweighs the potential benefit gained from their inclusion. The Betterment Core portfolio construction process excludes commodities and natural resources asset classes. Specifically, while commodities represent an investable asset class in the global financial market, we have excluded commodities ETFs because of their low contribution to a global stock/bond portfolio's risk-adjusted return. In addition, real estate investment trusts (REITs), which tend to be well marketed as a separate asset class, are not explicitly included in the Core portfolio strategy. Betterment does provide exposure to real estate, but as a sector within equities. Adding additional real estate exposure by including a REIT asset class would overweight the exposure to real estate relative to the overall market. Incorporating awareness of a benchmark Before 2024, we managed the Core portfolio strategy in a “benchmark agnostic” manner, meaning we did not incorporate consideration of global stock and bond indices in our portfolio optimization, though we have always sought to optimize the expected risk-adjusted return of the portfolios we construct for clients. The “risk” element of this statement represents volatility and the related drawdown potential of the portfolio, but it could also represent the risk in the deviation of the portfolio’s performance relative to a benchmark. In an evolution of our investment process, in 2024 we updated our portfolio construction methodology to become “benchmark aware,” as we now calibrate our exposures based on a custom benchmark that expresses our preference for diversifying across global stocks and bonds. A benchmark, which comes in the form of a broad-based market index or a combination of indices, serves as a reference point when approaching asset allocation, understanding investment performance, and aligning the expectations of portfolio managers and clients. In our case, we created a custom benchmark that most closely aligns with our future expectations for global markets. The custom benchmark we have selected is composed of (1) the MSCI All Country World stock index (MSCI ACWI), (2) the Bloomberg Global Aggregate Bond index, and (3) at low risk levels, the ICE US Treasury 1-3 Year Index. Our custom benchmark is composed of 101 risk levels of varying percentage weightings of the stock and bond indexes, which correspond to the 101 risk level allocations in our Core portfolio. At low risk levels (allocations that are less than 40% stocks), we layer an allocation to the ICE US Treasury 1-3 Year index, which represents short-term bonds, into the blended benchmark. We believe that incorporating this custom benchmark into our process reinforces the discipline of carefully evaluating the ways in which our portfolios’ performance could veer from global market indices and deviate from our clients’ expectations. We have customized the benchmark with 101 risk levels so that it serves clients’ varying investment goals and risk tolerances. As we will explore in the following section, establishing a benchmark allows us to apply constraints to our portfolio optimization that ensures the portfolio strategy’s asset allocation does not vary significantly from the geographic and market-capitalization size exposures of a sound benchmark. Our benchmark selection also makes explicit that the portfolio strategy delivers global diversification rather than the more narrowly concentrated and home-biased exposures of other possible benchmarks such as the S&P 500. III. Portfolio Optimization As an asset manager, we fine-tune the investments our clients hold with us, seeking to maximize return potential for the appropriate amount of risk each client can tolerate. We base this effort on a foundation of established techniques in the industry and our own rigorous research and analysis. While most asset managers offer a limited set of model portfolios at a defined risk scale, the Betterment Core portfolio strategy is designed to give customers more granularity and control over how much risk they want to take on. Instead of offering a conventional set of three portfolio choices—aggressive, moderate, and conservative—our portfolio optimization methods enable the Core portfolio strategy to contain 101 different risk levels. Optimizing Portfolios Modern Portfolio Theory requires estimating variables such as expected-returns, covariances, and volatilities to optimize for portfolios that sit along an efficient frontier. We refer to these variables as capital market assumptions (CMAs), and they provide quantitative inputs for our process to derive favorable asset class weights for the portfolio strategy. While we could use historical averages to estimate future returns, this is inherently unreliable because historical returns do not necessarily represent future expectations. A better way is to utilize the Capital Asset Pricing Model (CAPM) along with a utility function which allows us to optimize for the portfolio with a higher return for the risk that the investor is willing to accept. Computing Forward-Looking Return Inputs Under CAPM assumptions, the global market portfolio is the optimal portfolio. Since we know the weights of the global market portfolio and can reasonably estimate the covariance of those assets, we can recover the returns implied by the market.3 This relationship gives rise to the equation for reverse optimization: μ = λ Σ ωmarket Where μ is the return vector, λ is the risk aversion parameter, Σ is the covariance matrix, and ωmarket is the weights of the assets in the global market portfolio.5 By using CAPM, the expected return is essentially determined to be proportional to the asset’s contribution to the overall portfolio risk. It’s called a reverse optimization because the weights are taken as a given and this implies the returns that investors are expecting. While CAPM is an elegant theory, it does rely on a number of limiting assumptions: e.g., a one period model, a frictionless and efficient market, and the assumption that all investors are rational mean-variance optimizers.4 In order to complete the equation above and compute the expected returns using reverse optimization, we need the covariance matrix as an input. This matrix mathematically describes the relationships of every asset with each other as well as the volatility risk of the assets themselves. In another more recent evolution of our investment process, we also attempt to increase the robustness of our CMAs by averaging in the estimates of expected returns and volatilities published by large asset managers such as BlackRock, Vanguard, and State Street Global Advisors. We weight the contribution of their figures to our final estimates based on our judgment of the external provider’s methodology. Constrained optimization for stock-heavy portfolios After formulating our CMAs for each of the asset classes we favor for inclusion in the Betterment Core portfolio strategy, we then solve for target portfolio allocation weights (the specific set of asset classes and the relative distribution among those asset classes in which a portfolio will be invested), with the range of possible solutions constrained by limiting the deviation from the composition of the custom benchmark. To robustly estimate the weights that best balance risk and return, we first generate several thousand random samples of 15 years of expected returns for the selected asset classes based on our latest CMAs, assuming a multivariate normal distribution. For each sample of 15 years of simulated expected return data, we find a set of allocation weights subject to constraints that provide the best risk-return trade-off, expressed as the portfolio’s Sharpe ratio, i.e., the ratio of its return to its volatility. Averaging the allocation weights across the thousands of return samples gives a single set of allocation weights optimized to perform in the face of a wide range of market scenarios (a “target allocation”). The constraints are imposed to make the portfolio weights more benchmark-aware by setting maximum and minimum limits to some asset class weights. These constraints reflect our judgment of how far the composition of geographic regions within the portfolio’s stock and bond allocations should differ from the breakdown of the indices used in the benchmark before the risk of significantly varied performance between the portfolio strategy and the benchmark becomes untenable. For example, the share of the portfolio’s stock allocation assigned to international developed stocks should not be profoundly different from the share of international developed stocks within the MSCI ACWI. We implement caps on the weights of emerging market stocks and bonds, which are often projected to have high returns in our CMAs, and set minimum thresholds for U.S. stocks and bonds. This approach not only ensures our portfolio aligns more closely with the benchmark, but it also mitigates the risk of disproportionately allocating to certain high expected return asset classes. Constrained optimization for bond-heavy portfolios For versions of the Core portfolio strategy that have more than or equal to 60% allocation to bonds, the optimization approach differs in that expected returns are maximized for target volatilities assigned to each risk level. These volatility targets are determined by considering the volatility of the equivalent benchmark. Manually established constraints are designed to manage risk relative to the benchmark, instituting a declining trend in emerging market stock and bond exposures as stock allocations (i.e., the risk level) decreases. Meaning that investors with more conservative risk tolerances have reduced exposures to emerging market stocks and bonds because emerging markets tend to have more volatility and downside-risk relative to more established markets. Additionally, as the stock allocation percentage decreases, we taper the share of international and U.S. aggregate bonds within the overall bond allocation, and increase the share of short-term Treasury, short-term investment grade, and inflation-protected bonds. This reflects our view that investors with more conservative risk tolerances should have increased exposure to short-term Treasury, short-term investment grade, and inflation-protected bonds relative to riskier areas of fixed income. The lower available risk levels of the Core portfolio strategy demonstrate capital preservation objectives, as the shorter-term fixed income exposures likely possess less credit and duration risk. Clients invested in the Core portfolio at conservative allocation levels will likely therefore not experience as significant drawdowns in the event of waves of defaults or upward swings in interest rates. Inflation-protected securities also help buffer the lower risk levels from upward drafts in inflation. IV. Tax Management Using Municipal Bonds For investors with taxable accounts, portfolio returns may be further improved on an after-tax basis by utilizing municipal bonds. This is because the interest from municipal bonds is exempt from federal income tax. To take advantage of this, the Betterment Core portfolio strategy in taxable accounts is also tilted toward municipal bonds because interest from municipal bonds is exempt from federal income tax, which can further optimize portfolio returns. Other types of bonds remain for diversification reasons, but the overall bond tax profile is improved by tilting towards municipal bonds. For investors in states with some of the highest tax rates—New York and California—Betterment can optionally replace the municipal bond allocation with a more narrow set of bonds for that specific state, further saving the investor on state taxes. Betterment customers who live in NY or CA can contact customer support to take advantage of state specific municipal bonds. V. The Value Tilt Portfolio Strategy Existing Betterment customers may recall that historically the Core portfolio strategy held a tilt to value companies, or businesses that appear to be potentially undervalued based on metrics such as price to earnings ratios. The latest iteration of the Core portfolio strategy, however, has deprecated this explicit tilt that was expressed via large-, mid-, and small-capitalization U.S. value stock ETFs, while maintaining some exposure to value companies through broad market U.S. stock funds. We no longer favor allocating to value stock ETFs within the Core portfolio strategy in large part as a result of our adoption of a broad market benchmark, which highlights the idiosyncratic nature of such tilts, sometimes referred to as “off benchmark bets.” We believe our chosen benchmark that represents stocks through the MSCI ACWI, which holds a more neutral weighting to value stocks, more closely aligns with the risk and return expectations of Betterment’s diverse range of client types across individuals, financial advisors, and 401(k) plan sponsors. Additionally, as markets have grown more efficient and value factor investing more popularized, potentially compressing the value premium, we have a marginally less favorable view of the forward-looking, risk-adjusted return profile of the exposure. That being said, we have not entirely lost conviction in the research supporting the prudence of value investing. The value factor’s deep academic roots drove decisions to incorporate the value tilt into Betterment’s portfolios from the company’s earliest days. For investors who wish to remain invested in a value strategy, we have added the Value Tilt portfolio strategy, a separate option from the Core portfolio strategy to our investing offering. The Value Tilt portfolio strategy maintains the Core portfolio strategy’s global diversification across stocks and bonds while including a sleeve within the stock allocation of large-, mid-, and small-capitalization U.S. value funds. We calibrated the size of the value fund exposure based on a certain target historical tracking error to the backtested performance of the latest version of the Core portfolio strategy. Based on this approach, investors should expect the Value Tilt portfolio strategy to generally perform similarly to Core, with the potential to under- or outperform based on the return of U.S. value stocks. With the option to select between the Value Tilt portfolio strategy or a Core now without an explicit allocation to value, the investment flexibility of the Betterment platform has improved. VI. Innovative Technology Portfolio Strategy In 2021, Betterment launched the Innovative Technology portfolio strategy to provide access to the thematic trend of technological innovation. The premise of investing in this theme is that your investments incorporate exposure to the companies that are seeking to shape the next industrial revolution. Similar to the Value Tilt portfolio, the Core portfolio strategy is used as the foundation of construction for the Innovative Technology portfolio. With this portfolio strategy, we calibrated the size of the innovative technology fund exposure based on a certain target historical tracking error to the backtested performance of the latest version of the Core portfolio strategy. Through this process, the Innovative Technology portfolio maintains the same globally diversified, low-cost approach that is found in Betterment’s investment philosophy. The portfolio however has increased exposure to risk given that innovation requires a long-term view, and may face uncertainties along the way. It may outperform or underperform depending on the return experience of the innovative technology fund exposure and the thematic landscape. VII. Conclusion After setting the strategic weight of assets in the Betterment Core portfolio strategy, the next step in implementing the portfolio construction process is Betterment’s investment selection, which selects the appropriate ETFs for the respective asset exposure in a generally low-cost, tax-efficient way. In keeping with our philosophy, that process, like the portfolio construction process, is executed in a systematic, rules-based way, taking into account the cost of the fund and the liquidity of the fund. Beyond ticker selection is our established process for allocation management—how we advise downgrading risk over time—and our methodology for automatic asset location, which we call Tax Coordination. Finally, our overlay features of automated rebalancing and tax-loss harvesting are designed to be used to help further maximize individualized, after-tax returns. Together these processes put our principles into action, to help each and every Betterment customer maximize value while invested at Betterment and when they take their money home. VIII. Citations 1 Markowitz, H., "Portfolio Selection".The Journal of Finance, Vol. 7, No. 1. (Mar., 1952), pp. 77-91. 2 Black F. and Litterman R., Asset Allocation Combining Investor Views with Market Equilibrium, Journal of Fixed Income, Vol. 1, No. 2. (Sep., 1991), pp. 7-18. Black F. and Litterman R., Global Portfolio Optimization, Financial Analysts Journal, Vol. 48, No. 5 (Sep. - Oct., 1992), pp. 28-43. 3 Litterman, B. (2004) Modern Investment Management: An Equilibrium Approach. 4 Note that the risk aversion parameter is essentially a free parameter. 5 Ilmnen, A., Expected Returns.

ETF Selection For Portfolio Construction: A Methodology When constructing a portfolio, Betterment focuses on exchange traded funds (“ETFs”) securities with generally low-costs and high liquidity. TABLE OF CONTENTS Why ETFs Total Annual Cost of Ownership Mitigating Market Impact Conclusion 1. Why ETFs? When constructing a portfolio, Betterment focuses on exchange traded funds (“ETFs”) securities with generally low-costs and high liquidity. An ETF is a security that generally tracks a broad-market stock or bond index or a basket of assets just like an index mutual fund, but trades just 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—and are bought and sold like stocks throughout the day. ETFs have certain structural advantages when compared to mutual funds. These include: A. Clear Goals and Mandates Betterment generally selects ETFs that have mandates to passively track broad-market benchmark indexes. A passive mandate explicitly restricts the fund administrator to the singular goal of replicating a benchmark rather than making active investment decisions constituting market timing, building concentration in either a single name, group of names, or themes in an effort to beat the fund’s underlying benchmark. Adherence to this mandate ensures the same level of investment diversification as the benchmark indexes, makes performance more predictable, and reduces idiosyncratic risk associated with active manager decisions. B. Intraday Availability ETFs are transactable during all open market hours just like any other stock. As such, they are heavily traded by the full spectrum of equity market participants including market makers, short-term traders, buy-and-hold investors, and fund administrators themselves creating and redeeming units as needed (or increasing or decreasing the supply of ETFs based on market demand). This diverse trading activity leads to most ETFs carrying low liquidity premiums (or lower costs to transact due to competition from readily available market participants pushing prices downward) and equity-like transaction times irrespective of the underlying holdings of each fund. This generally makes ETFs fairly liquid, which makes them cheaper and easier to trade on-demand for activities like creating a new portfolio or rebalancing an existing one. C. Low Fee Structures Because most benchmarks update constituents (i.e., the specific stocks and related weights that make up a broad-market index) fairly infrequently, passive index-tracking ETFs also register lower annual turnover (or the rate a fund tends to transact its holdings) and thus fewer associated costs are passed through to investors. In addition, ETFs are generally managed by their administrators as a single share class that holds all assets as a single entity. This structure naturally lends itself as a defense against administrators practicing fee discrimination across the spectrum of available investors. With only one share class, ETFs are investor-type agnostic. The result is that ETF administrators provide the same exposures and low fees to the entire spectrum of potential buyers. D. Tax Efficiency In the case when a fund (irrespective of its specific structure) sells holdings that have experienced capital appreciation, the capital gains generated from those sales must, by law, be accrued and distributed to shareholders by year-end in the form of distributions. These distributions increase tax liabilities for all of the fund’s shareholders. With respect to these distributions, ETFs offer a significant tax advantage for shareholders over mutual funds. Because mutual funds are not exchange traded, the only available counterparty available for a buyer or seller is the fund administrator. When a shareholder in a mutual fund wishes to liquidate their holdings in the fund, the fund’s administrator must sell securities in order to generate the cash required to satisfy the redemption request. These redemption-driven sales generate capital gains that lead to distributions for not just the redeeming investor, but all shareholders in the fund. Mutual funds thus effectively socialize the fund’s tax liability to all shareholders, leading to passive, long-term investors having to help pay a tax bill for all intermediate (and potentially short-term) shareholder transactions. Because ETFs are exchange traded, the entire market serves as potential counterparties to a buyer or seller. When a shareholder in an ETF wishes to liquidate their holdings in the fund, they simply sell their shares to another investor just like that of a single company’s equity shares. The resulting transaction would only generate a capital gain or loss for the seller and not all investors in the fund. In addition, ETFs enjoy a slight advantage when it comes to taxation on dividends paid out to investors. After the passing of the Jobs and Growth Tax Relief Reconciliation Act of 2003, certain qualified dividend payments from corporations to investors are only subject to the lower long-term capital gains tax rather than standard income tax (which is still in force for ordinary, non-qualified dividends). Qualified dividends have to be paid by a domestic corporation (or foreign corporation listed on a domestic stock exchange) and must be held by both the investor and the fund for 61 of the 120 days surrounding the dividend payout date. As a result of active mutual funds’ higher turnover, a higher percentage of dividends paid out to their investors violate the holding period requirement and increase investor tax profiles. E. Investment Flexibility The maturation and growth of the global ETF market over the past few decades has led to the development of an immense spectrum of products covering different asset classes, markets, styles, and geographies. The result is a robust market of potential portfolio components which are versatile, extremely liquid, and easily substitutable. Despite all the advantages of ETFs, it is still important to note that not all ETFs are exactly alike or equally beneficial to an investor. Betterment’s investment selection process seeks to select ETFs that provide exposure to the desired asset classes with the least amount of difference between underlying asset class behavior and portfolio performance. In other words, we attempt to minimize the “frictions” (the collection of systematic and idiosyncratic factors that lead to performance deviations) between ETFs and their benchmarks. Betterment’s measure of these frictions is summarized as the “total annual cost of ownership”, or TACO: a composition of all relevant frictions used to rank and select ETF candidates for the Betterment portfolio. 2. Total Annual Cost of Ownership (TACO) The total annual cost of ownership (TACO) is Betterment’s fund scoring method, used to rate funds for inclusion in the Betterment portfolio. TACO takes into account an ETF’s transactional and liquidity costs as well as costs associated with holding funds. In addition to TACO, Betterment also considers certain other qualitative factors of ETFs, including but not limited to, whether the ETF fulfills a desired portfolio mandate and/or exposure. TACO is determined by two components, a fund’s cost-to-trade and cost-to-hold. The first, cost-to-trade, represents the cost associated with trading in and out of funds during the course of regular investing activities, such as rebalancing, cash inflows or withdrawals, and tax loss harvesting. Cost-to-trade is generally influenced by two factors: Volume: A measure of how many shares change hands each day. Bid-ask spread: The difference between the price at which you can buy a security and the price at which you can sell the same security at any given time. The second component, cost-to-hold, represents the annual costs associated with owning the fund and is generally influenced by these two factors: Expense ratios: Fund expenses imposed by an ETF administrator. Tracking difference: The deviation in performance from the fund’s benchmark index. Let’s review the specific inputs to each component in more detail: Cost-to-Trade: Volume and Bid-Ask Spread Volume: Volume is a historical measure of how many shares may change hands each day. This helps assess how easy it might be to find a buyer or seller in the future. This is important because it tends to indicate the availability of counterparties to buy (e.g., when Betterment is selling ETFs) and sell (e.g., when Betterment is buying ETFs). The more shares of an ETF Betterment needs to buy on behalf of our client, the more volume is needed to complete the trades without impacting market prices. As such, we measure average market volume for each ETF as a percentage of Betterment’s normal trading activity. Funds with low average daily trading volume compared to Betterment’s trading volume will have a higher cost, because Betterment’s higher trading volume is more likely to influence market prices. Bid-Ask Spread: Generally market transactions are associated with two prices: the price at which people are willing to sell a security, and the price others are willing to pay to buy it. The difference between these two numbers is known as the bid-ask spread, and can be expressed in currency or percentage terms. For example, a trader may be happy to sell a share at $100.02, but only wishes to buy it at $99.98. The bid-ask currency spread here is $.04, which coincidentally also represents a bid-ask percentage of 0.04%. In this example, if you were to buy a share, and immediately sell it, you’d end up with 0.04% less due to the spread. This is how traders and market makers make money—by providing liquid access to markets for small margins. Generally, heavily traded securities with more competitive counterparties willing to transact will carry lower bid-ask spreads. Unlike the expense ratio, the degree to which you care about bid-ask spread likely depends on how actively you trade. Buy-and-hold investors typically care about it less compared to active traders, because they will accrue significantly fewer transactions over their intended investment horizons. Minimizing these costs is beneficial to building an efficient portfolio which is why Betterment attempts to select ETFs with narrower bid-ask spreads. Cost-to-Hold: Expense Ratio and Tracking Difference Expense Ratio: An expense ratio is the set percentage of the price of a single share paid by shareholders to the fund administrators every year. ETFs often collect these fees from the dividends passed through from the underlying assets to holders of the security, which result in lower total returns to shareholders. Tracking Difference: Tracking difference is the underperformance or outperformance of a fund relative to the benchmark index it seeks to track. Funds may deviate from their benchmark indexes for a number of reasons, including any trades with respect to the fund’s holdings, deviations in weights between fund holdings and the benchmark index, and rebates from securities lending. It’s important to note that, over any given period, tracking difference isn’t necessarily negative; in some periods, it could lead to outperformance. However, tracking difference can introduce systematic deviation in the long-term returns of the overall portfolio when compared purely with a comparable basket of benchmark indexes other than ETFs. Finding TACO We calculate TACO as the sum of the above components: TACO = "Cost-to-Trade" + "Cost-to-Hold" As mentioned above, cost-to-trade estimates the costs associated with buying and selling funds in the open market. This amount is weighted to appropriately represent the aggregate investing activities of the average Betterment client in terms of cash flows, rebalances, and tax loss harvests. The cost-to-hold represents our expectations of the annual costs an investor will incur from owning a fund. Expense ratio makes up the majority of this cost, as it is the most explicit and often the largest cost associated with holding a fund. We also account for tracking difference between the fund and its benchmark index. In many cases, cost-to-hold, which includes an ETF’s expense ratio, will be the dominant factor in the total cost calculations. Of course, one can’t hold a security without first purchasing it, so we must also account for transaction costs, which we accomplish with our cost-to-trade component. 3. Minimizing Market Impact Market impact, or the change in price caused by an investor buying or selling a fund, is incorporated into Betterment’s total cost number through the cost-to-trade component. This is specifically through the interaction of bid-ask spreads and volume. However, we take additional considerations to control for market impact when evaluating our universe of investable funds. A key factor in Betterment’s decision-making is whether the ETF has relatively high levels of existing assets under management and average daily traded volumes. This helps to ensure that Betterment’s trading activity and holdings will not dominate the security’s natural market efficiency, which could either drive the price of the ETF up or down when trading. We define market impact for any given investment vehicle as the Betterment platform’s relative size (RSRS) in two key areas. Our share of the fund’s assets under managements is calculated quite simply as RS of AUM = ('AUM of Betterment' / 'AUM of ETF') while our share of the fund’s daily traded volume is calculated as RS Vol = ('Vol of Betterment' / 'Vol of ETF') ETFs without an appropriate level of assets or daily trade volume might lead to a situation where Betterment’s activity on behalf of clients moves the existing market for the security. In an attempt to avoid potentially negative effects upon our investors, we generally do not consider ETFs with smaller asset bases and limited trading activity unless some other extenuating factor is present. Conclusion As with any investment, ETFs are subject to market risk, including the possible loss of principal. The value of any portfolio will fluctuate with the value of the underlying securities. ETFs may trade for less than their net asset value (NAV). There is always a risk that an ETF will not meet its stated objective on any given trading day. Betterment reviews its asset selection analysis on a periodic basis to assess: the validity of existing selections, potential changes by fund administrators (raising or lowering expense ratios), and changes in specific ETF market factors (including tighter bid-ask spreads, lower tracking differences, growing asset bases, or reduced selection-driven market impact). Betterment also considers the tax implications of portfolio selection changes and estimates the net benefit of transitioning between investment vehicles for our clients. We use the ETFs that result from this process in our allocation advice that is based on your investment horizon, balance, and goal. For the details on our allocation advice, please see Betterment’s Goal Allocation Recommendation Methodology.