Betterment Joins Wealthfront In an About Face About Smart Beta

Betterment has joined its major Robo Advisor competitor Wealthfront in doing a 360 on the use of "smart beta" in its portfolio,



From their website in an article published in June of 2015
Market Capitalization: Still the Anchor

The starting point for any allocation model is a market capitalization-weighted portfolio.  By anchoring to market capitalizations, you free ride on the collective wisdom of millions of investors and traders globally. You also know how much you are diverging from market allocation; that divergence is the foundation for generating outperformance.

The same logic can also inform portfolio construction for clients who want to take on more or less risk. While the market holding of U.S. small caps, for instance, reflects the risk that investors on average are willing to bear, individual investors may be comfortable with more or less risk in their portfolio. It is up to the individual advisor to determine how to take on more or less risk while still maintaining a diversified portfolio.

The cleanest way to do this is to use the global market as a benchmark for determining asset allocation. Allocations should consider the market value of available assets; the implied expected returns from those assets should guide a proportional allocation to the different markets. This was the insight behind the pioneering work of Fischer Black and Bob Litterman in creating the Black-Litterman model for creating diversified portfolios at every risk level.

Based on that approach this is how their asset allocation is described on the website

Our U.S. exposure covers the total U.S. market with a slight tilt towards value and small-cap stocks. The value and small-cap tilt has tended to beat the market in the long term, based on research by Nobel-prize winner Eugene Fama and Kenneth French

Here is their list of  ETFs used in their" simple" portfolios using market cap weighted ETFs

An article on their website from 2016 entitled  How Active is Your ETF Index I

notes:

A new breed of ETFs is similar in name only to passive ETFs, but instead exhibits the characteristics of a traditional actively managed portfolio—particularly in fees and turnover, and for less than certain higher returns.
Examples are inverse (or “short”), leveraged, and smart-beta ETFs. Smart-beta funds may only confuse rather than help most investors.
According to a Wall Street Journal report, smart beta funds’ stocks are weighted “by rules or ‘factors’ other than their market value, such as their dividends, value or low volatility.”
While proponents say that these funds can outpace a straight index over extended periods—say, a full market cycle or two, “don’t expect outperformance every year,” said the report.
In fact, according to ETF.com, “Actively managed ETFs by design are expected to deliver outperformance, but they often underperform their benchmarks.”

Investors should also be aware that smart-beta ETFs rely on the actions of fund managers who dictate the actual execution of the fund’s investment strategies

I would note that many of the smart beta ETFs specifically state that the readjustments are made quarterly to avoid transaction costs and many  are available with very low fees

That atttitude towards smart beta at Betterment was then...this is now:

In a September 2017 addition to its website Betterment announces

IIntroducing Our Smart Beta Portfolio Strategy by Goldman Sachs

Betterment will now offer a smart beta portfolio strategy developed by Goldman Sachs Asset Management. The strategy reflects the underlying principles of Betterment’s core portfolio strategy while seeking higher returns by deviating away from market capitalization in and across asset classes.

The website includes a nice explanation of smart beta for people like me and someone who has taken a few courses in finance with citations to other research. But how many of its clients will understand the strategy be able to make the judgement as to whether to use the strategy in their portfolio and to stick to the strategy.

The website notes

Why invest in a smart beta portfolio?

As we’ve explained above, we generally only advise using Betterment’s choice smart beta strategy if you wish to attempt to outperform a market-cap portfolio strategy in the long term despite potential periods of underperformance.

For investors who fall into such a scenario, our analysis, supported by academic and practitioner literature, shows that the four factors above can persistently drive higher returns than a portfolio that uses market weighting as its only factor. While each factor weighted in the smart beta portfolio strategy has specific associated risks, some of these risks have low or negative correlation, which allow for the portfolio design to offset constituent risks and control the overall portfolio risk.

Of course, these risks and correlations are based on historical analysis, and no advisor could guarantee their outlook for the future. An investor who elects the Goldman Sachs Smart Beta portfolio strategy should understand that the potential losses of this strategy can be greater than those of market benchmarks. In the year of the dot-com collapse of 2000, for example, when the S&P 500 dropped by 10%, the S&P 500 Momentum Index lost 21% 

That's a alot to absorb for the Betterment customer who was marketed a service that was supposed to simplify their investing (and the explanation of smart beta is likely to make the eyes of everyone but a finance geek glaze over ,...and those people are likely self directed investors in any case..

I would think that based on the description above few people would turn down the opportunity to outperform the market weighting in the long term and few people think they would abandon a strategy becase of short term underperformance. in the short term. No one thinks they will be the investor that will panic and sell everything...they have read that is the wrong thing to do...but obviously many people do it. And few would turn down the opportunity to outperform the market based on historical analysis and a portfolio created by Goldman Sachs based on state of the art academic research.

I also dont understand the example given above of how the momentum factor did during the dotcom crash of 2000 . It would seem to me anyone from Betterment explaining the Goldman Sachs strategy  to a client would explain that moementurm is only one of 4 factors used in the strategy. In fact pointing out the performance of the momentum factor is a good argument in favor of the Goldman Sachs approach.

Betterment's CEO wasquoted as stating:

We have been hearing from customers that different portfolio strategies would be better fit for different goals,” Dan Egan, director of behavioral finance and investments at the firm, told ThinkAdvisor. 

"Betterment has an increasingly diverse customer base; they all want to put their money to work, but not necessarily in the same way," said Betterment founder and CEO Jon Stein, in a statement announcing the new portfolio strategies.

The Goldman smart beta strategy is designed to deliver stronger risk-adjusted returns than traditional market-weighted index funds generate. “Clients are a bit uncomfortable with market-cap weighted systemic approach,” says Egan. Trademarked as ActiveBeta, the Goldman strategy is based on four drivers (factors) of performance: value, momentum, quality and low volatility

From the website this additional note about the portfolio allocation

It tends to have higher allocation to emerging markets and small-cap stocks in the U.S. and developed economies and includes REITs and high-yield bonds with longer duration. Its expense ratios range from 0.11% to 0.24%.

I am confused by the above Goldman Sachs Active Beta (available in its ETFs) has nothing to do with REITs and bonds.

It is really hard for me to imagine that clients of Betterment which at least initially was sold as a simple solution to investing were sophisticated enough to express the fact that they were uncomfortable with a market cap portfolio. There is enough debate around professionals and academics on this issue its hard to imagine many Betterment clients have reached conclusion on this. And did those investors sophisticated enough to want a non market cap weighing for their stocks also indicate they were comfortable getting it as part of a "package deal" with the REITS and long duration high yield bonds?

I have nothing against smart beta. I have been using it in client accounts through mutual funds of Dimensional Fund Advisors before there were ETFs in this category and when their form of smart beta was called a tilt to the factors of size and value. And I have incorporated smart beta ETFs into client portfolios.

I also think the Goldman Sachs product has potential to be an excellent addition to portfolios in addition to or in place of ETFs based on only one of the "smart beta? factors

But I do think it will be extremely difficult for investors to understand and choose between the "new Betterment portfolios and the "old ones". And it seems Betterment investors can only buy the "whole package"that goes with a smart beta ETF. I think if they truly understood the "new portfolios" they might opt for making use of smart beta but passing on the allocation to other elements of the portfolio. I have seen lots of research with evidence of the outcomes of use of the smart beta factors. I have never seen at research about benefits of adding REITs and High Yield Bonds to such a portfolio.

The Betterment website cites the research of Rick Ferri on the advantages of a low cost index portfolio. But Ferri also has written and article entitled

The Dark Side Of Smart Beta

and doesn't make use of the strategy in his client portfolios.

I am totally biased of course but I would argue that incorporating "smart beta " in a portfolio is a decision best made by a dedicated do it yourselfer or someone working with a personal advisor that doesn't present only two choices   "smart beta" and "non smart beta" portfolio which ultimately is one  (actually one of  two) size fits all and can clearly explain the strategy.