A product only a banker could love

May 25, 2010 in Finance,Internet

There's a lot of excitement about just-launched startup Betterment, but I'm very wary. At best, it's an example of "bad" financial innovation. At worst, it's a straight up scam. It goes to show that it doesn't take complexity and structured products to pull the wool over investors' eyes; all you need is a website and the adoration of an unsaavy site like TC.

Here's the pitch: Betterment provides a "better savings account" which consists of a mix of two portfolios: one an extremely diversified basket of stocks and the other comprised solely of TIPS. Users transfer money to Betterment, choose an allocation between the two portfolios, and are expected to treat the resulting exposure as if it were a savings account.

Please pay close attention: you'd have to be out of your mind to consider this a savings account! Savings accounts pay interest and don't decrease in value; that's why they are for saving. Betterment is nothing more than a brokerage account in sheep's clothing, giving you access to a single equity product and investing the balance of your cash in TIPS. And don't make the mistake of thinking your Betterment account is principal-insured. It can go to zero just like any equity portfolio. So a savings account this most assuredly is not.

And paying for this sort of account? Even more insane and wholly unnecessary. The only real service the site provides is an automatic reallocation but only to one risky asset, so there's no justification for paying the indicated levels -- or anything at all. Yes,there's a price to be paid for convenience, but it's well below this level.

Stocks Can Go Down

Betterment discloses the fact that their portfolio can lose money deep within their website - it takes a couple clicks to reveal the disclaimer, in the section comparing Betterment to traditional bank accounts:

While your Betterment account is as easy to use as an online savings account with a bank, there are a few main differences. Although most bank accounts are guaranteed not to lose value, there is a possibility that your Betterment savings could lose value depending on market conditions.

At the same time, a Betterment account is better than a bank savings account because you could receive higher returns than a savings account.

Notice that you could receive higher returns -- nothing guarantees it. Another section of the FAQ addresses the downside risk specifically:

Like all market investments, the securities you own in your account are subject to market risk. If the markets are up, your balance will grow. When markets are down, your account will lose money. Fluctuations are especially hard to predict over the short term, but historic data shows that over the long term your investment is likely to increase.

Though there is an obligatory "past performance is no guarantee of future results" notice at the bottom of the section, they actually invoke historical returns as evidence for expected results! You simply can't use phrases like "likely to increase" when pitching an investment. It's unethical by any standard.

Portfolios Are Not What They Seem

Betterment provides two portfolios: an "ultra-safe and secure" TIPS portfolio and a highly-diversified equity portfolio "which allows you to invest in literally thousands of companies all at once. It’s like owning a little piece of every public company in America."

First off, despite being backed by the full faith and credit of the US Government, TIPS can lose value. Bond yields are only locked in if you hold them to maturity. Indeed, the Betterment TIPS portfolio has experienced a drawdown of 10% in the last 6 months. I've never seen a savings account do that before - but I've seen an awful lot of people freak out (not to mention a few senators) when stocks fall by a similar amount.

An article published yesterday notes that "the company has already provided returns for its beta users. While the S&P 500 is up 23 percent on the year, Betterment’s stock portfolio is up 29 percent across the same period, which is a significantly higher return than a savings account."

I have no idea what universe the author is in, thinking the S&P is up 23%. Maybe he meant to refer to 2009, in which the SPX was up about 26.5%. Or maybe he was referring to Betterment's beta period. I'm not sure, but here's what scares me about those numbers: Betterment claims that its stock portfolio is extremely diversified -- so where is that extra 6% coming from? A fully diversified portfolio should have the market return.(Edit: David Haber points out that I should specify I'm referring to a value-weighted diversified portfolio, in order to be Markowitz-compliant.) Examining the actual holdings, I see that the portfolio is skewed heavily toward a value style of investing -- not necessarily good or bad, but something you might want to know. Especially when the S&P's actual YTD return is -3% and counting. Extrapolating Betterment's beta on that return means the stock portfolio's YTD performance is somwhere in the -4% range. Some savings account.


And here's the kicker -- Betterment makes a big deal about their simple fee structure:

When you change your allocation between our two investment baskets or transfer money to your linked account, there are no transaction fees. Our low, straightforward advisory fee—0.9% annually of your average balance—covers everything. So you can easily access your money whenever you want, without worrying about the cost.

But you'd better be worried about that cost -- it's obscenely high! 90 basis points of assets to invest in the aggregate market and government securities? I've invested in actively managed mutual funds which charged half that amount!

This is where Betterment looks like a scam to me. The company takes investors' money, places it in ETFs, and collects a fee. But they're not even choosing a portfolio for you -- they're just handing off your cash to the ETF. And those ETFs charge their own management fees, which you're on the hook for as well (implicitly). So if you're already paying a separate fee to the portfolio manager, what on Earth are you paying 90 bps for? While claiming to cut out the middleman, Betterment is nothing more than a middleman itself.

If you're the do-it-yourself type, you can form an identical portfolio for far less. Charles Schwab will let you transact ETFs for $8.95 flat (and that's not an annual fee). Moreover Schwab will let you trade TIPS for free!

Once you own those ETFs, the expense ratios are significantly less than 90 basis points, ranging from 7 to 25 bps (there's one ETF described on the website, an iShares S&P 1000 Value ETF, which I simply can't find...). You don't really need all the different ETFs that Betterment holds to achieve full diversification -- they're all indices anyway. The Vanguard is the cheapest at 7 bps, and tracks every common stock regularly traded on NYSE, AMEX and NASDAQ. It's hard to diversify any more than that. Buy that ETF for yourself and you can keep the 83 bps that you'd otherwise give to Betterment for absolutely no reason.

If you don't want to deal with trading actual TIPS bonds, there's an ETF for that as well. You could use the very same one that Betterment uses, in fact. Its expense ratio is just 20 bps.

Now, Betterment is providing a real service: they will automatically rebalance your portfolio and maintain your specified allocation. It's not worth even close to 90 bps, though, because it can be done for almost nothing (though not with a nice "speedometer" graphic), aside from small transaction costs to a company actually providing a financial service. For example, at Schwab's commission rates, you would have to make 100 rebalancing trades a year on a $100,000 account before Betterment's fee became attractive.


This sums up the Betterment inspiration:

“When you go to a broker you have to pick among a menu of funds and stocks that are available,” said CEO and founder Jonathan Stein. “It’s an overwhelming experience for many people, even Columbia MBAs.”

I'm not sure what the arbitrary Columbia reference is for, but it is definitely true that choosing a portfolio can be intimidating. What I don't get is why anyone in their right mind would pay almost 1% of their assets to a company which is implementing a passive market strategy! You already know what they're going to invest in, and I've demonstrated that you can do it yourself for a fraction of the cost. This is anti-efficiency. This is an obfuscation of clarity.

I get it, from a certain angle - there's a CAPM-style appeal. Betterment lets you choose between a risky portfolio and a riskless portfolio: a "roll your own Markowitz-optimal portfolio" sort of paradigm. I'm sure there's a market out there for people who desperately want to put their money in stocks (because they're doing so well this year...) but don't know how, and the stripped-down simplicity of Betterment's site makes that possible for them. I think they'd be insane to pay 1% of their wealth for that simplicity, but that's the internet for you.

Stein goes on to say:

“We want to take this really big. We want to make investing accessible for people as soon as possible.”

Oh, I'm sure they do. Highway robbery is so much easier when your customers line up to be frisked.


If you're looking for a Web 2.0 banking solution, keep an eye on BankSimple. I won't vouch for them directly because I haven't actually seen their product yet, but it looks very promising and I've had the chance to talk shop with one of the founders, who definitely knows what he's doing.

And if the thought of online-only banking doesn't terrify you, I can't recommend Charles Schwab highly enough. Their customer service is beyond outstanding (I've never even waited on hold) and I have yet to be charged a fee for anything at all.

(Via Michael Broukhim)

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