How Betterment Wins by Reducing the Cost Structure of Investment Management
Betterment is disrupting investment management by leveraging software and automation to reduce the costs associated with investing and maintaining a balanced portfolio. It heralds a new world that promises to be more efficient, inclusive, and transparent.
Betterment is a FinTech startup that provides investment management services to individuals of all types. By leveraging software and automation, the team has drastically reduced the cost structure of investing and disrupted a well-protected and inaccessible industry.
Americans are poorly invested because the existing infrastructure for creating and maintaining savings plans is difficult to navigate and expensive to administer. According to techcrunch, “30.9% of the population has no retirement savings or pension plan. For millennials, many of whom were late to the job market thanks to the financial crisis of 2008, those numbers are actually just above 50%.”
Technology has enabled Betterment to automate portfolio allocation based on easy to understand preferences such as investment horizon and risk tolerance. Replacing portfolio managers as the gate keepers with crystal balls, Betterment simply creates diversified portfolio (then adds on a few fancy features like tax loss harvesting) and takes its hands off the wheel.
Creating Value
Betterment offers better net returns (+4.30% vs. DIY investor according to the company), more accessible investing, and less human bias. They are able to offer better net returns (vs. avg. DIY investors) for several reasons. First, they are able to charge less because their service is highly automated so marginal cost per dollar invested is very low. Second, they provide automated services that most portfolio managers simply can’t offer, such as automatic rebalancing. Rebalancing has historically been high touch and slow. Slow rebalancing can be costly because it causes suboptimal risk-adjusted returns. And lastly, betterment gives much broader diversification that most portfolio managers. This diversification can only be accomplished using automation.
Next, Betterment makes investing more accessible. Historically, individuals have been given options for investing amongst a list of funds administered by Fidelity, Vanguard, etc., these funds charge higher rates yet don’t provide clarity on the investment objectives. For someone who doesn’t know much about finance (or even someone who does) this process can be overwhelming. Betterment asks simple questions about the investors objectives and designs a custom allocation based on those preferences.
Betterment introduces less human bias into the investing process. Portfolio mangers’ objectives are not aligned with those of the investor. They are driven to take risky bets in order to compete for investment dollars. Betterment has created a unified algorithm that doesn’t make bets based on “instincts” but rather on fundamentals.
Broader Implications
Betterment is a winner because it has broken into a $5.5 trillion industry with a small team and a simple mission. Their use of technology directly supports that mission and provides real value to the customer. This investing strategy may have broader implications for the economy (where investment is less correlated with news/earnings), but for the early adopters who gain cheap access to investment in a much better pool of assets – Betterment will do great things.
I wrote about Wealthfront and found your blog about Betterment very interesting. From what I can tell, there is really no difference between the two as both automate the portfolio building process and invest in ETFs to minimize the cost. Did you find any important differences? This certainly isn’t a winner takes all market and the two together have over $5bn in assets under management which is pretty impressive.
Fascinating post! What do you think about an incumbent like Charles Schwab [arguably] self-disrupting and offering its own robo-advisor services? It seems like Betterment and Wealthfront are leagues ahead in any event, though. http://www.nerdwallet.com/blog/investing/investments/charles-schwab-intelligent-portfolios-review/
@Julie: Betterment is more of a full stack business (i.e. vertically integrated) as compared to wealthfront, which may allow it to have a lower cost structure long term.
I like the concept of low cost beta investing (although there’s really nothing THAT special going on here and the “technology” is not a true barrier to entry as evidenced by Wealthfront and Betterment both pretty much having the same capabilities) but I worry about customer acquisition costs, which is where I bet these companies are spending the vast majority of their money (read: cash is being burned and not necessarily on technology). I like that Betterment has supplemented their B2C model with Betterment Institutional, which is focused on providing technology to financial advisors (at both independent firms and large firms). This is a more sustainable business model in my opinion.
As an aside, I think a real opportunity is in retirement income, a problem which neither firm is ready to tackle at this time (Betterment is trying but they only work with single accounts. Retirement income is an optimization problem that must occur across several accounts).
Betterment’s system to reduce subjectivity and human bias in portfolio planning by focusing only on the numbers sounds terrific in theory. In practice, however, automated algorithms such as these make investment decisions based on such limited analyses as accretion/dilution models. Many mergers that appear to be accretive on paper (and result in fast automatic trades) turn out to be ineffectual, if not downright disastrous for the companies involved. Data aggregation and the law of large numbers would have us assume that all companies are created equal, but that is only the case if an investor is diversified broadly. Computer algorithms that pick individual stocks over others without comprehensive equity analysis remain high risk.
Great post! I find FinTech to be one of the most dynamic sectors these days. It is fascinating to watch how digital innovations make cracks in the walls of an industry that for centuries has been guarded by powerful established players. I see some similarities here with the legal industry, the subject of my post, which until recently had also been remarkably immune from major digital disruptions.
Another question that came to my mind while reading your post: can we indeed accurately put a framework and quantify certain dimensions of decision making process. I wonder whether there is an extension of Betterment’s model to other asset classes such as building portfolios of say private equity funds based on algorithms.