## Summary

- Betterment has been called the 'Apple of finance' for the sleekness of its design.
- Over the last 10 years, betterment's 70% stock portfolio would have generated impressive average annual returns but also exposed investors to a large drawdown.
- A hedged portfolio, such as one of the ones discussed below, can offer a higher potential return with significantly lower risk.

## Betterment: "The Apple Of Finance"

Quartz has called the software-based, online investment manager Betterment the "Apple of finance" for the sleekness of its design. Betterment aims to maximize each investor's returns given his risk tolerance, without the complexity of do-it-yourself brokerage accounts, and for a fraction of the fees of a traditional financial advisor. For an investor with a $100,000 account, Betterment charges an advisory fee of only 0.15%.

## The Betterment Portfolio

In keeping with its focus on low fees, Betterment's portfolio consists of ETFs that have relatively low management fees. Betterment draws from the following stock and bond ETFs in constructing investor portfolios:

Stock ETFs:

- Vanguard Total Stock Market (NYSEARCA:VTI)
- iShares S&P 500 Value (NYSEARCA:IVE)
- iShares Russell Mid-Cap Value (NYSEARCA:IWS)
- iShares Russell 2000 Value (NYSEARCA:IWN)
- Vanguard FTSE Developed Markets (NYSEARCA:VEA)
- Vanguard FTSE Emerging Markets (NYSEARCA:VWO)

Bond ETFs:

- iShares Short-Term Treasury (NYSEARCA:SHV)
- Vanguard Short-Term Inflation Protected (NASDAQ:VTIP)
- iShares Core US Total Bond Market (NYSEARCA:AGG)
- iShares iBoxx Investment Grade Corporate (NYSEARCA:LQD)
- Vanguard Total International (NASDAQ:BNDX)
- Vanguard Emerging Markets Government (NASDAQ:VWOB)

## Risk And Return Of Betterment's Portfolio

Betterment started managing client funds in 2010, but, drawing on historical returns of the ETFs in its portfolio, it offers a graph showing that a 70% stock Betterment portfolio would have generated an impressive average annual return of 8.8% over the last ten years**;** significantly better than a simpler 70% stock portfolio split between the S&P 500 and Treasury Inflation-Protected Securities (TIPS). Below is an image of Betterment's performance graph, on which I've added a couple of red horizontal lines, noting the drawdown that occurred over a period of several months spanning late 2008 and early 2009.

The part of the graph between the two horizontal red lines I've added appears to be the maximum drawdown that would have occurred within any ~6 month period over the last 10 years, had you been invested in a 70% stock Betterment portfolio. From eyeballing this graph, that drawdown appears to have been about 42%.

Assuming that Betterment's average returns are going to be similar going forward, and assuming that a 42% drawdown is the worst one might expect in the future, an investor in the 70% stock Betterment portfolio is essentially risking a maximum drawdown nearly 5x greater than the average annual return he might expect.

## A Higher Potential Return With Lower Risk

Betterment's portfolio construction process uses a sophisticated application of Modern Portfolio Theory, but, like many other MPT-based, unhedged portfolios, it exposes investors to the risk of severe drawdowns. Using a hedged portfolio, an investor can get a higher potential return while risking a maximum drawdown only a third as large as the one Betterment's portfolio would have had in 2008-2009.

Let's review some of the basics of hedged portfolios, and then see how we can create one using Betterment's ETFs as a starting point for an investor with $100,000 to invest, who wants to maximize his potential return with the constraints that he wants to limit his downside risk to a drawdown of no more than 14% in a worst-case scenario, and minimize his hedging cost (we're assuming that investor attracted to Betterment's low fees would be sensitive to hedging costs and want to minimize them as much as possible). First, a few caveats:

- The Betterment historical hypothetical return is net of its fees. The hedged portfolio potential returns below will not include any commissions or fees.
- We do not know how Betterment's 70% stock portfolio will perform in the future, and we also do not know how the hedged portfolios will perform. We believe the actual performance of the hedged portfolios may lag their potential returns, for a reason we'll discuss below, but by how much we won't be able to estimate until we have empirical results in hand for the batch of tests we began last month.
- We are exploring ways in which a hands-off investor could invest in a hedged portfolio, but at the moment, we aren't aware of one. We do not know of a Betterment-like service that will invest its clients' money using a hedged portfolio approach. We mention an automated tool below, but this tool will not execute trades for you.

## Risk Tolerance, Hedging Cost, and Potential Return

All else equal, with a hedged portfolio, the greater an investor's risk tolerance -- the greater the maximum drawdown he is willing to risk (his "threshold") -- the lower his hedging cost will be and the higher his potential return will be.

## Constructing A Hedged Portfolio

In a previous article ("Rethinking Risk Management: A New Approach To Portfolio Construction"), we discussed a process investors could use to construct a hedged portfolio designed to maximize potential return while limiting risk. We'll recap that process here briefly, and then explain how you can implement it yourself. Finally, we'll present examples of two hedged portfolios constructed this way with an automated tool. The process, in broad strokes, is this:

- Find securities with high expected returns.
- Find securities that are relatively inexpensive to hedge.
- Buy a handful of securities that score well on the first two criteria; in other words, buy a handful of securities with high expected returns net of their hedging costs (or, ones with high net expected returns).
- Hedge them.

The potential benefits of this approach are twofold:

- If you are successful at the first step (finding securities with high expected returns), and you hold a concentrated portfolio of them, your portfolio should generate decent returns over time.
- If you are hedged, and your return estimates are completely wrong, on occasion -- or the market moves against you -- your downside will be strictly limited.

## How to Implement This Approach

**Finding securities with high expected returns.**Presumably, if you have a Betterment account, you believe its ETFs have attractive expected returns, so we'll start with them. If you are willing to invest in stocks as well (as we are -- more on why below), to complement it, you could, for example, look at the top holdings of a billionaire investor, as we did with Carl Icahn's holding company in a recent article ("Investing Alongside Carl Icahn While Limiting Your Downside Risk"). To quantify expected returns for these securities, you can, for example, use analysts' price targets for them and then convert those to percentage returns from current prices. In general, though, you'll need to use the same time frame for each of your expected return calculations to facilitate comparisons of expected returns, hedging costs, and net expected returns. Our method starts with calculations of six-month expected returns.**Finding inexpensive ways to hedge these securities**. First, you'll need to determine whether each of these are hedgeable. Then, whatever hedging method you use, for this example, you'd want to make sure that each security is hedged against a greater-than-14% decline over the time frame covered by your expected return calculations (our method attempts to find optimal static hedges using collars as well as married puts going out approximately six months). And you'll need to calculate your cost of hedging as a percentage of position value.**Sorting The Securities By Hedging Cost**. Because we're seeking primarily to minimize hedging cost, we add this step here. We sort these securities inversely by hedging cost, so we rank the ones with the lowest hedging costs (as percentages of position) first. We'll only consider the ones from the top of this list (the ones with the lowest hedging costs) for the next step.**Buying the securities with the highest net expected returns.**In order to determine which securities these are, you'll need to subtract the hedging costs you calculated in the previous step from the expected returns you calculated for each position, and sort the securities by their expected returns net of hedging costs, or net expected returns. If any of the names in your sort have negative net expected returns (that is, the cost of hedging them is more than their expected return over the same time frame), you'll want to exclude them.**Fine-tuning portfolio construction**. You'll want to stick with round lots (numbers of shares divisible by 100) to minimize hedging costs, so if you're going to include a handful of securities from the sort in the previous step and you have a relatively small portfolio, you'll need to take into account the share prices of the securities. Another fine-tuning step is to minimize cash that's leftover after you make your initial allocation to round lots of securities and their respective hedges. Because each security is hedged, you won't need a large cash position to reduce risk. And since returns on cash are so low now, by minimizing cash you can potentially boost returns. In this step, our method searches for what we call a "cash substitute": that's a security collared with a tight cap (1% or the current yield on a leading money market fund, whichever is higher) in an attempt to capture a better-than-cash return while keeping the investor's downside limited according to his specifications. You could use a similar approach, or you could simply allocate leftover cash to one of the securities you selected in the previous step, provided you have enough to purchase an additional, hedged round lot.

## An Automated Approach

Here we'll show an example of creating a hedged portfolio starting with the Betterment portfolio, and using the general process described above, facilitated by the automated portfolio construction tool at Portfolio Armor. In the first step, we'll enter the ticker symbols of the ETFs Betterment's portfolio, the dollar amount of our investor's portfolio (100000), and the maximum decline he's willing to risk in percentage terms (14). We'll set the strategy to "Minimize Hedging Cost".

In the second step, we're given the option of entering our own expected returns for each of these ETFs. In this example, we will leave this blank, and use the tool's own expected return calculations.

A few minutes after clicking the "create" button above, we were presented with this hedged portfolio. The data in it are as of Tuesday's close.

## Why These Securities?

The tool included 4 of the ETFs in Betterment's portfolio: IVE, IWN, VEA, and VWO. IWN and VWO were included as a cash substitutes, hedged with optimal collars with their caps set at 1%. They were hedged as cash substitutes because they had significantly lower hedging costs that way. In its initial allocation process, the tool added one additional ETF, the Proshares Ultra DJ US Natural Gas (NYSEARCA:BOIL), and two additional stocks, Ciena Corporation (NYSE:CIEN) and Weatherford Internationa (NYSE:WFT), based on their low hedging costs and relatively high net expected returns. During its fine-tuning step, the tool added CIEN again, this time hedged as a cash substitute.

## Each Security Is Hedged, So Stocks Are Included

It makes sense that the Betterment portfolio includes only ETFs and not stocks. Since the Betterment portfolio isn't hedged, the diversification of ETFs helps ameliorate stock-specific risk (although, as Betterment's historical hypothetical performance chart shows, this sort of diversification does not protect against systemic, or market risk). In the hedged portfolio linked to above, since each of the underlying securities is hedged, stock-specific risk is strictly limited, without the need for broad diversification. By hedging each position, we can consider individual stocks as well as ETFs for inclusion. Here is a closer look at the hedge for the first position in the hedged portfolio, BOIL.

As you can see in the image above, BOIL is hedged with an optimal collar with its cap set at 16.71%. Using an analysis of historical returns as well as option market sentiment, the tool calculated an expected return of 16.71% for BOIL over the next several months. That's why 16.71% is used as the cap here: the idea is to capture the expected return while offsetting the cost of hedging by selling other investors the right to buy BOIL if it appreciates beyond 16.71% over the next several months. As you can see at the bottom of the screen capture, the net cost of the optimal collar for this optimal collar, as a percentage of position value, was -0.81%.[i]

## Negative Hedging Cost For The Portfolio

As you can see below in the summary for this hedged portfolio, the hedging cost of the entire portfolio (which includes the hedging cost of the BOIL position above) was negative, meaning an investor would have collected about $2,680 more from selling the call legs of the hedges than he would have paid for the put legs.

## Lower Risk, Higher Potential Return

If we assume that the Betterment portfolio's expected return will be similar to its hypothetical historical return over the last 10 years, it would have an expected return of about 4.4% over six months, while exposing an investor to the risk of a significant drawdown in the event of a severe market correction. The hedged portfolio above features a potential return of 7.59% over six months, while exposing an investor to a maximum drawdown of 13.55% in the worst-case scenario (if each of its securities went to zero before their hedges expired). Note that we refer to the 7.59% figure as the "potential" return of the portfolio rather than an expected one.

That potential return is what how much the portfolio will appreciate over the next six months if each of its underlying securities appreciates to the level of its cap (which was set at 1% for the cash substitutes, and at each security's expected return for the other securities). Since it's more likely that some of the securities will fall short of their expected returns and some will exceed their expected returns, and since these securities have their upsides capped, the actual return of this portfolio may trail its potential return.

## Another Approach: Starting With A Clean Slate

In the example above, we used the Betterment portfolio ETFs as a starting point when using the automated portfolio construction tool. If we used the same parameters otherwise ($100,000 portfolio, threshold of 14%, and the Minimize Hedging Cost strategy), but didn't enter any ticker symbols in Step 1, we would have been presented with a portfolio with a higher potential return, as shown in summary below, and, in more detail, at this link.

[i] To be conservative, the net cost of the collar was calculated using the bid price of the calls and the ask price of the puts. In practice, an investor can often sell the calls for a higher price (some price between the bid and ask) and he can often buy the puts for less than the ask price (again, at some price between the bid and ask). So, in practice, an investor may have collected more than $80, or 0.81% of his position value, to open this hedge.

**Disclosure: **I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.