Betterment.com brings index funds to the masses
If you’ve been thinking about getting started in investing but don’t have a lot of money, an option has opened up that could ease you into the stock market.
A company called Betterment.com is essentially bringing index funds to the masses by providing a Web-based service that allows you to invest small amounts — even just $10 or $15 — and still get a diversified portfolio of both stocks and bonds.
Index funds are investment pools that buy and hold every stock or bond in a particular market index with the notion that the fund will reflect the performance of the entire market. They’re offered to reflect stock indexes, bond indexes, international and real estate investment indexes.
Many seasoned investors like index funds because they usually beat the performance of actively managed funds over time. Also, index funds charge fees that amount to only about 0.2% of assets, versus actively managed funds that typically charge 1% or more.
But it has been tough for small investors to buy index funds because the lowest-cost funds simply can’t afford to take small deposits. If you invested $100 in Vanguard’s Total Stock Market Index fund, which charges 0.18% a year, for example, the fund company would lose money just by sending you an annual statement. Your account would generate an 18-cent profit — the envelope and stamp would cost at least three times that.
As a result, Vanguard usually requires minimum investments of at least $3,000 and restricts adding money to an account in increments of less than $100.
Index funds have a sister product, called Exchange Traded Funds, that can hold the same underlying investments but don’t impose investment minimums. But you buy them through brokers and have to pay a trading fee each time you buy or sell. Even the deepest discount broker charges at least $4 per trade, which makes buying ETFs on a monthly basis too costly for the small investor to contemplate.
Betterment.com, which launched in May, changes the model by offering ETFs without the brokerage fees. Instead, you pay an annual fee of 0.9% of your invested assets. It doesn’t matter how many trades you make.
How does that help? Consider an investor who wants to invest $50 a month. He or she could open an account with a deep discounter, such as Sharebuilder.com, and pay just $4 per trade. But even at that, the $4 adds up to $48 a year, which effectively eats up one of the 12 monthly deposits.
The Betterment model would cost less than $3 in that first year because of the way the company charges fees. Those fees are levied quarterly based on your average annual balance. In simple terms, because the investor is building a balance from zero to $600 over the course of the year, the average works out to be $300. A 0.9% fee on that amounts to $2.70.
(Under either model, the investor would also pay 0.2% average management fees on the ETF portfolio.)
“Betterment compares very well to a brokerage account where you are paying a fee for every share that you buy,” said Jon Stein, the company’s chief executive. “You can set this up in 10 seconds and you have this automatic savings plan.”
The other bright side to Betterment’s approach is that you get both stocks and bonds. Betterment gives you a pro-rata share of a basket of funds that are designed to reflect the entire U.S. stock market, plus a fixed-income portfolio that’s made up of Treasury Inflation Protected Securities, also known as TIPS. You decide on the investment mix.
But the Betterment approach, with its same fee formula, makes sense only for small investors or those just starting out. Steve Vernon, an Oxnard actuary and author of “Recession-Proof Your Retirement Years,” says Betterment’s economics start to turn sour once an investor accumulates as little as $3,000.
If you had $3,000 to invest, for example, you could get a similar mix of stocks and bonds by buying into Vanguard’s Star Fund. Star is a balanced fund that keeps about 40% of its assets in fixed-income funds and about 60% in stocks. Vanguard charges $20 in annual maintenance fees when you have less than $10,000 in your account, plus 0.37% in management fees. But it also does not charge any fees to buy or sell.
The bottom line: If you had $3,000 in the Vanguard fund, you’d pay $11.10 in annual management fees plus $20 in account maintenance fees, for a total of $31.10. If you invested through Betterment, you’d pay the site’s 0.9% fee, plus the 0.2% average management fees on the ETF portfolio, for a total of $33.
Admittedly, you can’t start with nothing at Vanguard the way you can at Betterment, and it’s probably not worth switching to Vanguard from Betterment for a cost savings that amounts to less than $5 annually. That said, Vernon thinks that you’ve got to consider a switch once you accumulate $5,000 to $10,000 — that’s when Betterment’s model starts costing $55 to $110 each year.
And it’s a really bad deal for somebody with $100,000 invested who would pay $1,100 annually with Betterment versus $370 with Vanguard’s Star Fund.
“Paying 0.9% of assets gives me a headache,” the cost-conscious Vernon said.
Betterment’s Stein says the site is considering cutting fees for bigger accounts, but hasn’t done so yet.
For now, Betterment is a great place to start, but not a place to stay.