Is This a Better Way to Invest?

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If you don't have the time to spend researching stocks and keeping up with your investments, mutual funds and ETFs can sound enticing. Drop your money into Vanguard S&P 500 ETF (NYSE: VOO  ) , and it's instantly diversified across 500 of the largest U.S. companies for a small expense ratio, in this case 0.06%.

To make investing even easier, a company called Betterment offers an automatically allocated portfolio with zero transaction fees, albeit with a modest boost in expenses compared to investing directly in Vanguard ETFs. The interface offers an extremely simple way to begin investing with no trades to enter, just a dial to set your allocation between stocks and bonds. However, is Betterment worth the extra expense? Currently, Betterment's stock basket is made up of the following:


Betterment Allocation

Vanguard Total Stock Market (NYSE: VTI  ) 25%
iShares S&P 500 Value Index (NYSE: IVE  ) 25%
Vanguard Europe Pacific (NYSE: VEA  ) 25%
Vanguard Emerging Markets (NYSE: VWO  ) 10%
iShares Russell Midcap Value Index 8%
iShares Russell 2000 Value Index 7%

Source: Betterment.

Betterment's bond basket is split evenly between iShares Barclays TIPS Bond Fund and iShares Barclays 1-3 Year Treasury Bond Fund. Replicating any Betterment allocation through your own brokerage account could carry heavy commission fees, especially if you rebalance quarterly, as Betterment does. However, Vanguard offers similar portfolios through their Target Retirement funds -- the difference being you can't set the allocation between stocks and bonds.

Let's take a look at who wins and who loses by using Betterment, with a few hypothetical investors.

The new long-term investor
Jared Greenhorn just landed his first job out of college, luckily enough debt-free, and sees that his savings account is growing substantially with his paychecks. Jared, a civil engineer, never understood nor paid attention to the stock market. Now with his first job, he's thinking about putting some of his growing savings, now at $5,000, into something that gets him better returns than his savings account. He's comfortable not touching money that he puts into the market, and will add at least $100 per month, qualifying him for Betterment's "Builder" plan. Should he pay extra for Betterment?

Over one year with Betterment, Jared would pay a 0.35% expense ratio plus the expense ratios of the underlying funds. Since he's young, he's set his dial to 90% stocks and 10% bonds, and with that allocation the total expense ratio works out to be 0.51%. This allocation compares to the Vanguard Target Retirement 2055 Fund, which automatically rebalances into more bonds and less risk closer to retirement age. This Vanguard fund's expense ratio, however, is 0.19%. At a $5,000 balance, Jared pays over $25 for Betterment, or just $10 with Vanguard -- assuming he uses Vanguard's online service.

The new short-term investor
Sally Greenhorn, Jared's twin, is in the same exact situation as Jared, except she is currently investing a few thousand dollars into a friend's business and needs access to her money. Vanguard requires a $1,000 account balance, whereas Betterment allows any balance, albeit with a $3 monthly fee for any month in which she cannot deposit $100 into her Betterment account. That could add up if she's not careful.

The long-term seasoned investor
Jared and Sally's father, Bill Greenhorn, expects to retire in five years, and feels comfortable investing $200,000 of his savings, with about 55% in stocks and 45% in bonds. With Betterment, Bill pays an expense ratio of 0.15% along with the underlying fund fees, which totals 0.32%. The Vanguard Target Retirement 2015 Fund, which has a similar allocation between stocks and bonds, has an expense ratio of 0.17%. For a $200,000 balance, Betterment fees add up to over $600, whereas Vanguard's would add up to $340.

For balances over $100,000, Betterment, being a small start-up, does offer a custom portfolio with its CEO willing to develop a specialized financial plan. With Vanguard, chances are a $100,000 balance won't get you time with the CEO.

Should you use Betterment?
Decide for yourself if the cost difference makes Betterment worth it for you. Betterment does provide immediate diversification with a broad control over allocation between its basket of stocks and bonds, with a clean interface, a $0 minimum balance, and likely more personal attention due to its small size. However, if you don't mind relinquishing that control of allocation, will definitely keep at least $1,000 invested, and are willing to do some extra work to save on fees, check out Vanguard's Target Retirement funds.

If you intend to recreate Betterment's portfolio yourself, however, by purchasing each ETF separately, watch out for commission fees. Betterment would likely end up as the cheaper option, although some brokers, including Vanguard, offer commission-free purchases and sales on select groups of ETFs.

While investments like Betterment and Vanguard's Target Retirement funds offer a chance to participate in the overall market returns, they do not give you a chance to outperform the market -- something that The Motley Fool's Stock Advisor newsletter has done by over 70 percentage points since 2002. For a look at three stocks recommended by Stock Advisor, check out our free report: "3 Stocks That Will Help You Retire Rich."

Fool contributor Dan Newman holds no shares of the companies mentioned above. Follow him @TMFHelloNewman.

The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

Read/Post Comments (2) | Recommend This Article (6)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 09, 2013, at 10:37 AM, wazeldazel wrote:

    Does the Vanguard retirement fund reallocate quarterly (or yearly) with monthly contributions? Or will I have to manually reallocate?

    I realize the savings with Vanguard can be substantial over the long term, but I like that Betterment reallocates automatically, giving beta exposure and therefore reducing risk. which I am fine with as I have a "sandbox" to play in and beat the market with fools help.

  • Report this Comment On October 08, 2015, at 4:48 PM, Mnementh818 wrote:

    Despite the fact that this article is quite old, it makes such an elementary mistake that I made an account just to comment.

    When the author mentions Betterment's services, he always makes sure to mention that you are paying their advisory fee as well as the expenses for the underlying funds. However, when he talks about Vanguard target retirement funds, he fails to mention that the exact same thing is true. The expense ratio of any mutual fund that owns other mutual fund will not include the expenses of the funds that it owns. Those expenses are simply part of the prices of those funds.

    Vanguard's target retirement funds are good for people that don't want to think about their investments, but the suffer from holding the investor shares of the underlying funds instead of admiral or institutional. Due to this, the true expenses of the target retirement funds is closer to 0.40%. For people investing more than $10,000, Betterment is a better deal than Vanguard's target retirement funds due to these hidden costs.

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