The NYC-based auto-advisor will flash tax ramifications at investors as they test drive trades

October 30, 2014 — 11:44 PM UTC by Brooke Southall

5 Comments

Brooke’s Note: Given the nosebleed pace of advancement by software-based advisors, most methods of inserting sunshine into portfolios have been snapped up. Now one robo-firm is peeling off from the crowd by taking the opposite tack — delivering more bad news more quickly. “If it bleeds it leads” has long been a maxim in the new business; now one VC-fueled automated advisor will give you truth that you can — and should — handle.

Betterment is reversing the usual protocol of giving the customer the good news about the gross proceeds of a trade by hitting the investor with the bad news of the associated tax bill.

The New York City-based automated financial advice website will now first deliver the harder-to-stomach news of how much of a trade’s proceeds will eventually be handed over to Uncle Sam or to the state treasury.

In most trading scenarios, the investor sees a breakdown of the principal traded and the commission. So a trade that produces, say, a $55,000 gain might also make the investor aware that an additional $8.95 was subtracted for an adjusted total of $54,991.05.

Press here

Yet the face amount could mask significantly higher ancillary subtractions from the net proceeds of a trade. “It’s thousands and thousands of dollars instead of $8.95,” Stein says. See: Talking taxes: Why advisors need two approaches to shatter two counterproductive client attitudes.

When an investor initiates a sale of securities — a withdrawal or allocation change — Betterment’s algorithms first determine which ETFs to sell and selects the most tax-efficient lots, selling losses first, and short-term gains last.

At that point, the firm’s “tax impact preview” kicks in and investors will be invited to view “estimated tax impact.” When selected, it gives detailed estimates of expected gains and/or losses, breaking them down by short- and long-term investments. See: Is your alpha big enough to cover its taxes? A classic journal article, revisited.

The 94% factor

The move is intended to make customers think before they sell — and to send a message that many commission-based competitors do not.

“Maybe [wirehouses] want to encourage you to trade and be active. That’s what Morgan Stanley wants you to do. But it’s not about trading. It’s about goals.”

Two weeks prior to its full release, Betterment released the tax impact preview gizmo to 50% of its customers to see how it affected their behaviors. Investors hit with the tax data made 14.3% fewer allocation changes. This comparison includes investors whose estimate did not show a positive tax owed (i.e. their transactions would have realized losses).

Of those investors who viewed their estimated tax impact, and saw that a tax would be owed, 94% decided to not proceed with the transaction.

Also, Betterment charges a management fee of 15 to 35 basis points based on an investor’s assets. So, the more assets in the account, the more the company earns. See: How Jon Stein plans to make the most of $45 million of VC money in remaking the RIA business.

Labor intensive

But strategy and idealism aside, Stein says Betterment is currently the only firm providing this service for a more pragmatic reason.

“It’s hard to prepare and present in real time,” he says.

But the pay-off can be big in terms of giving investors the straight dope.


Mentioned in this article:

Betterment Holdings Inc.
Financial Planning Software
Top Executive: Jon Stein



Share your thoughts and opinions with the author or other readers.

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Brian Froisy said:

October 31, 2014 — 2:52 PM UTC

I am not a Betterment customer, so forgive me in advance if my conclusions are off target. That said, ...
The tax preview is stated to be for investor-inititated withdrawal or changes in allocation. But what about automated trades during rebalancing (i.e., no change in asset class allocation)? The most tax-efficent lots are chosen. Suppose that the trades incur a significant tax liability but only improve the asset class imbalance a little. It would seem that the optimal action would be “do nothing” and allow a small imbalance to persist. That is, consider the tradeoff between the degree of imbalance and the transaction costs (commission, tax and spread). I wonder if Betterment and other rebalancing algorithms explicitly consider all transaction costs.

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LCD said:

October 31, 2014 — 6:33 PM UTC

This is on top of what Brian said. So 94% saw the tax implications and didn’t proceed with the transaction and that is a good thing? What about the fact that very often the decision to sell is the right one in spite of the tax implications. Letting the tax tail be a primary decision making criteria is a dumb way to invest. More and more bells and whistles and less and less substance.
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brooke southall said:

October 31, 2014 — 6:44 PM UTC

LCD,

It seems like implicitly you are saying that investors can’t handle the truth. That is certainly the prevailing wisdom on Wall Street when it comes to charging fees and hiding them, never mind taxes.

And maybe investors can’t handle real price and tax data because they have had so little experience in digesting it. Nobody has ever trusted them to swallow it. But if tax implications become part of the everyday meal, I’d guess maybe the right equilibrium of emotions and hard numbers would be reached over time.

Brooke

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Daniel Egan said:

October 31, 2014 — 8:57 PM UTC

Hi Brian,

Yes, our rebalancing algorithms do take known costs involved in rebalancing into account, and do not rebalance blindly nor over-actively (allowing a small imbalance to persist).

Note that Betterment customers do not pay per-transaction fees (or commissions) of any kind. Our AUM fee is the only charge our customers every pay.

Because we use cash flows (deposits, withdrawals and dividend re-investments) to rebalance, sizable imbalances are mitigated, keeping the vast majority of accounts below our rebalancing threshold.

However, if that threshold is exceeded, we then take tax liability into account before proceeding, and will not sell any lots that impose a high tax burden upon the customer. For instance, we almost always wait for capital gains to be long-term rather than short-term.

Finally, note that Betterment customers often do not pay the full bid-ask spread:
https://www.betterment.com/resources/inside-betterment/our-story/vertical-integration-better-business-better-returns/

Best,
Dan

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LCD said:

October 31, 2014 — 10:42 PM UTC

Brooke,
I am not implicitly saying anything like that, and when did taxes become analogous to charging fees and hiding them. I am part of an RIA and clients hire us for one specific reason, to make money for them when opportunities exist and not to give it back when opportunities contract. We are not traders so almost every sale we have ever made triggered only long term capital gains. That said we just had a client call who thinks like you do, he said he was upset because we had sold him out of positions we thought were going to roll over and he would owe taxes on the gains. Here was our response, “we just made you a pile of money, suck it and pay your taxes”. We don’t lose any sleep when we make clients money and they owe taxes as a result. Not selling out of position when you should to avoid paying taxes is about as dumb as it gets.
You seem to be drinking too much of the cool aid, I might suggest you read Mike Edesess in your competitor Advisor Perspectives as he has made some excellent points about the dubious value of tax harvesting and constant rebalancing.


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