Custom Portfolio Trading Behavior Disclosure

Advisors who use Betterment’s custom portfolios should consider the following information before using any of the features, and for communicating this information, as necessary, to their clients.

Custom Portfolio Rebalancing Behavior

Advisors should be aware of how custom portfolios interact with other Betterment portfolio management features, including rebalancing and smart transitions, as well as the other features and limitations described in the custom portfolio agreement.

Rebalancing is a Betterment feature that seeks to reduce drift in client portfolios. Betterment performs two types of rebalancing on clients’ behalf. First, in response to cash flows such as deposits, withdrawals, and dividend reinvestments, Betterment buys underweight holdings and sells overweight holdings. Second, if cash flows are not sufficient to keep a client’s portfolio within its applicable drift tolerance (such parameters, as disclosed in Betterment’s Form ADV), automated rebalancing sells overweight holdings in order to buy underweight ones, aligning the portfolio more closely with its target allocation. 

As a part of custom portfolios, Advisors can set customized drift thresholds for rebalancing for a particular client’s goal, and Betterment evaluates the custom portfolio’s drift at the security group level. For reference, security groups are groupings of tickers that include a primary ticker, and may include secondary and/or tertiary tickers designed to help avoid wash sales and allow for tax-loss harvesting opportunities.

When Betterment’s automated rebalancing algorithm evaluates opportunities to reduce drift, it is calibrated to avoid frequent small rebalance transactions and to seek tax efficient outcomes, such as preventing wash sales and minimizing short-term capital gains. The rebalancing algorithm also seeks to increase expected returns of the portfolio through rebalancing, and will prioritize using new cash flows and proceeds from sales of securities to buy underweight securities groups with the highest expected returns by default, and such prioritization cannot be modified by Advisors. In custom portfolios, because drift is measured at the security group level, this may lead to rebalancing that sells certain overweight securities to purchase underweight expected high-growth assets, namely equities, regardless of the overall stock-bond breakdown of the portfolio.

Sell-Only Substitutes

A “sell-only” substitute is a ticker assigned to a security group within a custom portfolio that contributes to a security group’s weight and may be sold during rebalancing if the security group is overweight. Advisors, on their client’s behalf, can transfer the ticker into the client’s account and define it as a sell-only substitute. After defining a ticker as a sell-only substitute in a custom portfolio and transferring positions in that ticker from another custodian into the client's Betterment account, Betterment’s portfolio management system will then incorporate and manage the position in the portfolio. Advisors should be aware that Betterment’s automated rebalancing feature will work differently with a sell-only substitute. 

If a security group becomes overweight and portfolio drift exceeds the designated threshold, Betterment’s automated rebalancing feature will aim to sell shares from the overweight group to help manage overall risk. When determining which shares of the security group should be sold, all primary, secondary, and sell-only substitute positions are evaluated equally. As noted above, rebalancing is also calibrated to avoid frequent small rebalance transactions and to seek tax-efficient outcomes, such as preventing wash sales and minimizing short-term capital gains.

• Betterment’s rebalancing algorithm decides which holdings to sell within the security group by picking the lots that will minimize the tax cost of the rebalance. In deciding what to sell, it considers primary, secondary and holdable tickers.
• For example, rebalancing may prioritize selling the primary or secondary security of an overweight security group, rather than the sell-only substitute, particularly if the sale of the sell-only substitute would have a higher tax impact relative to the other holdings in the security group (including, even if the sale of the sell-only substitute would result in long-term capital gains). 

While this behavior seeks to minimize the tax impact of rebalancing transactions, it can result in the Advisor’s client’s portfolio retaining the sell-only substitute rather than selling out of the sell-only substitute.

Rebalancing will not buy additional shares of a sell-only substitute if its security group becomes underweight relative to the target allocation in the custom portfolio. For more information about rebalancing and custom portfolio trading behavior, please review Betterment’s rebalancing disclosures and smart transitions disclosures.