Advisor’s Alpha Part 1

A 2014 Vanguard study attempts to estimate the value proposition of using an advisor with best practices in wealth management and terms these value-adds collectively as “Advisor’s Alpha”.  The value of working with an advisor is subjective, individual to each investor, and challenging to quantify.  Vanguard’s framework is a helpful attempt to clarify the potential for added value and to provide a basic measurement.  Not all of the strategies are applicable to every investor, and value will vary based on individual client circumstances as well as the implementation by the advisor. 

According to the study, working with an advisor can potentially add up to “about 3%” of net return annually (in addition to the unquantifiable value of peace of mind which may come from working with an advisor).  That estimate sounds generous to us, but it does bring attention to the advantages of working with an advisor that investors may not consider when deciding whether to seek advice or opt for a Do-It-Yourself approach. 

Strategies that add value include: Asset Allocation, Cost Effective Implementation, Rebalancing, Behavioral Coaching (adhering to a plan), Asset Location, Spending Strategy (withdrawal order), and Total-Return Investing. 

Vanguard quantifies the value-add of best practices in wealth management

-Value-add relative to "average" investor experience

Notes: Return value-add for Modules I and VI was deemed significant but too unique for each investor to quantify.  Also, for “Potential value added,” we did not sum the values because there can be interactions between the strategies. Source: Vanguard

Let’s discuss the first two strategies:

I. Suitable Asset Allocation

Asset allocation is the most important determinant of portfolio risk and long-term returns.  It is imperative that investors have an appropriate asset allocation of broadly diversified investments that aligns with their goals and future needs.  A sound investment plan should begin with an Investment Policy Statement that defines targets for asset allocation based on an investor’s financial objectives, risk tolerance, investment time horizon, tax considerations, and distribution needs.  This is the foundation that an appropriate portfolio is built upon to lead to investing success.  The value gained from an appropriate asset allocation is positive yet difficult to quantify.  Advisors should take a considerable amount of time to understand their client’s current financial situation as well as future goals and, through a collaboration of financial planning and investment management, set appropriate targets to allow for growth and income to meet a client’s long-term needs.

II. Cost Effective Implementation

Simple math tells us that gross return minus costs equals net return.  Those costs can come from management fees, expense ratios, trading costs, and taxes.  Advisors can certainly add value but that value is greater when management fees are reasonable for the services provided.  When appropriate, costs can be minimized by using funds with low expense ratios or, better yet, investing in individual stocks and bonds (with even lower costs than index funds), and limiting turnover.  For asset classes where mutual funds are used, advisors can have access to share classes of funds that have no load fees and lower expense ratios than share classes offered to retail investors.  Some entire fund families are only available to select advisors.  Funds that have relatively high costs should only be used when they are unique strategies that have the potential to provide significant value and a low cost alternative is not available.  Trading costs from the custodian of your accounts should be negotiated to a minimal amount by your advisor.  Tax-efficient investing is an often overlooked way to reduce costs.  In taxable accounts, limiting realized capital gains and harvesting losses during market declines allows for less of a tax burden on the portfolio.  A good advisor will evaluate investments based on net return expectations and focus on maintaining a well-diversified portfolio in balance with an appropriate asset allocation while keeping costs low. 

Part 2 of this series will focus on Rebalancing, Behavioral Coaching and Asset Location.