Note:Last summer, I published a column entitled "The Value of Financial Advice," which was very well received. I have since revised and updated the column and am presenting the new versionin a two-part series here.
Good financial planning decisions extend well beyond where and how you invest. Two major research efforts have attempted to quantify how good financial decision making can enhance your lifetime standard of living. It is important to understand what this research means, because this may not always equal a higher portfolio return in the short term.
The research identifies how good decision making can enhance sustainable lifetime income on a risk-adjusted basis. The ability to spend more than you could have otherwise effectively means your assets are generating a higher net return after accounting for taxes, fees, and good decision making, which makes the higher spending possible.
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View galleryIn the field of finance, the term “alpha” identifies how a fund manager can combine securities into a portfolio that provides excess returns to investors above the appropriate related benchmark for those investments on a risk-adjusted basis. In simple terms, achieving alpha means earning more money than a risk-appropriate index would have provided.
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This generally is achieved through either timing market trends correctly or picking winning individual securities. If a fund manager charges a fee of 1% of assets under management and produces alpha of 2%, the investor enjoys an overall net gain of 1%. After fees, the investor earned 1% more than they would have had they invested directly in the benchmark index.
In practice, it is very difficult to achieve alpha consistently from market timing and security selection, though many investment managers still seem to believe otherwise. Some investment managers are able to beat the market, but it is difficult to separate skill from luck, and even more difficult for those managers to subsequently continue to outperform.
The difficulty in generating investment alpha can help explain the rise of indexing in recent years as a more effective alternative. Low-cost index funds generally perform better than the majority of actively managed funds, at least after accounting for management fees.
As a side note, many readers may not even realize they are paying fees on mutual funds since the fees do not appear on portfolio statements and investors never receive a receipt. It is important to look for the ongoing expense ratio and loads charged at the time of purchase or sale.
After fees, alpha is typically negative for actively managed funds. Mathematically, the average fund must earn the average market return before fees. Some do better and some worse, but the average is the average.
After fees, though, the average fund will fall behind the market. Those who understand this point can dramatically simplify their portfolio by filling it with strategic well-diversified, low-cost funds and generally avoiding trading except for rebalancing, tax reasons, or to generate distributions for retirement spending.
In this regard, investing has now mostly been commoditized, at least when investing is done without regard for the overall financial plan. Financial advisors solely focused on selecting investments will struggle to add value for clients. Unfortunately, this is all many advisors do, and the public is often unaware of the existence of advisors who do much more than just manage investments.
Another development from this changing investment world is that for good advisors, investing does not occur in a vacuum. The old investing framework went something like this: “Let’s invest, see how it goes, and then determine what you can spend.” Because there is no alpha (and we can’t control luck), the new methodology for good advisors is to first figure out what you want to accomplish with your wealth.
Your goals provide the context for how to structure and deploy assets. The structure, process, and ongoing plan adjustment to accommodate life’s ever-changing desires and goals becomes the method for adding value to the financial plan.
There is immense value in comprehensive financial planning and good financial decision making. It is important to remember and easy to forget that the end goal of comprehensive financial planning goes beyond choosing investments.The term “alpha” has been shown to be insufficient when it comes to financial planning, since it only refers to investing in a vacuum. Two articles sought to replace it with a term that represents more than merely beating the market.
Vanguard developed their Advisor Alpha concept in 2001. Their infographics show their overall estimate for Advisor Alpha as 3% on a net basis (4% less an assumed 1% advisory fee). In the introduction of their , they explain their objective is to shift the focus away from “traditional beat-the-market objectives” (i.e. traditional alpha) toward what they view as the “best practices of wealth management.”
These best practices are separated into several categories, shown below, that focus on tax efficiency, costs, risk management, and making good investment decisions.
Exhibit 1. Components of Vanguard’s Advisor Alpha: Impact on an Investor’s Returns
| (1) Build a customized investment plan aimed at achieving goals and meeting constraints for risk tolerance and risk capacity | |
| > 0% | suitable asset allocation with broadly diversified investments |
| 0.45% | focus on low-cost investments (low expense ratios) |
| 0 - 0.75% | locating assets properly in taxable and tax-advantaged accounts |
| >0% | focusing on total-returns investing instead of income investing |
| (2) Minimize risks and tax impacts | |
| 0.35% | rebalancing to the strategic asset allocation |
| 0 - 0.70% | deciding where to draw assets from (tax-deferred or taxable) to meet spending |
| (3) Behavioral coaching | |
| > 1.5% | providing support to stay the course in times of market stress |
| Overall net impact of good advice: about 3% | |
Suppose a good comprehensive financial advisor who does all these things charges a fee of 1% of assets under management. An investor who can do all of the above on his or her own can keep that fee. However, investors who don’t know how to effectively implement everything above—or choose to devote their time and energy elsewhere—miss this extra Advisor Alpha. Even though they saved the 1% fee, they will likely end up worse off for not implementing all of these other important aspects of a good financial plan.
Justin Wagner from Vanguard offers the following example for this important point. Suppose the overall market return is 8%. Without good financial decision making, the combined impact of fees, taxes, and poor investment decisions is around 4%. This leaves a net return of 4% to the investor.
However, for someone working with a capable advisor, they eliminate poor investment decisions, minimize taxes, and only pay the 1% fee, leaving a net return of 7%. These higher net returns can then be translated into an improved retirement lifestyle and a better ability to meet financial goals. That is the Advisor Alpha.
The value added by good advice can greatly exceed the fees, which leaves the investor in a much better position even after paying the advisor. It is incorrect to view advisory fees as a zero-sum game the advisor wins at the expense of the client; both can be winners.
