The Advisor’s Alpha
Field Note: July 2019
In 2001 Vanguard attempted to quantify the value-add of wealth management services; Vanguard proposed that fee-based financial advisors provide clients with an additional 3% net return on an annual basis. Since Vanguard’s initial publishing of what they termed the “Advisor’s Alpha,” additional studies have been released asserting that fee-based advisors may add anywhere from 159 basis points (1.59%) to 300 basis points in annual additional savings. The three most recognized studies on the economic benefits of financial advice are described below.
In the age of the internet and DIY culture, it is easy to become a hobbyist at any pursuit. Intelligent professionals often question the value-add of financial advisors who charge 1-2% in fees of assets under management. With a liberal arts education and access to self-help books, anyone can manage their own investment portfolio, but should they? Self-management is a cost-effective tool for individuals with fewer assets; however, as the number of assets, dependents, and complexity of taxes increases, so does the need for a fee-based financial advisor.
Skyline believes it’s important that clients understand the different elements of service that yield return. Below are summaries of relevant research listed categorically
Financial Planning Advice
The instrumental value of creating a financial plan is difficult to quantify. While Envestat estimates that financial planning advice produces 50 basis points (bps) of value on an annual basis, the value of goal setting and professional partnership should not be defined solely by a monetary value. According to a FPSC study, investors that engage in comprehensive financial planning are more likely to be prepared to deal with financial emergencies, be on track for retirement, and have a stronger sense of well being.
Asset Class Selection/Allocation & Product Selection
Also know as the investment Beta, the systematic risks of investing can be curtailed by appropriate asset allocation. Financial advisors balance a fine line between maximizing returns and minimizing risk. By using an array of risk-mitigating strategies financial advisors add between 28bps and 67bps in returns.
Lower Cost Investment Selection
High expense ratios decrease total returns. Envestnet estimates that implementing a portfolio with passively managed investments (which typically tout lower expense ratios), can add 0.82% to investor returns every year. Vanguard estimates the annual savings between the average asset-weighted expense ratio ETFs and the lowest expense ratio ETFs can save investors up to 39bps annually.
Systematic Rebalancing
Systematic rebalancing minimizes risk and market volatility. Failing to rebalance regularly causes equity allocation to shift over time, thereby exposing investors to larger losses during market corrections. Between 1960 and 2015, a 60% equity portfolio would have drifted to a 90% equity portfolio without rebalancing. Using the same historical 60/40 equity portfolio, Vanguard estimated a 0.35% annual value-add for rebalancing services.
Tax-Efficient Withdrawal Ordering
Strategically withdrawing from retirement accounts can decrease tax burden and increase portfolio longevity. Vanguard determined that retirees can add up to 110bps annually by withdrawing savings via RMDs, then retirement savings from taxable accounts, taxable assets, and tax-advantaged assets. However, order of asset distribution however can vary widely based on retiree age, marginal tax bracket, and total assets.
Asset Location
An extension of the tax-efficient withdrawal ordering, ideal asset location can vary by investor’s sources of income, annual income, total assets, and age. Asset location within taxable or tax-advantaged accounts also varies by client goals. Morningstar and Vanguard valued the benefits of asset location between 0.23% and 0.75% in annual returns respectively.
Behavioral Coaching
Another difficult category to quantify, behavioral coaching varies largely by individual client. Even the most analytical investor can be tempted to chase performance or capitalize on market timing, but a strong advisor-client relationship reinforces adherence to the original financial plan instead of succumbing to volatile markets. Vanguard estimates that investors who deviate from their initial retirement investment trailed performance of target-date funds by 1.5% annually. In addition, behavioral coaching may help clients to annually save 143% more than their peers, which subject to the 3% Advisor’s Alpha would amass significant wealth over a lifetime.
Tax Management
Financial advisors can increase clients’ net gains by deferring capital gains taxes. Advisors employ multiple strategies for tax deferment such as qualified retirement contributions, a buy-and-hold investment portfolio, and tax-loss harvesting. Envestnet quantified the benefits of tax management to saving an additional 1% annually.
The above listed examples are only eight of many additional avenues for advisors to provide value-add services. Financial advisors may also proffer advice on charitable giving, insurance analysis, business continuation planning, and more. Contact your Skyline advisor if you have questions about Advisor Alpha.