Advisor Alpha: The View from Vanguard

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At Index Fund Advisors, we have repeatedly cautioned investors to avoid getting ensnared in the never-ending pursuit of alpha by either picking stocks or hiring an active manager to pick stocks on their behalf. Nevertheless, by engaging in a few prudent practices such as controlling costs, maintaining discipline, and tax awareness, investors can achieve a higher long-term return than the overwhelming majority of their peers.

Last year, Vanguard coined a term for the value added by investment advisors who adhere to these "passive" principles, “Advisor’s Alpha”. In a speech at the annual Inside ETFs conference, Vanguard’s Chief Investment Officer Tim Buckley quantified advisor’s alpha at 3% relative to advisors or unadvised investors who do not adhere to these guidelines.

Mr. Buckley summarized the concept of advisor’s alpha as follows:

“Guiding clients to investing success happens not as a result of some fanciful, perfect product but from advisors’ adherence to certain guiding principles. Among the best practices followed by the most successful advisors:

  • Being a behavioral coach who helps clients to get on the right path and prevents them from taking wrong turns. (Also see Investor Return from Morningstar)
  • Being tax-efficient through prudent asset location and tax-smart spending strategies.
  • Keeping investment costs low.
  • Rebalancing in a disciplined fashion.”

In explaining advisor’s alpha, Vanguard includes this very important caveat:

“The extent of actual value added varies by an advisor’s adherence to the described practices, the manner of a client’s portfolio management historically, and the client’s investment horizon and tax situation. Potential value will most likely not be apparent on a quarterly or annual statement as an identifiable excess return over a passive portfolio. Instead, advisor value is considered additive in the sense that it subtracts less on an after-tax, after-fee, after-costs basis than would the performance of an average investor, advised or otherwise.”

In other words, not following the practices outlined above can lead to a diminution of returns, and a good advisor will help her clients avoid that. So just how big of a diminution is 3%? In terms of long-term growth of wealth, the word “enormous” comes to mind. For the 30 years ending 12/31/2013, IFA’s Index Portfolio 70 on glide path had an annualized return of 9.46%. If a hypothetical unadvised (or improperly advised) investor only got 6.46% (which is 68% of the 9.46% return), here is what would have happened to an initial investment of $100,000 over that 30-year period.

Growth of a $100,000 Investment over the 30-Year Period Ending 12/31/2013

IFA Index Portfolio 70 on glide path: Annualized Return of 9.46% = $1,505,439

3% Lower Return: Annualized Return of 6.46% = $654,024 (43% of the Index Portfolio 70 amount)

Please note that although the hypothetical unadvised investor got 68% of the advised investor's return, the effect of compounding cased him to only get 43% of the growth of wealth.

At IFA, we are always looking for ways to become better advisors to our clients, as this is part and parcel of our fiduciary duty. If you would like to learn more about the advantages of working with an IFA Wealth Advisor, please call us at 888-643-3133.