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Advisor Alpha: The View from Vanguard

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For more than two decades, researchers at indexing pioneer Vanguard have been digging into how much fiduciary-minded wealth advisors — i.e., those who put their clients' interests first — can help to boost net portfolio returns. As a result, they've coined the term "Advisor's Alpha."

Typically, alpha refers to an active manager's excess return relative to an appropriate benchmark. In this case, Vanguard is quantifying how much working with a professional advisor can mean in terms of improving an individual's net total return. 

"In creating the Vanguard Advisor's Alpha concept in 2001, we outlined how advisors could add value, or alpha, through relationship-oriented services such as providing cogent wealth management through financial planning, discipline, and guidance, rather than by trying to outperform the market," Vanguard researchers explained in a paper outlining their work.1

By focusing on strategies core to passive management and mitigating poor investment behavior, this research series finds a fiduciary-minded wealth advisor can help to increase portfolio returns around 3% net in an average year. 

To illustrate how much of an advantage this represents over time, let's consider the globally diversified IFA Index Portfolio 70 — with an allocation of 70% stocks and 30% bonds — over an extended period (1991 through 2020). Since investors typically move into portfolios with less risky assets as they age, for this exercise we'll apply a glide path. That means the portfolio's stock allocations were reduced by 1% a year. Meanwhile, positions in less risky assets (i.e., bonds) were increased by the same amount.

As shown in the blue bars in the chart below, during this 30-year period:

  • The IFA Index Portfolio 70 set to a glide path produced an annualized return of 7.61%.
  • With an investment of $100,000, this equated to a total net value of a little more than $900,000 ($903,522.79). 

By contrast, the red bars in this chart represent results using the Vanguard Advisor's Alpha model:

  • With a 3% lower return per year, such an "unadvised" portfolio's annual gain (1991-2020) would've been 4.61%, per Vanguard's estimate of an advisor's overall impact on investment results.
  • That would result in an investor's initial $100,000 investment at the end of this 30-year period growing to a lower total of $365,010.04.

Please note that although the hypothetical "unadvised" investor got nearly 61% of the "advised" investor's return, the effect of compounding caused him/her to only get 40.4% of the IFA Index Portfolio 70's growth of wealth over this extended period. 

The statistical modeling of Advisor's Alpha involves comparisons between "the projected results of a portfolio that is managed using well-known and accepted best practices for wealth management and those that are not," according to Vanguard. While such a methodology might seem somewhat "abstract" to some, the firm's researchers note how difficult it is to rely simply on past investment performance. As they observed in the 2019 paper presenting such estimates: 

"For advisors who promise better returns, the question is: Better than what? Those of a benchmark or 'the market'? Not likely, as evidenced by the historical track record of active fund managers, who have regularly failed to consistently outperform benchmarks in the pursuit of excess returns (see Rowley, Walker and Ning, 2018)."

In crunching numbers from different hypothetical portfolios, Vanguard's researchers focused on wealth managers who delivered in four key areas:

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

The table below shows results of Vanguard's most recent number crunching to quantify the value advisors can bring by practicing each part of such a comprehensive and fiduciary-minded discipline. 

It's important to point out, however, these estimates are offered as snapshots of longer-term averages found by Vanguard's researchers over decades worth of studying such data. 

For instance, consider that the five quantifiable practices — implementation of cost-effective funds, disciplined rebalancing, behavioral coaching, asset location and an annual withdrawal strategy — added up to improving returns by up to 3.95% in 2018. Four years earlier, though, these fiduciary-minded practices were estimated to have boosted gains by as much as 3.75%. 

As a result, IFA's investment committee doesn't view such numbers as set in stone. This sort of a variance in Advisor's Alpha over shorter periods also indicates that patience is required to realize the benefits of hiring a wealth advisor. 

In explaining Advisor Alpha, Vanguard includes this very important caveat:

"Because clients only get to keep, spend, or bequest net returns, the focus of wealth management should always be on maximizing net returns. We do not believe this potential 3% improvement can be expected annually; rather, it is likely to be very irregular. Further, the extent of the value will vary based on each client's unique circumstances and the way the assets are actually managed." 

In other words, not following the practices outlined above can lead to a diminution of returns. Conversely, advisors acting as true fiduciaries by putting their clients' interests first and employing a rigorous, well-thought out wealth planning process stand to "add value." 

It's also worth noting that even though they've refrained from trying to give a specific value for "determining an appropriate asset-allocation" strategy, Vanguard's researchers still list this practice as a key "value-add" for investors working with an experienced wealth advisor. (They also don't provide estimates for advisors who keep their clients focused on "total return investing" as opposed to "reaching for yield" by investing in riskier assets like high dividend-paying stocks or non-investment grade bonds.) 

At IFA, we're always looking for ways to become better advisors to our clients, as this is part and parcel of our fiduciary duty. Fundamental to our financial planning process is assessing how much risk a person really needs to be exposed to in order to meet his or her financial goals. It's a critical variable that we find too many investors don't spend enough time evaluating. That's why we've developed an online tool, the IFA Risk Capacity Survey, for anyone interested in digging deeper into their asset-allocation process. 

The wealth of IFA's educational materials are available for Apple iOS and Android devices via the IFA App. This free App is available to download from both the Apple App Store and the Google Play Store for Android.

Along these lines, we also urge those who've already built existing relationships with us to take advantage of our complimentary offer to create an individually tailored financial plan. Such a holistic planning approach aims to take a comprehensive view of a client's investments and financial situations. As part of this process, our wealth managers can look into a range of financial issues, from household budgeting and retirement planning to educational savings and health care spending needs.

Our wealth advisors can also tap into the resources of our accounting and tax planning division, IFA Taxes. It's headed by John Dahlin, a certified public accountant (CPA). When hired separately to help individual taxpayers and business owners to prepare their taxes and handle other accounting-related assignments, he charges based on a flat-fee rather than hourly basis. You can reach CPA Dahlin by phone at: (888) 302-8765. He can also be contacted directly via email at: [email protected]

Footnote:

1.) Vanguard, "Putting a Value on Your Value: Quantifying Vanguard Advisor's Alpha," Feb. 2019.


This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com. This is intended to be informational in nature and should not be construed as tax advice. IFA Taxes is a division of Index Fund Advisors, Inc.

Certified Public Accountant (CPA) is a license to provide accounting services to the public awarded by states upon passing their respective course work requirements and the Uniform Certified Public Accounting Examination.