alpha

Advisor Alpha: Vanguard Estimates 3% Excess Return from Passive Advisors

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A little more than a month ago, we published this article that introduced the concept of advisor’s alpha as the value added by passive advisors who adhere to the principles of controlling costs, maintaining discipline, and tax awareness. We also noted that 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. Today, we will explore the components of the 3%, based on a recent whitepaper1 from Vanguard Research.

Before we begin, there are a few important caveats. First, the alpha that can be provided by the advisor is completely dependent on the client’s unique situation. For example, clients who have all of their assets in a tax-deferred account would not derive any benefit from tax aware strategies such as asset location, until they develop saving outside of those accounts. Second, with the exception of using lower-cost investment vehicles, none of the advisor benefits are constant from year to year. For example, the gains from rebalancing in late 2008 or early 2009 could have paid for several years of advisory fees, but rebalancing in late 2012 (assuming equities were sold) would have had a negative impact on returns. On average, rebalancing results in a lower risk and therefore is a strategy of risk maintenance, not a strategy to increase returns. Finally, we wish to clarify that we are simply reporting, explaining, and in some cases critiquing the numbers produced by Vanguard Research. We are not claiming these numbers as our own. With that said, here are the numbers presented by Vanguard.

Perhaps the single most important function of investment advisors is to determine an appropriate asset allocation for their clients. One of the landmark papers that is cited in IFA’s Investment Policy Statement shows that the overwhelming majority (94%) of investor’s long-term returns can be explained by asset allocation. To further emphasize the importance of asset allocation, Vanguard cites the NACUBO study which shows that for the 28-year period ending 6/30/2013, a simple 60/40 index portfolio beat 90% of all college endowments. Unfortunately, as noted by the Vanguard researchers, there is no good way to quantify this benefit because we don’t have a baseline for what the client would have done without the advice. In looking at our client’s portfolios before they became clients, we have seen situations where they were holding far more risk than we deemed appropriate, and we have also seen the opposite. Another goal of asset allocation selection is to design a portfolio that clients are likely to hold, rebalance and glide path. In our opinion, the largest mistake clients make is giving up on their current asset allocation after bad or good market returns.

Once the asset allocation is determined, the advisor’s next job is to implement it in a cost-effective manner (i.e., index funds). Vanguard calculated the annual value of this benefit to be 0.45% based on comparing the weighted average expense ratios of all mutual funds and ETFs against the weighted average of the lowest 7%. By their own admission, this is a very conservative estimate because it ignores the additional costs beyond the expense ratio such as turnover which can lead to lower returns and higher tax bills. It has been our observation that unadvised (or poorly advised) investors gravitate towards higher expense funds, so using a baseline of the whole mutual fund universe appears to be unnecessarily conservative.

Once the portfolio is implemented, it is the advisor’s responsibility to keep it in balance. This is not for the purpose of maximizing returns (as is commonly assumed) but to control risk. Based on an analysis of returns over the 54 years ending 12/31/2013, holding a 60/40 portfolio that was not rebalanced subjected the holder to the same risk as holding an 80/20 portfolio that was rebalanced, but the rebalanced 80/20 portfolio had a 0.35% higher return, and that is what Vanguard determined as the benefit of disciplined rebalancing.

Naturally, there are times when rebalancing is psychologically very difficult such as late 2008 or early 2009 when all the pundits were talking about the beginning of a second Great Depression. Likewise, in late 1999/early 2000, it was extraordinarily difficult to sell equities when we were on the cusp of a new era where the Dow would go to 36,000. The behavioral coaching aspect of investment advice is assigned a value of 1.50% based on a Vanguard internal study of actual client behavior focusing on investors who deviated from their initial retirement fund asset allocation over the last five years. As with rebalancing, this is by no means, a constant amount.

After asset allocation and fund selection, the initial set up of the client’s accounts should consider asset location, the placement of tax-inefficient asset classes in qualified accounts and tax-efficient asset classes in taxable accounts (using tax-managed funds where available). The potential benefit of asset location depends on three factors:

1)      The breakdown between taxable and non-taxable accounts.

2)      The overall asset allocation.

3)      The investor’s marginal tax rates

Vanguard quantifies the value of asset location between zero and 0.75%.

For retired investors who are annually withdrawing from their portfolio, the order in which they take withdrawals from different account types can significantly impact their tax liabilities. Vanguard places the value of a well-considered withdrawal strategy between zero and 0.70%. As with asset location, it is completely dependent on the breakdown of the different tax treatments of the client’s accounts.

An additional aspect of portfolio withdrawals where an advisor can add value is charitable giving. Specifically, the advisor can identify securities in taxable accounts that have high long-term capital gains and are also sensible candidates for trimming back to keep the portfolio in balance, thereby potentially producing a double benefit for clients. Furthermore, a knowledgeable advisor can help the client establish a donor-advised fund, which is a charitable investment account that is held at a custodian such as Schwab, Fidelity, or TDAmeritrade. The client determines when and to which charity a donation is to be made from the account. In addition to providing growth potential for charitable assets, a donor-advised fund allows the client to have greater control over the timing of tax deductions while providing an opportunity to educate the client's family about investing and philanthropy. Laura J. Malone provides more inforamtion on Donor Advised Funds in this two part video series: Part 1 and Part 2.

The final factor considered is total return investing vs. income investing (or reaching for yield, as we refer to it). In several articles, we have highlighted the problems with reaching for yield with vehicles such as high-yield bonds, high-dividend stocks, or other more exotic alternatives. The basic conclusion is that there is no free lunch, so more yield automatically implies more risk. Advised investors who can be persuaded to accept the idea that returns that come from capital gains are as good as, or even better than returns that come from dividends and bond coupon payments are able to hold a globally diversified portfolio that maximizes the probability of achieving their investment objectives. Unfortunately, there is no good way to quantify the value of this factor.

Putting it all together, and considering the fact that very few investors can realize the full potential benefit of all the factors, Vanguard places the overall advisor’s alpha at 3%. We think that this is an eminently reasonable, if not a low number considering other benefits such as glide path strategy, risk capacity identification and monitoring, investment selection and monitoring, proper benchmarked performance reporting, alternative investment evaluation and avoidance, continuing investor education, concierge type custodian services, retirement goal and portfolio survival monitoring, college savings advice, estate planning coordination and referrals, and insurance advisor referrals. 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.

1Kinniry, Francis M., Jr., Colleen M. Jaconetti, Michael A. DiJoseph, and Yan Zilbering, 2014. Putting a Value on Your Value: Quantifying Vanguard Advisor’s Alpha.  Valley Forge, Pa.: The Vanguard Group.