The Vanguard Group is a well-known sponsor of low cost no-load mutual funds. This article will cover the key findings from their study of how much value an investment advisor can add to client portfolio returns. This extra added value that would not otherwise be achieved is called “Alpha”.
Vanguard found that the average advisor added about 3% of increased returns after taxes and fees are included in the calculation of client expenses. This means, for example, that an advisory firm that charges a 1% annual fee for investment management actually produces about 4% average additional returns, of which, its clients receive 3%. This also shows that the average advisor’s ability to create additional returns provides more than enough additional value to cover the advisor’s fee, resulting in no actual net cost, only extra value for the client.
Of course, 3% is just the average. For some advisors and clients, the “Alpha” may be much higher and for some lower. So, it is important to ask an advisor for evidence of what net additional return (“Alpha”) has been created for their clients’ investment accounts over time.
The amount of Alpha that is created will vary for each year based on client circumstances and investment market conditions. It also can be gained very quickly and dramatically during periods of extreme market volatility.
The 3% average Alpha will be conservative for many advisors, because some components that also contribute to Alpha are not included in Vanguard’s 3% average benefit calculation. Examples are the extra value that may be derived from receiving advice on matters such as estate and succession planning or offering advice on long-term care insurance and charitable giving.
Portfolio Alpha that Can be Quantified
$$$ Portfolio Construction- Investment returns can be increased by choosing low-cost mutual funds and exchange-traded-funds (ETFs) and by choosing the best investment types for both taxable and sheltered investment accounts. Proper diversification will help reduce portfolio volatility and “downside” risk during negative market periods.
$$$ Wealth Management- By taking a comprehensive approach in providing investment and financial advice to clients, advisors gain better ability to manage clients’ financial situation and guide decisions related to finances and future planning. Developing effective spending strategies will direct clients’ withdrawals from their portfolios for expenses and income needs in the most efficient way. Rebalancing portfolios, when needed, can also improve risk-adjusted returns over time.
$$$ Behavioral Coaching- Guidance to help keep clients from straying from their financial plans when strong emotions may develop from exposure to positive and negative external conditions that may produce disconcerting euphoria or fear will also benefit portfolio returns. This helps keep clients from “selling-low” and “buying-high” and missing periods of positive returns that would otherwise be gained.
In summary, additional returns (that on average measure 3%) will be created over time, if these three areas of management are effectively included when providing investment advisory services to clients. Some advisors will be able to demonstrate that they have provided Alphas from their services that are significantly higher due to superior investment management performance. But, at a minimum, it is important to learn what Alpha the advisor has provided over time. At a minimum, the relationship should be a “win-win” that will compensate advisors for good advice while at the same time provide additional financial returns for clients.
Greg Tinaglia
Last Updated: 10/11/2019