Vanguard recently published a white paper on “advisor’s alpha,” in which they discuss and attempt to quantify the value an investment advisor can provide for his or her clients.1 They concluded that an advisor who dispenses sound advice in six specific areas adds about 3% per year in client returns. Vanguard arrived at this figure by calculating value added in the following areas: 1) asset allocation; 2) cost-effective implementation; 3) rebalancing; 4) behavioral coaching; 5) asset location; and 6) spending strategy. The Vanguard paper does not suggest that an advisor can add value through stock selection or market timing.
Asset Allocation: Asset allocation is the most important determinant of long-term portfolio returns. Developing a well-balanced, globally diversified portfolio tailored to your investment goals, risk tolerance and time horizon, and sticking with this investment plan during periods of market euphoria or duress, can add substantial value.
Cost-Effective Implementation: An advisor can also add value by keeping their investment management fees at a reasonable level and selecting mutual funds and ETFs with low annual expense ratios.
Rebalancing: Portfolios that are not rebalanced inevitably drift from the target allocation and may eventually become overweighted in stocks, which makes them more vulnerable to equity market corrections. Rebalancing involves taking profits from holdings that have done well and investing them in underperforming asset classes, which can dampen portfolio volatility over time.
Behavioral Coaching: Abandoning an established asset allocation strategy can be costly. An advisor can help investors maintain a long-term perspective and avoid jumping in and out of stocks in emotionally charged markets. Vanguard’s research shows that most investors benefit from a disciplined approach and from resisting the temptation to chase performance or time the market.
Asset Location (Tax-Efficient Investing): Investment related taxes can be minimized by allocating assets appropriately among taxable, tax-deferred, and tax-free accounts. Clients in the higher tax brackets should hold government and corporate bonds in tax advantaged accounts and tax-free municipal bonds in their taxable accounts. Real estate securities are tax inefficient and should only be held in tax advantaged accounts. Tax- managed equity funds can be used for stock holdings in taxable accounts to help lower your annual tax liability. There are also a number of more esoteric strategies, such as overweighting international equities in your taxable account to utilize the foreign tax credit, or emphasizing securities with high growth potential in your Roth accounts to maximize the proportion of assets that qualify for tax-free withdrawal during retirement.
Spending Strategy (Withdrawal Order): The manner in which money is withdrawn from your portfolio, particularly during retirement, can have a significant effect on the amount of taxes paid over the long term. For most investors, retirement living expenses should be funded by withdrawals in this order: 1) required minimum distributions; 2) interest and dividends from taxable assets; 3) taxable assets; 4) tax-advantaged assets.
As always, please feel free to contact me with any questions or comments.
Jeffrey J. Brown, MD CFA Principal, Shearwater Capital
1.) Vanguard Research: "Putting a Value on Your Value: Quantifying Vanguard Advisor's Alpha." March, 2014