Is Your Financial Advisor Adding Value?
Research by Vanguard concluded that a financial advisor could add up to, or even exceed 3% in net returns for clients. However, the actual value depends on your unique circumstances and, more importantly, your advisor’s competence and ability to implement value-adding strategies.
I'll use The Vanguard Advisor’s Alpha® study as a framework to help you assess whether an advisor meets the standards for adding value or merely collects a fee for boilerplate service.
How Can a Financial Advisor Add Value?
Vanguard segmented potential value-adding strategies into seven modules.
*Basis points (bps) represent 1/100th. 100bps equals 1%.
Figure I – The Value-Add of Best Practices in Wealth Management
Some modules are highly dependent on qualitative factors unique to the client, so the value isn't quantified. However, these modules are often the most impactful.
Does Your Financial Advisor Use Asset Allocation?
Asset classes like stocks, bonds, real assets, alternatives, and cash are each assigned a percentage weight to comprise an investor’s asset allocation.
Asset allocation has been shown to account for more than 90% of return variability and long-term performance of broadly diversified portfolios with limited market timing (Brinson, Hood, and Beebower, 1986; Brinson, Singer, and Beebower, 1991)[i].
Active vs. Passive Investment Management
Investors must choose between a passive, diversified portfolio driven by asset allocation or an active portfolio reliant on a manager’s security selection and market timing skills.
While active management is often marketed as a value-adding service, Figure II shows most actively managed funds underperform their respective benchmark over sustained periods.
Figure II - S&P Dow Jones SPIVA Report
Evaluating Advisors with Asset Allocation
Prudent advisors help investors determine their asset allocation in the context of a financial plan that considers their goals, time horizon (not age!), liquidity needs, tax situation, risk tolerance, and various other factors.
Investors should question the merit and suitability of investment recommendations made without these considerations.
Does Your Financial Advisor Control Investment Costs?
Vanguard’s research found that investors could add up to 30bps of annual value using the lowest-cost funds in the mutual fund/ETF industry.
Even better, investors don’t have to sacrifice performance for lower fees. Funds with higher expense ratios are associated with lower excess returns for US stock and bond funds (Rowley and Plagge, 2022)[ii].
In addition, Morningstar’s white paper, Predictive Power of Fees, shows how fund expense ratios have been the most proven predictor of future fund returns (Kinnel, 2016)[iii].
Evaluating Advisors with Investment Costs
Ask advisors about their investment philosophy, their preferred investment vehicles, and their investment screening process. In addition, use FINRA’s Fund Analyzer tool to compare funds and see the significant effect costs have on long-term wealth.
Fees aren’t the only consideration when evaluating investment options, but low costs should be at the top of an advisor’s criteria.
Does Your Advisor Rebalance Your Portfolio?
The performance of different asset classes causes an investor’s portfolio to diverge from their risk-aligned asset allocation. When the portfolio drifts outside certain parameters, rebalancing returns the portfolio to the investor’s targets.
The primary benefit of rebalancing is maintaining an allocation that fits the investor's risk tolerance. However, rebalancing may also result in added returns.
Research by AQR found annually rebalancing a portfolio composed of 50% stocks, 40% bonds, and 10% commodities decreased volatility by more than 10% and added 0.5% to net returns when compared to a buy-and-hold portfolio with the same allocation (Ilmanen and Maloney, 2015)[iv].
Evaluating Advisors with Rebalancing
Advisors should be able to provide an in-depth explanation of their trading practices, the due diligence used to support their methodology, and the risk-return potential in client portfolios.
If your portfolio regularly experiences volatile swings outside your comfort level, you may want to revisit your desired asset allocation and your advisor's rebalancing practices.
Does Your Advisor Practice Behavioral Coaching?
Vanguard asserts that circumventing the hardwired emotions and mental biases that cause investors to abandon calculated, sensible investment strategies can potentially add more than 2% in net returns.
When market volatility spikes and investment performance is poor, the theory of investors' emotional biases becomes reality.
Investment talk shows stoke loss aversion fears and compound herd behavior, prompting us to sell while the market is in free fall. Further complicating the situation, our overconfidence bias leads us to believe we have the intellect to reinvest at the bottom of the market and generate outsized gains.
Contrary to our belief, both equity and bond mutual fund investors’ attempts at timing the market have led to widespread, long-term underperformance compared to their respective benchmarks (DALBAR, 2015)[v].
Figure III shows more than half of the 50 best trading days from 1993-2022 happened during a bear market when many investors’ emotions and mental biases kept them on the sidelines.
Figure III – Quantifying Investor Behavior
Source: Hartford Funds
Evaluating Advisors with Behavioral Coaching
Behavioral coaching is a proactive exercise. Investors should seek advisors who regularly educate them on the risk-return potential of their portfolio and how those risks factor into their recommendations for helping clients achieve their lifestyle goals.
Additionally, investors are best served with an advisor who provides transparent performance reporting against an appropriate benchmark. This allows investors to evaluate their advisor's investment performance in the context of the overall market.
Does Your Advisor Use Tax-Efficient Asset Location?
Asset location refers to where assets are invested across taxable (individual or joint brokerage), tax-deferred (traditional IRA, 401(k), etc.), and tax-free accounts (Roth IRA, 401(k), etc.).
In general, asset location decisions come down to the asset’s expected return and tax efficiency.
Figure IV provides a framework for making high-level asset location decisions. However, the optimal location and precise value-add depend on the investor’s financial profile, current and future tax laws, and tax characteristics of the asset classes in their portfolio (Daryanani and Cordaro, 2005)[vi].
Figure IV – Asset Location Framework
Evaluating Advisors with Asset Location
The value of asset location varies by investor, but some degree of value is achievable by nearly everyone. The simplicity of attaining this added value makes failed implementation a major red flag.
Review advisor or self-managed portfolios to evaluate if investments are located to optimize tax efficiency and timeline for using funds.
Does Your Advisor Recommend Withdrawal Strategies
Withdrawal order refers to the order an investor withdraws from taxable, tax-deferred, and tax-free investment accounts to fund spending needs. Withdrawals from each account type are taxed differently and dictate the amount of tax paid over the investor’s lifetime.
Vanguard suggests value is added by exhausting all taxable assets prior to tax-advantaged assets. This strategy could result in less tax paid over the investor’s retirement. However, the ideal withdrawal order is almost entirely decided by the investor’s goals, cash flow needs, asset mix, and retirement tax circumstances.
For example, current tax law affords a step-up in cost basis on taxable assets when inherited. If a client has concentrated stock positions with low cost basis, they could pass the positions on to heirs without paying tax on the gains.
Additionally, tax-deferred assets inherited by non-spouse beneficiaries are required to be withdrawn by the end of a ten-year timeframe and are subject to ordinary income taxes. If the IRA recipient is in a high tax bracket, they could end up paying tax at a higher marginal rate than if the original IRA owner had withdrawn the assets.
The number of scenarios requiring a unique withdrawal strategy are endless. While it would be difficult to measure, an optimal withdrawal strategy tailored to a client’s unique goals and circumstances is likely more valuable than the 120bps suggested by Vanguard.
Evaluating Advisors with Withdrawal Strategies
Optimal withdrawal strategies require foresight only made available by a long-term financial plan that accounts for and incorporates a client’s specific goals and circumstances.
Investors should expect comprehensive financial planning from their advisor and be wary of plans that don’t include long-term cash flow projections formed after an extensive data gathering process.
What's Your Advisor's View on Total Return vs. Income Investing?
Total return investing aims to satisfy withdrawal needs from portfolio dividends, interest, and capital appreciation. Income investing attempts to support cash flow needs with only the income generated from the portfolio.
Investing for total return allows an investor to maintain diversification across asset classes. Income investing requires over or underweighting certain aspects of the portfolio to generate the necessary income.
These tilts can impair portfolio growth and expose the investor to unintended consequences like interest rate risk, credit risk, increased volatility, and reduced tax efficiency.
Evaluating Advisors with Investment Style
Today’s investment landscape requires investors accept a degree of equity exposure and accompanying risk to sustain their portfolio and achieve their goals.
Determining the asset allocation that balances growth potential with investor risk tolerance is a crucial advisor responsibility. Investors should refer to the asset allocation section for methods a prudent advisor uses.
Vanguard’s Advisor Alpha® framework makes it clear that a qualified advisor can add immense value to their clients.
Fortunately, retail investors are more empowered to find advisors capable of helping them pursue financial independence than ever before. Investors should use this and other resources to ensure the value they receive justifies the fees they pay.
You can read the full Vanguard study here.
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[i] Gary P. Brinson, L. Randolph Hood, & Gilbert L. Beebower. (1986). Determinants of Portfolio Performance. Financial Analysts Journal, 42(4), 39–44. http://www.jstor.org/stable/4478947 and Gary P. Brinson, Brian D. Singer, & Gilbert L. Beebower. (1991). Determinants of Portfolio Performance II: An Update. Financial Analysts Journal, 47(3), 40–48. http://www.jstor.org/stable/4479432 [ii] Rowley Jr., James and Plagge, Dr. Jan-Carl (2022). The case for low-cost index fund investing. https://www.vanguardsouthamerica.com/content/dam/intl/americas/documents/latam/en/2022/05/mx-sa-2217207-the-case-for-low-cost-index-fund-investing.pdf [iii]Kinnel, Russell (2016). Predictive Power of Fees – Why Mutual Fund Fees Are So Important. https://assets.contentstack.io/v3/assets/blt4eb669caa7dc65b2/blt70866588660aea5a/60416664f9638443346d4e9b/predictive-power-of-fees.pdf [iv] Ilmanen, A., & Maloney, T. (2015). Portfolio Rebalancing, Part 1: Strategic Asset Allocation. AQR Website. Retrieved March 8, 2023, from https://www.aqr.com/research-archive/research/white-papers/portfolio-rebalancing-part-1-strategic-asset-allocation [v] DALBAR (2015). DALBAR’s 22nd Annual Quantitative Analysis of Investor Behavior. https://cdn2.hubspot.net/hubfs/5341408/EP_Wealth_Advisors_April2019/pdf/2016-Dalbar-QAIB-Report.pdf [vi] Daryanani, Gobind, and Chris Cordaro. (2005). Asset Location: A Generic Framework for Maximizing After-Tax Wealth. Journal of Financial Planning 18 (1): 44–54. [vii] Kitces, M. (2014). Advanced Concepts & Strategies In Asset Location. The Kitces Report. https://www.kitces.com/wp-content/uploads/2014/04/Kitces-Report-March-April-2014-Advanced-Asset-Location-Strategies1.pdf