Content provided by Kostya Etus, CLS Investment Research Analyst

Vanguard has written a revolutionary whitepaper on quantifying the value of an Advisor on portfolio performance.

The original, “Vanguard Advisor’s Alpha” introduced in 2001 (a pivotal time for the industry), had outlined how advisors could add value through relationship-oriented services. One of the value-adds was providing cogent wealth management via financial planning, discipline, and guidance, rather than by trying to outperform the market.

Since then, they have taken it a step further and actually attempted to quantify the benefits of an advisor. This seems appropriate as fees deducted annually for the advisory relationship could be justified. They believe that by implementing all of the tools that an advisor has to offer, about 3% can be added in net returns to client portfolios.

Vanguard claims the way to attain the most of this stated value is to follow the Advisor’s Alpha framework for wealth management.  The framework breaks down the tools at advisor’s disposal into seven modules. Below is a summary table quantifying the value-add of best practices in wealth management, as well as an overview of each module from the Advisor’s Alpha.

Module I. Asset allocation

“Market performance and headlines change far more often than do clients’ objectives. Thus, not reacting to the ever-present noise and sticking to the plan can add tremendous value over the course of your relationship. The process sounds simple, but adhering to an investment plan, given the wide cyclicality in the market and its segments, has proven to be very difficult for investors and advisors alike.”  “Asset allocation and diversification are two of the most powerful tools advisors can use to help their clients achieve their financial goals and manage investment risk in the process.”

Module II. Cost-effective implementation

“If low costs (expense ratios, trading or frictional costs, and taxes) are associated with better investment performance (and research has repeatedly shown this to be true), then costs should play a role in an advisor’s investment selection process.” Also, higher costs equate to lower growth for assets under management (from which fee revenues are calculated), as result, cost-effective implementation is a ’win-win’ for clients and advisors alike. “It’s important to note, too, that this value-add has nothing to do with market performance. When you pay less, you keep more, regardless of whether the markets are up or down.”

Module III. Rebalancing

“As a portfolio’s investments produce different returns over time, the portfolio likely drifts from its target allocation, acquiring new risk-and-return characteristics that may be inconsistent with your client’s original preferences. Note that the goal of a rebalancing strategy is to minimize risk, rather than maximize return.”  “The bottom line is that an investment strategy that does not rebalance, but drifts with the markets, has experienced higher volatility” (the true benefit of rebalancing is realized in the form of controlling risk).

Module IV. Behavioral coaching

“Because investing evokes emotion, advisors need to help their clients maintain a long-term perspective and a disciplined approach—the amount of potential value an advisor can add here is large. Most investors are aware of these time-tested principles, but the hard part of investing is sticking to them in the best and worst of times…”  “Abandoning a planned investment strategy can be costly, and research has shown that some of the most significant derailers are behavioral: the allure of market-timing and the temptation to chase performance.”

Module V. Asset location

“Asset location, the allocation of assets between taxable and tax-advantaged accounts, is one tool an advisor can use that can add value each year, with an expectation that the benefits will compound through time. From a tax perspective, optimal portfolio construction minimizes the impact of taxes by holding tax-efficient broad-market equity investments in taxable accounts and by holding taxable bonds within tax-advantaged accounts. This arrangement takes maximum advantage of the yield spread between taxable and municipal bonds, which can generate a higher and more certain return premium.”

Module VI. Withdrawal order for client spending from portfolios

“Advisors who implement informed withdrawal-order strategies can minimize the total taxes paid over the course of their clients’ retirement, thereby increasing their clients’ wealth and the longevity of their portfolios.”  “The primary determinant of whether one should spend from taxable assets or tax-advantaged assets is taxes.”  “Advisors can minimize the impact of taxes on their clients’ portfolios by spending in the following order: Required minimum distributions (RMDs), if applicable, followed by cash flows on assets held in taxable accounts, taxable assets, and finally tax-advantaged assets.”

Module VII. Total-return versus income investing

“Historically, retirees holding a diversified portfolio of equity and fixed income investments could have easily lived off the income generated by their portfolios. Unfortunately, given historically low yield levels, that is no longer the case.” Investors have three choices if their current cash flows fall short of their spending needs: spend less, reallocate their portfolios to higher-yielding investments, or they can spend from the total return on their portfolio (income plus capital appreciation).  “Be aware that for many investors, moving away from a broadly diversified portfolio could actually put their portfolio’s principal value at higher risk than spending from it.”

Information contained in this blog came directly from, or is directly based on opinion derived from:Francis M. Kinniry Jr., CFA, Colleen M. Jaconetti, CPA, CFP, Michael A. DiJoseph, CFA, and Yan Zilbering.  “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha.”  Vanguard Research (March 2014).

0621-CLS-3/26/2014