Last September, Vanguard issued an updated research paper, "Putting a value on your value: Quantifying Vanguard Advisor's Alpha®." The "your" in the title refers to financial advisors; that's who the paper was written for. It's about advisors valuing their services when explaining themselves to clients.
Although Vanguard's Advisor's Alpha concept has been around since 2001, I only recently discovered it through references in a Seeking Alpha article. The article used it to support the general notion that with advisors, investors (over time) gain about 3% per year in value for their investments, compared to what they would get by not employing an advisor.
Advisor fees are commonly estimated at 1% per year, although of course there are a myriad of arrangements, including hourly fees. The implication of "Advisor's Alpha," of course, is that the 3% additional annual gain that an individual gets from working with an advisor more than justifies the 1% annual fee (or other fees) that the advisor charges. So the 3% advantage becomes a marketing point.
As an individual investor who has never used an advisor (except once, for which I was not charged), I find myself oddly curious about what advisors do to market themselves. I think it's fascinating.
My curiosity reduces to a single question: What is the value proposition that an advisor offers to his or her potential clients? And of course the follow-up question would be, is the value proposition true? That is, do clients receive the value suggested by the marketing proposition?
Per Vanguard, their updated research paper does the following:
[D]elves into the concept of Vanguard Advisor's Alpha®, which outlines how you can add value, or alpha, through relationship-based services such as financial planning, discipline, and guidance, rather than by trying to outperform the market….
Use this paper to:
- Discover five modules that help quantify the benefits of advisor's alpha.
- Understand the intermittent, but significant, value that relationship-based services can ultimately bring to a portfolio.
- Learn how to quantify benefits such as guiding clients to "stay the course" as compared to the alternate history they would have experienced with a knee-jerk response to the market.
Note how the last bullet comes right out and states that without the advisor, the individual investor would experience an "alternate history" characterized by "knee-jerk response to the market."
To my eye and ear, that last bullet is opinion stated as fact, which almost always makes me suspicious.
I then read and studied the paper. First off, these are the seven modules that Vanguard has identified to quantify the advisor's value proposition.
Note that the 3% total value-added claimed by Vanguard is a net number, presumably meaning after fees. If the advisor is charging 1% per year for his or her services, they would need to have the client's assets outperform by 4% per year to net out to a 3% annual benefit to their clients.
As you can see, 4 of the 7 categories offer as little as 0% value add for clients. Throughout the paper, Vanguard (as they should) repeats and emphasizes that quantifying the value of particular services is difficult and varies from client to client.
That said, the remaining 3 areas (modules II, III, and IV) are presented with specific values that account for 2.25% of the total 3% net value-add for clients if they use advisors. Those are the areas that I want to discuss. I will take them in rising order of their purported value.
Rebalancing - 0.35% per year
Vanguard's estimate of the value of rebalancing is based entirely on historical data about rebalancing a 60% stock/40% bond portfolio over 55 years.
The chart above shows what happens when you let a portfolio drift from its original allocation percentages without rebalancing. The left axis is the percentage in equities, starting at about 60%.
The blue line shows how, since 1960, a non-rebalanced portfolio gradually became heavier and heavier in equities. That's because over time, equities performed better than bonds. Left alone, a portfolio that started at 60/40 became about 90/10 over 45 years.
So if equities performed so much better than bonds over time, how does rebalancing increase returns? Vanguard does not claim that it does.
An investor wishing to maximize returns, with no concern for the inherent risks, should allocate his or her portfolio to 100% equity to best capitalize on the equity risk premium….[W]e believe the equity risk premium will persist, and that investors who do not rebalance over long time periods will have higher returns than the target portfolio….
Confused? I sure was. Vanguard's statements about the better actual returns from not rebalancing seem to go against their overall point that using an advisor to guide rebalancing increases returns.
They even illustrate the better returns from not rebalancing.
The center column - the drifted portfolio - returned an average 0.27% more per year than the rebalanced portfolio shown in the left column. The right column shows that a heavier stock portfolio - 80/20 - would have done better still.
So how does advisor-assisted rebalancing help the investor achieve better returns? Vanguard does not say.
Their explanation does not address better returns. Rather it addresses risk. As you probably know, "risk" in modern portfolio theory is equated to the volatility of returns. More volatility = more risk; less volatility = less risk.
So Vanguard's explanation about the importance of rebalancing is really about the importance (in their eyes) of maintaining the same "risk profile" (i.e., volatility) as the original 60/40 portfolio.
Note that the goal of a rebalancing strategy is to minimize risk, rather than maximize return. An investor wishing to maximize returns, with no concern for the inherent risks, should allocate his or her portfolio to 100% equity…. The bottom line is that an investment strategy that does not rebalance, but drifts with the markets, has experienced higher volatility….[T]he true benefit of rebalancing is realized in the form of controlling risk. If the portfolio is not rebalanced, the likely result is a portfolio that is overweighted to equities and therefore more vulnerable to equity-market corrections….[emphasis in original]
Are you still not seeing how advisor-assisted rebalancing leads to 0.35% annual greater returns for the investor? Me either. In fact, since the drifted portfolio had a 0.27% annual advantage, it seems that Vanguard needs to come up with 0.35% + 0.27% = 0.62% advantage for advisor-assisted rebalancing to support their thesis.
Frankly, I couldn't find a quantitative justification for the claim. The last part of the module is all about behavior, not numbers. In a nutshell, Vanguard asserts that advisor-assisted rebalancing will help investors stick to their plan.
Helping investors to stay committed to their asset allocation strategy and remain invested in the markets increases the probability of their meeting their goals, but the task of rebalancing is often an emotional challenge…. An advisor can provide the discipline to rebalance when rebalancing is needed most….[Also an] advisor can add value for clients by balancing these trade-offs, thus potentially minimizing the associated costs [of rebalancing]. For example, a portfolio can be rebalanced with cash flows by directing dividends, interest payments, realized capital gains, and/or new contributions to the most underweight asset class…. An advisor can furthermore determine whether to rebalance to the target asset allocation or to an intermediate allocation based on the type of rebalancing costs…
There is no real quantitative explanation to support Vanguard's claim of 0.35% more annual returns for the client if they use an advisor. The bottom line is that it seems just like a good guess.
Cost-effective implementation (expense ratios) - 0.40%
Moving along, an even more worthwhile claimed advantage of advisor assistance - worth 0.40% per year - is cost-effective implementation.
Vanguard explains that this value-add is the difference between the average investor experience, as measured by the asset-weighted expense ratio of the entire mutual fund and ETF universe, and the lowest-cost funds within the universe.
Vanguard helpfully points out that simple math illustrates that when you pay less, you keep more, regardless of whether the markets are up or down. They call this a win-win for both the advisor and the investor.
Gross return minus costs (expense ratios, trading or frictional costs, and taxes) equals net return. Every dollar paid for management fees, trading costs, and taxes is a dollar less of potential return for clients. And, for fee-based advisors, this equates to lower growth for their assets under management, the base from which their fee revenues are calculated. As a result, cost-effective implementation is a "win-win" for clients and advisors alike.
Unlike in the rebalancing module, the math here is easier to see. Vanguard found that the average investor pays 37 bps annually for an all-bond portfolio and 54 bps annually for an all-stock portfolio. A balanced portfolio (such as 60/40) would have costs proportional to the percentage allocations.
For comparison, Vanguard states that the average investor in the least expensive funds can expect annually to pay 0.09% for an all-bond portfolio and 0.15% for an all-stock portfolio.
So Vanguard's advice to the advisor, and the marketing point to the client, is to invest in low-cost funds. Of course, this is in Vanguard's wheelhouse, since they are justifiably known for having some of the lowest-cost funds in existence. But that's OK: If it's true, it's true.
This chart illustrates that for the 60/40 portfolio, the cost advantage of low-cost funds vs. average funds is 0.335% per year, which is close to Vanguard's claimed 0.40% advantage to the client for using an advisor to implement the investment plan at low costs.
The extra savings, presumably, comes from the advisor finding other low-cost methods of implementation, such as avoiding sales commissions and 12-b-1 fees.
Behavioral coaching - 1.50% per year
This is the biggie. Vanguard suggests that the investor using an advisor gains 1.5% per year over and above the advisor's fee, which would be 2.5% above the average investor who is not using an advisor.
Based on a Vanguard study of actual client behavior, we found that investors who deviated from their initial retirement fund investment trailed the target-date fund benchmark by 150 bps. This suggests that the discipline and guidance that an advisor might provide through behavioral coaching could be the largest potential value-add of the tools available to advisors.
Since the advent of behavioral finance, there have been many studies about investor behavior, with nearly universal conclusions that investors are their own worst enemies, because they make irrational financial decisions. They chase performance and safety, causing them to buy high and sell low.
In "old" conventional theory, investors acted rationally and logically to increase their wealth. Information spread rapidly, and investors were fully informed rational actors unaffected by emotions in making financial choices.
But under the theories of behavioral economics, investors make mistakes and irrational decisions all the time.
According to Vanguard:
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-that is where you, as a behavioral coach to your clients, can earn your fees and then some. 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.[emphasis in original]
To quantify the impact of advisory coaching, Vanguard turns to its own study of more than 58,000 self-directed IRA investors for the 5 years ending in 2012. Their benchmarks for "correct" behavior are the applicable Vanguard target-date funds over the same period. Their reasoning is that the funds approximate the structure and guidance that an advisor might provide.
What they found was that investors who made fund exchanges during the period underperformed the target-date fund by an average of 1.5% per year.
Another way to look at the same phenomenon, which Vanguard also discusses, is via Morningstar's Investor Returns metric. In a nutshell, Morningstar calculates the difference between the returns that investors in particular funds actually receive vs. what the funds themselves achieve. They measure this by accounting for money flows into and out of each fund.
Their studies show that investors typically receive lower returns from their funds than the funds actually achieve. The shortfall, presumably, is based on irrational investor behavior - selling the fund when it is going down and buying it when it is going up, rather than simply leaving money in the fund. Cash flows from investors tend to lag fund returns; in other words, investors "chase" performance in both directions.
Per Morningstar, a fund's total return tells you how much its portfolio increased or decreased in value over a given period, whereas its investor return accounts for inflows and outflows, i.e., trading into and out of the fund. Total return assumes a buy-and-hold strategy, whereas investor return recognizes that investors often buy high and sell low. Investor returns tend to be worse than total returns. (For further information, see this article from Morningstar.)
Vanguard's suggestions to advisors about how to help clients behave better include:
- Education about the statistical outcomes of abandoning a planned investment strategy.
- Helping clients avoid the allure of market-timing and the temptation to chase performance.
- Persuading investors not to abandon the markets when performance has been poor.
- Dissuading clients from chasing the next "hot" investment.
- Building faith and trust with clients so that they will listen to you when bull- and bear-market periods that challenge investors' confidence are occurring.
Vanguard suggests that advisors, "…can act as emotional circuit breakers by circumventing clients' tendencies to chase returns or run for cover in emotionally charged markets."
Marketing point: "A single client intervention… could more than offset years of advisory fees."
Does Vanguard's Advisor Alpha Make Sense?
To me, whether or not to hire an advisor, or which one to hire, is basically a consumer decision with many similarities to decisions that we make daily. We figure out our need or desire for a product or service, shop around to see what is available, and arrive at a decision that matches our wants/needs with what is available.
But, of course, in another sense, whether or not to hire an advisor is unlike nearly all the other consumer decisions we make, because it is a decision with such huge implications.
We're talking about selecting and then engaging in a process that will determine whether you will have enough money for the rest of your life. The outcome will play a large role in determining not only your age of retirement, but also the quality of life in retirement.
Those kinds of stakes are way bigger than most consumer decisions. It's not like buying a food processor.
But it's still a consumer decision. Professionals are offering services. Individuals need to decide on whether to accept any of those offers, and if so, which one in particular looks the best.
Meanwhile, advisors are working hard on their value propositions to attract potential clients and keep the ones they already have.
For many, perhaps most, middle-class individuals, the question about financial advisors has an obvious answer: They will hire an advisor. They have to do it.
No matter how proficient they may be in their careers and professions, many people facing retirement subjects or investment questions are simply not equipped to deal with them. When it comes to personal finance, they don't have confidence in their ability to deal with investment options. They don't have the requisite understanding of what's available, how much money they need, how to plan things out, or how to choose. They are emotional about the whole subject.
I have many friends who absolutely need a financial advisor. Subjects like whether they have enough money, how to spend it, and how to invest lie far beyond their areas of interest and understanding. The specific value proposition of a particular financial advisor, to them, is almost beside the point: They simply must have an advisor. Without one, they would be in constant states of worry or panic about their financial situation.
Here at Seeking Alpha, we find a predominance of another sort of investor: The self-directed investor who knows or is learning a great deal about financial subjects, and who is not scared by them. Quite the opposite, they find such subjects fun and rewarding.
For such persons, many parts of Vanguard's Advisor's Alpha may seem almost silly.
- Rebalancing: Anyone can do that himself or herself, if you decide that it is worthwhile at all.
- Cost-effective implementation: Obviously, the biggest cost you can save is the cost of the advisor. It's like one of the little chance cards in Monopoly: "Add 1% to your returns every year for the rest of your life." Beyond that saving, one can use online brokers with rock-bottom commissions and purchase low-cost funds.
- Behavioral coaching: Some people simply do not need this. They either by nature or training don't panic at market drops; they stick to their plan and don't trade too much; and they don't need to be talked down from financial ledges.
The Vanguard study estimates the financial value of advisors' help and advice at 3% better net returns for the investor. Whether you agree with that estimate, there is no doubt that each "module" can be achieved without the help of an advisor if one is so inclined. All of the necessary information is available free, at Seeking Alpha as well of hundreds of investment-focused sites.
So in the end, the question of whether to hire an advisor is a matter of emotions, interests, and behavior. The math is a relatively small part of it.
My conclusion is that if someone needs an advisor emotionally and behaviorally, they probably will gain some measure of "Advisor's Alpha," at least compared to what they would accomplish without the advisor.
For those who don't need the assistance, hiring an advisor would be a waste of money, except maybe for a few specific questions that are beyond the reach of the individual. For those, an hourly rate would be fine, confined to the questions needing answering. There is no need for an annual fee that, compounded over many years, can amount to tens if not hundreds of thousands of dollars removed from your assets.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.