In 2001, Vanguard introduced the concept of Advisor Alpha, a method by which advisors can attempt to quantify their value or, at the very least, be aware of the areas where we can maximize value for clients.
Recently, in a September 2016 white paper, “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha,” Vanguard expounded upon their latest thinking in this area.
We find this subject vital because it helps us better understand where to focus. Our priority needs to be at the intersection of what’s important and what we can control. Because we can’t predict the future, we instead need to know what to emphasize and how to adhere to a long-term plan.
Vanguard breaks Advisor Alpha into seven “modules.” In a note we sent you on September 26th, we focused on the first three – asset allocation, cost-effective implementation and rebalancing. In this email we will focus on the final four – behavioral coaching, asset location, withdrawal order for client portfolio spending and total return investing.
Behavioral coaching, the fourth way advisors add value for their clients, is perhaps the most impactful, adding 1%-2% to returns according to Vanguard’s analysis. Advisors must establish trusting relationships with clients before times of market euphoria or stress, so they can properly influence client decisions.
It’s a fact that investing has a counterintuitive component. When the market is gripped by fear, it is often a great time to buy, yet also an emotionally difficult decision. The opposite is also true, that when markets are firing on all cylinders, it can be hard to reduce equity exposure because of the fear of missing out.
Vanguard calculates that its average large cap blend fund returned 6.44% annually in the ten years ending December 31, 2015, but that the average investor in these funds only earned 5.06%. The 1.38% shortfall results from poor timing as investors moved in and out of the funds at inopportune moments. These results are similar to other studies, like Dalbar’s, which shows a far larger deficit of actual investor returns versus the returns of underlying funds.
The fifth factor is asset location, the allocation of assets between taxable and tax-advantaged accounts. First, we always analyze client tax brackets to judge whether to use tax-free municipal bonds in taxable client accounts. This can be an important factor in boosting after-tax returns. Next, when rebalancing a client relationship, we can look to take a larger amount of capital gains from tax-deferred accounts, so investors can avoid these taxes.
Furthermore, as individual stock and bond investors, we can strategically take gains and losses in taxable accounts when it suits each client’s specific tax circumstances. Vanguard estimates that proper use of asset location can add up to 0.75% to client returns.
Withdrawal order for spending, which can add another 1.10% to investor returns, is the sixth component of Advisor’s Alpha. When completing Retirement Income Evaluations for clients, we analyze the buckets from which a client funds his or her retirement in order to minimize taxes and get the most “bang for the buck.”
A generic example involves funding retirement initially from taxable accounts, maximizing Social Security payments and waiting until age 70 and 1/2 (or the year after) to take one’s first IRA withdrawal (the legally mandated required minimum distribution, or RMD).
A few other considerations that vary depending on the client’s situation are reducing income by donating an RMD directly to a charity; carefully considering which assets will receive a step-up in cost basis at death (and therefore not liquidating them to fund retirement); preserving Roth IRAs for heirs; and determining the best assets from which to make gifts.
Finally, Vanguard highlights the importance of total return investing, i.e. taking a long-term approach to generating returns from a combination of interest, dividends and appreciation. Although Vanguard doesn’t quantify a percentage value-add for this component, they argue that overweighting purely income-producing assets like long-term bonds, high yield debt, preferred stocks and dividend-paying equities to generate enough pure dividends and income to cover distributions can result in underperformance – particularly if these securities are out of favor for an extended period.
A diversified, balanced approach to investing will lead to less volatility and therefore less temptation to bail when things get difficult because a disciplined process controls volatility and helps calm emotions. Furthermore, a total return portfolio, particularly an approach like ours that is built around individual securities, can be more tax-efficient as we take advantage of favorable long-term capital gains tax rates.
Although wordy to explain – over two emails – we see these seven modules as critical to serving you. We are grateful for your support and we are always working to develop and deliver the highest level of expertise to our clients. It’s a complicated world . . . and now more than ever, a knowledgeable advisor is worth the investment.