Published On: September 29, 2016
Written by: Ben Atwater and Matt Malick
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 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 plan.
Vanguard breaks Advisor Alpha into seven “modules.” In this note, we are going to focus on the first three – asset allocation, cost-effective implementation and rebalancing.
It’s been well known in academic circles for some time that the most important determinant of variability (risk) and performance (return) is asset allocation. We take a traditional approach to allocation.
We see stocks as a risk asset and high-quality bonds as the most consistent diversifier of equity volatility. When allocating clients between stocks and bonds, we test various asset allocations against projected income scenarios and work to determine – as a starting point – what is the lowest level of risk a client can assume and still meet their goals. In other words, how much equity does someone need to meet their long-term goals and how much can we invest in relatively less volatile bonds?
Vanguard puts it as well as anyone: “Complexity is not necessarily sophisticated, it’s just complex. Simple is thus a strength, not a weakness, and can be used to promote better client understanding of the asset allocation and of how returns are derived. These features can be used to anchor expectations and to help keep clients invested when headlines and emotions tempt them to abandon the investment plan.”
Therefore, regarding asset allocation, we need to 1) create a plan; 2) periodically test that plan against client goals; and 3) stick to that plan regardless of market volatility. If we can achieve these three things, then our clients have a higher likelihood of achieving their goals.
Next, let’s look at the three components of cost-effective implementation: 1) fees and expense ratios; 2) trading costs; and 3) taxes. From the beginning, we designed our investment philosophy to be effective in these three areas.
We are fee-only advisors, so we don’t collect any sales commissions, and our custodian’s trading costs are among the lowest in the industry. Furthermore, since we manage individual stock and bond portfolios, we avoid product-level fees (e.g. mutual fund or exchange-traded fund expense ratios), which means our clients only pay an account-level management fee. Very few advisors manage their own portfolios, resulting in a second layer of product fees for clients. In most cases, purely from a fee perspective, we offer substantial savings over other advisors.
We seek to minimize trading costs and taxes as well. Since we are long-term investors, we do not trade frequently, reducing trading costs and capital gains taxes. Funds distribute capital gains annually as a matter of course, whereas we have complete control over whether to realize capital gains in any given year. And additionally, we have the ability to harvest tax losses when it is appropriate. Our use of individual securities (including tax-free municipal bonds) in taxable accounts offers us a highly unique ability to control tax consequences.
With our single fee, low turnover and control over when and where to realize capital gains, our approach is cost-effective, meaning our clients can realize higher net-of-fee and after-tax returns.
The third and final module we will touch on today is rebalancing. Vanguard points out that “the true benefit of rebalancing is realized in the form of controlling risk.” In other words, in an ideal world, we hope to be adding to bond exposure after periods of stock outperformance, so that the next correction or bear market isn’t as brutal.
For example, if a client’s target allocation is 60% in stocks and 40% in bonds, then after a good stock market run, the client may now be invested 65% in stocks and 35% in bonds, potentially requiring a rebalancing of the client’s accounts.
We monitor allocations as interest and dividends post, when clients add to accounts, when maturities occur or any other cash flow event. It is better to incrementally rebalance versus a wholesale and deliberate rebalance (especially in taxable accounts because of capital gains considerations).
Again, Vanguard sums-up well how we incrementally rebalance for clients: “Advisors who can systematically direct investor cash flows into the most underweighted asset class and / or rebalance to the ‘most appropriate’ boundary are likely to reduce their clients’ rebalancing costs and thereby increase the returns their clients keep.”
Our accounts are not synched to computers that “rebalance” for us and generate unnecessary trades and realized capital gains, which is harmful to long-term returns. Rather, we rebalance along the way and we make the uncomfortable decisions about buying stock when the market is correcting or trimming stock positions when equities have outperformed. Rebalancing sounds easy in theory, but it’s much tougher in practice.
Vanguard points out that “the task of rebalancing is often an emotional challenge. Historically, rebalancing opportunities have occurred when there has been a wide dispersion between the returns of different asset classes (such as stocks and bonds). Whether in bull or bear markets, reallocating assets from the better-performing asset classes to the worse-performing ones feels counterintuitive to the ‘average’ investor. An advisor can provide the discipline to rebalance when rebalancing is needed most, which is often when the thought of rebalancing is a very uncomfortable leap of faith.”
Our willingness to rebalance at unpopular times and our ongoing efforts to rebalance accounts as cash flows occur add value for our clients in the same way that asset allocation and cost efficiency do. Accomplishing one of these is not enough. We need to do all three well to offer you a compelling value. So far, we’ve been largely successful in these areas and we will continue to work on “perfecting” our approach.
Please visit www.atwatermalick.com/ria for full disclosure materials related to recommendations contained in this update.