Over the years there have been a ton of articles and studies about the value advisors bring to clients. And of course I am talking about real financial advisors, not the insurance salespeople masquerading as anything other than people slamming clients into high-commission products. Now that I have that off my chest I will focus.
The articles quantify why it makes sense for most people to work with a financial advisor. The most popular study is one by Vanguard. However, I was sitting through a presentation with a new custodian and they shared some findings from other studies. I figure I will marry them all together and share the highlights of what they aptly describe as Advisor Alpha. And I am going in order from least value to most.
- Our first item is rebalancing. Rebalancing is where you sell and buy within your current investments to get them back to the original allocation you have decided upon. Rebalancing can be done on a calendar basis or percentage basis (my choice). While there is a lot of emphasis on rebalancing, it only adds about .25% to your alpha. .25% in my world is 25 basis points, better known as bps and pronounced as bips.
- In second place we have expense ratios. This seems odd as I bang the drum on fees all the time. Obviously there is a bigger difference when it comes to expense ratios of 1.5% vs. .25% than .40% vs .50%. However, the studies take the approach more clients are landing in the lower expense ratio arena, which brings down the alpha of expense ratio. Expense ratio alpha adds a surprisingly low .34% to your alpha. I guess the message here is not to let the expense tail wag the investment dog.
- Next we have asset allocation. Here is where you put your money. You know, how much goes to Large Cap Value companies vs International vs Long-Term Bonds and more. Surprisingly, this brings little alpha to clients and comes in around on average around .40% (40bps). My head kind of broke when I saw this as all the old research said how asset allocation was the grail.
- Having proper risk alignment is ready to make its alpha appearance. The right amount of risk adds roughly .80% or 80bps of performance to your investments. Not too shabby.
- Let’s now talk about distribution strategies. This is where I spend a lot of time with clients. You know, should you take money out of your taxable accounts, tax-deferred or tax-free accounts first, later, or maybe never. Having the proper order for taking money out brings about .90% or 90bps more alpha. Now we’re talking value!
- The next two strategies are all about taxes. First, let’s talk about tax management. This could fall under a lot of different areas related to taxes, but in my world we are talking about tax management of investments. Things like tax-loss harvesting. This adds about 1.25% of alpha.
- Next on the tax theme is direct indexing. I will be honest as I do not do much of this…YET. Direct indexing is basically choosing individual stock positions. While most of my tax-management is via ETFs, direct indexing allows clients to get deeper into specific holdings and provides more tax impact. Direct indexing has been around for years, but the minimums to participate have been high. Fortunately, technology advances in my world are now resetting the minimums to much lower levels for people to do direct indexing. This will allow me to do more direct indexing. Alpha for direct indexing averages about 1.5%.
- The final item where advisor alpha comes into play is with behaviors. You know, things like keeping clients from doing things like timing the market or going to all cash when clients say “I have a bad feeling” or wanting to follow recommendations from CNBC. Basically, it is not only making sure clients stay consistent with their behaviors, but more importantly it is helping clients figure out their behaviors in the first place. The alpha here towers above all the previous ones. Studies show behaviors add anywhere from 1.5% to 2.75% of alpha. This explains why the average investor over the last 20 years has averaged 2.9% a year vs a 60/40 portfolio averaging 6.4%.
When you total this out having the right financial advisor could add roughly 7% to your performance over time. This is an eye-opening amount even to me. What is more surprising and what I really think is the important takeaway is maybe we need to spend less time fixating on the optimal asset allocation or rebalancing schedules and focus more on what is important about money to us. You know, figure out what your plan is and then be sure to focus on staying true to it when things get a little crazy, because they always do.
We can’t control what the market does. We can only control our behaviors, which is the biggest and most important source of alpha for us all.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.