Do financial advisors really add value?
In the field of finance, added value is defined as ‘α’ (alpha). Alpha identifies how an investment manager can combine securities into a portfolio that provides excess returns to investors while not taking on more risk. Simply stated, achieving alpha means earning more money than expected. Investors typically achieve alpha either by timing market trends correctly or picking winning individual securities. For example, if you invest with an advisor who charges a 1% (100 basis points) annual fee and who earns 2% alpha, your net gain is 1%. In other words, you have earned a total of 1% more (net of fees) by hiring this manager as opposed to simply investing directly in the benchmark (i.e. S&P 500). Sounds great in theory, but in practice, it is very difficult to achieve consistent alpha, so difficult in fact that almost 90% of all active funds underperformed their benchmarks during a 15-year period ending December 2016, (Jeff Bukhari, FORTUNE, April 13, 2017) which explains the increasing popularity of index funds. We’ll save the discussion on the merits of index investing for another day. Today, we are interested to know, apart from the traditional financial advisor value proposition of promising to ‘beat’ the market, how else do advisors add value? And what is ‘advisor alpha?’
According to Vanguard, the concept of advisor alpha outlines how advisors can add more consistent value through wealth management in the form of financial planning, behavioral coaching, and ongoing guidance and handholding. And as to the question, do advisors really add value, research from several organizations including Vanguard, Morningstar, Aon Hewitt, and Envestnet strongly suggest that they do, both in terms of improving means and quality of life.
The chart below estimates the quantifiable value add of financial advice, after accounting for advisor fees.
Source: Derek Tharp, Kitces.com
But advisors only add value when clients know what to look for when choosing a good wealth-management partner. Our natural tendency, when choosing an advisor, will be towards those offering complex solutions or those who lead with bold claims of outperforming the market when, in truth, the best solutions are often the simplest and very few money managers ever outperform the market on a consistent basis. But what the research shows very clearly, more than managing investments, the greatest value advisors provide is in the form of behavioral coaching, ongoing guidance, and basic hand holding, especially during times of greed, fear, and sudden life changes.
Source: Vanguard Advisor’s Alpha Study, June 2016
As Vanguard has suggested in its research, while advisor-alpha is real and quantifiable, the benefits of advice are typically disproportionately experienced during times when rational decision-making becomes most difficult; greed, fear, and sudden life changes.
As it turns out, financial advice does add quantifiable value (net of fees), but there are limitations to the research. The reality is that in some cases the ‘best advice’ may result in sacrificing financial gains for other ends (for instance, psychological comfort, family goals, etc.) Just remember, think twice about the advisor who leads with complex and flashy promises of outperforming the market, and instead seek to partner with an advisor, preferably a Certified Financial Planner (CFP) professional, that will engage you with empathy and a measured-pace to understand your unique goals and challenges, and then focus on controllable factors proven to increase alpha, like costs, tax-efficiency, simplification, and ongoing guidance.
Donald G Bennyhoff, CFA / Francis M Kinniry Jr., CFA “Vanguard Advisor’s Alpha” June 2016
Daniel Crosby, Ph.D, “Behavioral Alpha: The True Power of Financial Advice” October 17, 2016
Wade Pfau, Ph.D., CFA “The Value of Financial Advice” July 21, 2015
David Blanchett, CFA, CFP® / Paul Kaplan, Ph.D., CFA “Alpha, Beta, and Now…Gamma” August 28, 2015