April 11, 2014
What is the Value of an Investment Advisor?
Does hiring an investment advisor improve your portfolio returns? This question is often on the minds of our clients or prospective clients. The value of an advisor is often easier to describe than define numerically. Many clients find value in hiring an advisor to provide “peace of mind” and comfort that a professional is watching over their portfolio. This value can be difficult to quantify because it varies by client.
Value measurement – What is Alpha?
Investors have many tools available to evaluate the performance of portfolio managers. One such tool is the Jensen Measure, named after its creator, Michael Jensen. The Jensen Measure calculates the excess return that a portfolio generates over its expected return. This measure of return is commonly known as Alpha. Alpha is an elusive quality. Very simply put, it is the ability to beat an index fund without adding risk to a portfolio. Investment managers are always seeking it but rarely sustain it.
The academic evidence strongly suggests that delivering above-average returns without adding additional risk is extremely difficult or nearly impossible in the long run. However, most of what we read in the business news or watch on TV is directly aimed at uncovering the elusive manager able to “beat the market” and deliver consistent Alpha to investors. The fixation on market beating returns has often led to dire results for the average investor.
So how does an investor measure the value of an advisor who plans to match market benchmark returns? It’s a question that Vanguard set out to answer in a recently published paper for investment advisors titled “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha.” Vanguard explored the idea of advisor Alpha more than a decade ago. They recognized that the conventional wisdom of advisors providing value by “beating the market” was outdated and disproved by academic evidence. Interestingly, the areas of best practices for wealth management that Vanguard identifies are identical to the values we have been providing for clients for over 20 years. They are:
- Asset allocation
- Low-cost implementation
- Discipline and behavioral coaching
- Asset location
- Optimal withdrawal strategy
- Total return vs. income investing