Advisory-dependent assets have been growing for years, as affluent investors recognize the increasing complexities of investment management and financial markets. Underlying that trend has been a rapid migration from transaction-based to fee-based advice. This growth in fee-based practices has been a powerful client-driven phenomenon tied to three main catalysts.
Market trends: The investment business and the advisory relationship entail significant client inertia. The 1980s and 1990s produced strong absolute returns, often in the double digits. Such returns masked costs. But with equity and bond returns of this past decade significantly below historical averages, the catalyst was set to break that client inertia.
Benchmark visibility: Availability and awareness of market information has soared over the past decade, increasing the focus on relative performance. The reversal in market returns coincided with increased benchmark transparency, allowing advised investors to compare their returns to a relevant benchmark.
Changed expectations: Investors have increasingly put a high premium on trust, ethics and relationships. From the client's perspective, asset-based fees largely remove concerns about potential conflicts of interest in the advisor's recommendations, and in some cases, obligate the advisor to act as a fiduciary.
It is this shift in expectations that leads us to advocate for "advisor's alpha." It is you, the trusted advisor, who adds alpha through your relationship with your client. The sophisticated client understands that the advisory fee being charged in most cases is a "value-added" net expense for proper asset allocation, rebalancing, tax planning, distribution planning and behavioral coaching. It is your relationship with your client—the trust, credibility and confidence you build over time—that adds alpha. Building your practice around "advisor's alpha" rather than the ability to outperform the market will most likely lead to a very successful, long-tenured relationship that is mutually rewarding to you and the family you are advising.
A NEW BENCHMARK
Historically, many advisors based their value proposition on an ability to deliver better returns for the client—but better returns relative to what? For many advisors and clients, the answer would be "the market." But a more pragmatic answer for both parties might be "better than investors would likely do without a professional advisor."
The typical performance-chasing behavior is often injurious to returns. Indeed, the returns that investors receive may be very different from those of the funds they invest in. That's because cash flows tend to be attracted by higher returns (rather than precede higher returns.)
On average, for the 10 years ending March 31, 2010, fund investors trailed a moderate policy allocation by 0.65 percentage point (65 basis points) per year, according to Morningstar. The advisor's alpha target, then, might be to improve upon this return shortfall by means that don't depend on market outperformance: asset allocation, rebalancing, tax-efficient investment strategies, cash flow management and, when appropriate, coaching clients to change nothing.
ADVISOR'S ALPHA ATTRIBUTES
No matter how great the advisor's investment acumen, the path to better investment results may not lie with the ability to pick investments or strategies. Instead, advisors should consider whether they can add alpha employing the following client-centric approaches:
• First, develop a well thought-out asset allocation plan, the primary driver of a portfolio's risk and return. The knowledge that the asset allocation was determined after careful consideration of the investor's circumstances, rather than by haphazardly buying funds with attractive recent returns, can serve as an important emotional anchor during those all-too-frequent uprisings of panic or greed in the markets.
• Second, implement that plan. Which investments will go in each asset bucket? Does the investor understand the relationship between risk and reward? Between cost and performance? Will active or passive strategies be used? Using history as a guide, index funds often provide higher returns and lower volatility over time relative to actively managed funds in the same category.
• Third on the list is maintenance. Since the markets are rapidly changing, in order to "stay the course," the advisor must rebalance the portfolio to maintain the asset allocation target. This is extremely difficult for many investors to do on their own. Not only are they unlikely to sell their "winners" to buy "losers," but they may also add to the winning asset class, knocking their allocation further out of kilter.
• Fourth is implementing tax-efficient strategies. Tax-conscious financial planning and tax-efficient portfolio construction are of great value to affluent investors. Advisors can improve clients' after-tax returns through asset location (placing the most tax-inefficient investments in tax-sheltered accounts) and tax-conscious drawdown strategies.
• Finally, advisors play a role as behavioral coaches. They can act as emotional circuit-breakers in bull or bear markets by circumventing their client's tendencies to chase returns or run for cover in emotionally charged markets.
A TIME OF TRANSITION
Investment performance can be deconstructed into three parts: the portions of return attributable to the market (that is, beta), to market-timing and to security selection. The latter two are specific to active management. Historically, many investment advisors have sought to add value through market-timing and security selection, despite the mounting data suggesting that these efforts are extremely challenging.
In the past, the passive portion of investment performance—the beta return—was viewed by many as leading only to "average" returns and requiring no investment skill. Today, ironically, the capturing of beta has become a cornerstone for leading financial advisors who routinely incorporate index funds or exchange-traded funds in their recommended portfolios.
This transition has been facilitated by at least two factors. First, the "democratization of indexing" via ETFs brought a plethora of index-oriented investment opportunities to anyone with a brokerage account. Second, the aforementioned move toward fee-based holistic investment guidance. In our view, it is these disciplined advisors who are best positioned to add value to their client relationships.
The compensation structure for advisors is evolving from a commission and transaction-based system to a fee-based, asset management framework.
In our view, for the reasons cited, we believe this is a mutually beneficial transition for clients and advisors. We expect this trend is in the early stages and will continue to gain traction.
Francis M. Kinniry Jr. is a principal in Vanguard's Investment Strategy Group.
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