An article by Vanguard Research published in March, 2014 set out to quantify the potential value-add provided by financial advisors. In this article, I will summarize the key areas of value-add and explain Brightwood Venture’s investment process steps designed to capture this value.
Before beginning, it is important to point out that measuring results can be difficult. Each investor’s circumstance is unique. In addition, the value-added can vary by year, based on the client’s situation. For example, if a client is selling investments to help fund a vacation home, the tax planning for that situation may have a large impact that year. Finally, the elements for the value-add interact with each other so final expected value-add is set lower than the sum of the individual components.
Asset Allocation
Estimated Benefit: > 0%
Asset allocation is the mix of investment classes that make up your total investment portfolio. Numerous studies have shown that asset allocation is the single largest contributor to investor returns. The value we can add with proper asset allocation comes in several forms. First, by adding the right asset classes we look to provide diversification benefit. Namely, higher returns for the same level of risk. There is an even more subtle benefit that arguably provides the largest long-term benefit. By building a financial plan that matches your unique circumstance we can model the right risk-return mix to ensure a high confidence that your retirement plan will work. Translating that to a specific annualized return is difficult. Think of this allocation step as optimizing the probability of your ability to retire when you want with how much you want.
Cost Effective Investments
Estimated Benefit: .45%
Investment expense ratio may be the single largest factor in predicting returns. The average mutual fund under-performs it’s benchmark by it’s expense ratio. This makes sense. When we add all funds together we have the entire market. If funds had no expenses, on average they should return the same rate as the market. After expenses and excess cash positions they under-perform. In addition, many investors don’t realize that brokers and mutual funds may add 12b-1 fees for ‘marketing and distribution expenses’. What does this mean? It means your broker may be accepting fees (or commissions) that you are paying by way of higher expenses in your funds. Brightwood Ventures is fee-only. We do not take any compensation from the investments we make. In addition, we use low-cost ETF and mutual funds that have expenses below industry average. (Morningstar reports that the average fund fee was .71% in 2014).
Rebalancing
Estimated Benefit: .35%
Over time with changes in investment value, the investment portfolio diverges from the target asset allocation. Rebalancing is the process of buying /selling shares to bring the asset classes back in line with the initial allocation. The process sounds straight forward, but many investors (and for that matter brokers) don’t routinely rebalance. Worse yet, behavior factors come into play. When the market is nearing its peak, inflows increase and when the market has fallen outflows peak. With our client portfolios we review accounts quarterly and rebalance periodically. The rebalancing decision is based on tax situation, deviation from the policy portfolio and market conditions.
Behavioral Coaching
Estimated Benefit: 1.5 %
Behavior bias plays a huge role in individual investor decision making. The impacts from irrational behavior are too numerous to cover in this article, but I will mention a few. First, as noted earlier, investors tend to time the market poorly. Investors perform several percentage points lower then the market based on buying at the market top and selling at the market bottom. Investors tend to hold on to losing investments and sell winning investments too early. Investor’s are over-confident in their ability to project investment prospects. In practice, I have seen a wide range of emotional and analytic errors that would otherwise lead people to poor investment choices. How do we manage this? First, we build allocation models and stick to them. We don’t manage risk after the fact, we manage it in advance. Second, we use quantitative models and do our best to make decisions based on advanced plans.
Asset Location
Estimated Benefit: 0 – .75%
Asset location is the term we use to describe where we place specific investments. Most investors have a mix of taxable accounts, tax deferred and sometimes tax-exempt accounts. By selecting the right location for assets we can impact the after-tax returns that will be realized. We model these impacts using cash flow analysis and tax projections.
Distribution Planning
Estimated Benefit: 0 – .70%
Distribution planning refers to the order in which we withdraw funds from accounts to cover requirement minimum distributions and/or living expenses or purchases. For those clients in high marginal tax brackets with significant assets in both taxable and tax-deferred accounts the impact can be large. We look at the client’s overall situation, including assets that we are not managing, and provide input on the order of withdrawals to minimize tax impacts.
Source: “Putting a Value on Your Value: Quantifying Vanguard Advisor’s Alpha”, Vanguard Research. March 2014