Financial advisors who charge investors a percentage of assets every year need to justify their fees. They find ammunition wherever they can. DALBAR publishes a report every year showing that investors at large, presumably without an advisor, earn drastically lower returns than the market returns. Now we know the DALBAR reports simply compare apples to oranges. See A Warning to the Advisory Profession: DALBAR’s Math is Wrong by Wade Pfau on Advisor Perspectives.
Even DALBAR admits the large difference between the investors’ returns and the market’s returns has nothing to do with professional management. It’s not their problem when other people misinterpret the results. From DALBAR’s response to Wade Pfau:
At no point has this study stated or implied that the difference in returns had anything to do with professional management.
When one myth is debunked, financial advisors who need to justify their asset under management fees move to something else. They point to a report from Vanguard on Vanguard Advisor’s Alpha®. While DALBAR only puts out two numbers and leaves others to mis-attribute the large difference to professional management, Vanguard directly quantifies the value of having an advisor. From the Executive Summary:
We believe implementing the Vanguard Advisor’s Alpha framework can add about 3% in net returns for your clients and also allow you to differentiate your skills and practice.
The “you” above means the advisor. And from page 3 of the report, in bold:
Paying a fee for advice and guidance to a professional who uses the tools and tactics described here can add meaningful value compared to the average investor experience, currently advised or not.
Like DALBAR, Vanguard leaves others to interpret the implications of the extra 3%. It’s easy to go down this path:
See, I’m adding value worth 3% a year. You are getting a great deal in paying me only 1%.
Such interpretation is wrong. It prays on people’s misunderstanding of fundamental economic concepts. Even if we take Vanguard’s number at face value, that having an advisor adds 3% a year, it doesn’t mean investors are getting a great deal when they pay 1% a year. In economics the split in value between consumers and producers doesn’t need to be 50:50 or 2:1. In many cases even 90:10 is too generous to the producers.
It’s easier to understand with an example. You probably heard of meal kit delivery service Blue Apron. They send you boxes of food ingredients and recipe cards as a subscription. If Blue Apron points to a study showing that not eating for seven days straight causes great damages to your health and therefore their boxes are worth $10,000 each, you’d have a good laugh.
The alternative to Blue Apron boxes isn’t starving yourself. It’s buying from other meal kit delivery companies or the grocery store or simply eating out. Therefore Blue Apron’s price has to be compared to other meal kit deliveries or the grocery store or restaurants. The health damages from starving is simply irrelevant. The customers are not going to starve anyway.
Similarly, the alternative to having a financial advisor who charges a percentage of assets is not flailing and making all kinds of mistakes on your own. It’s having an Advice-Only financial advisor and still receiving all the benefits from having an advisor. The cost of mistakes from bad asset allocation, expensive funds, buying high and selling low, etc. etc. is not relevant in justifying a 1% fee, just as the health damages from starving are not relevant to the price of meal kits. For the most part, the Advisor’s Alpha belongs to the investor.
The Vanguard report breaks down the 3% Advisor’s Alpha as follows:
|Suitable asset allocation using broadly diversified funds/ETFs||> 0%|
|Cost-effective implementation (expense ratios)||0.4%|
|Asset location||0% – 0.75%|
|Spending strategy (withdrawal order)||0% – 1.1%|
|Total-return versus income investing||> 0%|
Even if we accept 3% is the right number, no part of it is exclusive to advisors who charge a fee on assets under management. Let’s take a look at how an Advice-Only financial advisor delivers each component of the Advisor’s Alpha:
1. Suitable asset allocation using broadly diversified funds/ETFs
The Advice-Only financial advisor recommends suitable asset allocation using broadly diversified funds/ETFs after reviewing your accounts.
2. Cost-effective implementation (expense ratios)
The Advice-Only financial advisor recommends low-cost funds/ETFs.
The Advice-Only financial advisor tells you how to rebalance in follow-up reviews. You only need to rebalance once every few years anyway. See What About Rebalancing And Tax Loss Harvesting When I Go Advice-Only?
4. Behavioral coaching
This accounts for half of the Advisor’s Alpha but it’s also a weird one. Do you really need someone with good knowledge about investing or tax rules to deliver behavioral coaching? Is there any evidence that financial advisors are good at behavioral coaching?
An Advice-Only financial advisor can do behavioral coaching just as well as an advisor who charges asset under management fees. Many Advice-Only financial advisors send educational newsletters to clients.
5. Asset location
The Advice-Only financial advisor tells you what assets to hold in which account.
6. Spending strategy (withdrawal order)
The Advice-Only financial advisor tells you how much to withdraw from which accounts.
7. Total-return versus income investing
The Advice-Only financial advisor tells you how to invest for total returns, not just for income.
The Advisor’s Alpha may be real but it has nothing to do with how much an investor should pay. You still get the Advisor’s Alpha when you work with an Advice-Only financial advisor. It’s similar to how both index funds and actively managed funds deliver the market’s returns. In this regard the Advisor’s Alpha should be called the Advisor’s Beta. Financial advisors who charge a percentage of assets have to show how they are so much better than Advice-Only, similar to actively managed funds having to show how they are so much better than index funds, which we know as a group they can’t.
There may be some great advisors who do so much better than Advice-Only, but just pointing to the 3% Advisor’s Alpha doesn’t do it. That 3% Advisor’s Alpha belongs to the investors who work with an Advice-Only financial advisor.