However, that certainly is not meant to imply that we do not provide value for our clients when we manage their portfolios. On the contrary, that value is enormous. It’s just that it cannot be accurately measured. Most of us are familiar with Dalbar. In the 2014 update to the company’s Quantitative Analysis of Investor Behavior report, Dalbar conclusively demonstrates that average investors continue to chase investment returns to the detriment of their pocket books. Most likely motivated by fear and greed, investors pour money into equity funds on market upswings and are quick to sell on downturns.
Not surprisingly, most investors are unable to time the market and they may be left with equity fund returns that are lower than inflation. Since the inception of Dalbar’s report in 1984, the average equity investor earned a paltry 3.69% annually, while inflation was 2.8% and the S&P 500 index earned 11.11% annually for 29 years (1984-2013). And of course, this huge difference between investors’ returns and market returns is most likely due to individual behavior, particularly during down markets.
So it is not necessary for financial advisors to tell clients that beating the market is their primary value. Dalbar has demonstrated that, when left on their own, average investors got returns that were more than 8.3% lower than the market! As advisors, you do not need to beat the S&P to deliver value to your clients. You provide discipline. You see to it that they don’t overreact to market swings. You stop them from doing the things that average investors do that cause them to get inferior returns. (How many advisors protected their clients from overreacting during the 2008-2009 downturn?)
Yet there are far too many planners who diminish the importance of this discipline and judge themselves on their ability to beat some index. They fear clients won’t pay their fees if they don’t. They feel they must provide “alpha,” which they define as the return over some arbitrary benchmark that has nothing to do with their clients’ goals. And that alpha must be higher than their fees, or their clients will fire them.
By trying to justify the fees they charge by using some quantitative measurement, they may be setting themselves up for failure. We all know the technical definition of alpha, but financial life planners need to define it differently for their clients.
First, if we look at what we do quantitatively, the return we provide should be better on a risk-adjusted basis than what the clients’ would have gotten if left on their own—not a return above some index. However, that is very difficult to measure because we have no way of knowing what their results would have been had they not engaged our services. But Dalbar has certainly provided us with a clue of how well the average do-it-yourself investor does. In fact, if the return of the equity portion of the portfolios you managed for the period studied by Dalbar were 2% below the S&P, you still would have benefited the average investor by over 6% per year. We know of no advisor who is charging 6%!
However, if we stray from the technical definition of alpha and define it as “value we provide for our clients,” then the term takes on a much broader meaning and defines who we are as financial life planners and what we do for our clients. Alpha, if we insist on a quantitative measure, could be reaching or exceeding the client’s financial goals.
Alpha For Financial Life Planners
August 4, 2014
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Comments
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I also want to point out that the DALBAR study does NOT differentiate between kinds of investors (individual vs. advisors vs. institutional, etc.). Data is not kept the way everyone seems to think it is and so that kind of differentiation is impossible. The DALBAR study simply looks at asset flows into and out of mutual funds, creates returns based on when assets are and aren’t invested, and then compares those returns with the underlying returns of the mutual funds themselves (basically a dollar-weighted return vs. time-weighted return analysis). Morningstar does the same thing with its Investor Return vs. investment return. It’s certainly telling, but what it’s telling us is that individuals AND professionals all are horrible at timing when to get in and out of mutual funds. The scary thing is that since the vast majority of assets are controlled by professional investors, what the study really says is that the professionals in charge of the majority of wealth in the world make really bad decisions on a very regular basis! Sorry, Roy, I wish I had nicer things to say about your post.
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I agree that planners provide services that are difficult if not impossible to measure in a way that could ever justify a percent-of-assets-under-management fee structure, but isn't that the exact reason why charging a % of AUM makes no sense at all for planning services? Why should a client pay a % of assets for one-off pieces of advice like whether to buy or lease a car, refinance their mortgage, or fund an endowment for their alma mater? No, those services should be paid for via an hourly rate, and once those services are rendered and the fee charged, that's it…go find more advice-giving business. Ongoing fees for infrequent services and advice are great for the planner, but totally unfair for the client. Why clients don't complain is a function of an informational disadvantage on their part rather than satisfaction with the relationship. And the benefit for planners of that compensation arrangement is exactly why planners (and accountants, and lawyers, etc.) have gotten into the asset management business over the years. It’s high time someone called them out on it. Stick to an hourly rate and justify it however you think is appropriate. A %-of-AUM fee should only be charged for portfolio management services, and those services are most definitely measurable relative to a mutually agreed upon benchmark. That benchmark should reflect the level of risk to which the advisor will subject the portfolio, and measurement against that benchmark should include all fees and costs of management. If over time the advisor can offer returns near that benchmark, the client should be perfectly happy. As Roy points out, one doesn't need to beat the benchmark necessarily, since the advisor has at least saved the client the trouble of investing on his/her own and that's worth something. But measurement is crucial so that if one falls noticeably short of the benchmark, clients should inquire as to why and consider having someone else manage the portfolio or do it themselves. This notion that portfolio management services can’t or shouldn't be measured against a benchmark is ridiculous…and is the argument I would expect from someone who has a reason to hide from performance measurement. And while I’m criticizing, let me also point out that planners tend to include accounting and estate planning advice as services they provide (and charge that AUM fee on) when their disclosure materials all say they are not accountants or lawyers and therefore cannot provide such advice. Why is this, and why do their clients continue to pay a % of AUM for “advice†that is indirectly related to the AUM and cannot even be offered?! ? What usually happens is the planner “quarterbacks†such advice and refers their clients to accountants and estate attorneys to whom the client then pays hourly or service-related fees. While it might be appropriate for a planner to charge a referral fee in such instances (I don’t approve of the referral fee thing, either, by the way), but including accounting and estate planning services as part of what the services included in a % of AUM fee is highly dishonest and should be illegal. Leave accounting advice to CPAs and legal advice to the lawyers. It’s their careers on the line, not the planner’s, so they should receive the fruits of their labors rather than some “quarterback.†Sorry, Roy, I just don’t think you could be more wrong.
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Bravo - well thought out article. Thank you for the perspective on alpha. Right on!