Can Advisors Add Alpha Without Using Active Management?

Last Updated Jan 19, 2011 12:01 PM EST

Can an advisor add alpha without using active management? The talented research team at Vanguard recently looked at this question in a paper titled "Advisor's Alpha." My Buckingham Asset Management colleague Kevin Grogan, who co-wrote The Only Guide You'll Ever Need for the Right Financial Plan with me, wrote a short summary of this paper.

One of the key findings in the paper is: "A financial advisor has a greater probability of adding value, or alpha, through relationship-oriented services, such as providing cogent wealth management and financial planning strategies, discipline, and guidance, rather than by attempting to outperform the market."

Many advisors try to sell their services based on outperforming the market. For advisors to add alpha, they need to convince potential clients they would do better than they would on their own or with a competing advisor. The paper found that "Left alone, investors often make choices that impair their returns and jeopardize their ability to fund their long-term objectives...this is evident in market cash flows mirroring what appears to be an emotional response-fear or greed-rather than a rational one." Advisors can help investors make the disciplined, difficult and hopefully emotionless decisions necessary to achieve their goals.

Advisors can also add value by smart portfolio construction and implementation by tailoring portfolios to match each client's ability, willingness and need to take risk. It will also be the portfolio that achieves the targeted risk exposures at the lowest cost.

Taxes are another major consideration for most clients. Advisors who understand asset location and decide between tax-exempt and taxable bonds will add value to their clients' portfolios. The paper found that "Clients who are in retirement often can benefit from tax-conscious guidance about spending from their portfolios. On their own, investors often spend first from their tax-advantaged accounts, and to some degree this is understandable since those accounts were explicitly set up for this purpose. However, it is generally more advantageous to spend from taxable accounts first, allowing the tax-advantaged accounts to grow as much as possible." Further, good advisors pay attention to taxes year-round, not just at year-end. Tax-loss harvesting opportunities that exist in March and April may not be there in December.

When selecting an advisor, I strongly recommend you read my post 11 Principles for Selecting an Advisor. This will give you the framework for making the decision.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.