What is A Financial Advisor Worth?
Often clients try to quantify what good financial advice is worth. After all, how do you determine if the value of the service is greater than its cost? However, this is a tricky proposition, as it depends on how you define “good”. Nevertheless, several reports have broached this topic and I have attempted to give a brief overview of the strengths and weaknesses of a few that I believe are quite substantive. Clients should aim to understand these reports in the context of their own personal situation. Identify your own personal areas that require the most support and think about if you are are getting all of the focus that you need.
Quantifying A Financial Adviser’s Value Added
The goal of a financial advisor is to advance a client’s well-being with financial advice. For a client, understanding what a financial adviser does and assessing that value is essential to determining if the service is worth the cost. If the only thing a financial adviser did was to manage a portfolio, you could relatively easily quantify the portfolio returns and risk (volatility) to determine whether that adviser was worth the cost.
However, a financial adviser does a lot more than manage the portfolio. In fact, some advisers completely outsource portfolio management to third party investment management firms to focus on the more nuanced aspects of their job. In my eyes, great financial advice starts with understanding a client’s situation and navigating to appropriate strategies that could involve tax (asset allocation, tax loss harvesting), financial planning (structure of investments, withdrawal sequence, portfolio management), estate planning, risk assessments (insurance) and legacy issues (charitable giving).
As one might imagine, as you get into details … it gets complicated. For instance, quantifying value largely depends on defining the end goal (which itself is subjective). Is the client’s goal more wealth or less risk? For instance, what if you can increase a client’s financial security by purchasing more insurance, which would reduce risk, but raise costs that would likely lead to less tangible wealth? Even when you define a goal, what is that goal compared to? It is easy to quantify actual results using a financial adviser; you can only speculate what results would have been in absence of financial advice.
There are many financial studies that attempt to quantify a financial adviser’s worth in areas that the authors believe produced tangible value. I have chosen to highlight three studies that I consider very thoughtful and well-researched.
|Vanguard Adviser Alpha (1)||Morningstar Gamma (2)||Envestnet Capital Sigma (3)||Category Potential Value Added (4)|
|Tax Loss Harvesting||–||–||1.00%||1.00%|
Low Expense Funds
|0.40%||0.82-0.85%||0.40 – 0.85%|
|–||0.70%||>0.50%||0.50 – 0.70%|
|Tax Effective Withdrawals||0.0 – 1.10%||0.23%||–||0.0 – 1.10%|
|Rebalancing||0.35%||–||0.44%||0.35 – 0.44%|
|Asset Location||0.0 – 0.75%||0.10%||0.0 – 0.75%|
|Asset Allocation||>0.00%||0.45%||0.28%||0.00 – 0.45%|
|Total Return vs. Income Investing||>0.00%||–||–||>0.00%|
|Total||+/- 3.00%||+1.59%||+/- 3.00%|
- Kinniry, Francis, Colleen Jaconetti, Michael DiJoseph, Yan Zilbering and Donald Bennyhoff, “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha”. Vanguard Research, September, 2016.
- Blanchett, David and Paul Kaplan, “Alp[ha, Beta, and Now … Gamma”. Morningstar Investment Management, August 28th, 2013.
- Envestnet Quantitative Research, “Capital Sigma: The Return on Advice”. Envestnet, 2016,
- Sapling Wealth Management.
A similar study that tilts slightly more towards analyzing investment performance, was published by individuals in Vanguard’s research department after studying approximately 58,000 self-directed Vanguard IRA accounts. The authors of the Vanguard report state that over time the annual value of an adviser averages to be “about 3% in net returns”. The authors also note that in two additional areas, diversification and total return investing, there could be additional value added, but it was too unique to each investor to quantify.
- Interesting Aspects of This Report: This report attempts to quantify an adviser’s value in five primary areas: (1) lower expense ratios; (2) rebalancing; (3) behavioral coaching; (4) asset allocation; (5) spending strategy (withdrawal order). The area that added the most value, by far, is behavioral coaching (about 50% of the total 3.00% in annual value over time). Vanguard’s research team analyzed 58,168 self-directed IRA investors from 2008-2012 and found that the average investor who made “even one” exchange over this period underperformed the benchmark target-date funds by 1.50% annually. The report simply states, “abandoning a planned investment strategy can be costly” and “the amount of potential value an advisor can add here is large.” Vanguard notes that when acting as behavioral coaches, advisors can be an “emotional circuit breaker” that prevents the impulse driven investing decisions of chasing returns (bull market) and running for cover (bear market).
- Potential Criticism of This Report: The area that added the most value in the study (behavioral coaching) does necessarily apply to all investors. Vanguard notes that investors who did not make any exchanges over the five year period only trailed the target-date fund benchmark by (0.19%), a statistic that is materially lower. Therefore, behavioral coaching may not add as much value for investors that are able to stick to their investment strategies in every type of market environment. Additionally, other metrics (such as investment management fees, tax advantages) may not always apply to individuals already attentive to these issues.
In the report titled “Alpha, Beta, and Now … Gamma” David Blanchett and Paul Kaplan of Morningstar found that the benefit of financial advice for retirees generated 22.6% more “certainty-equivalent Income”, which they estimated was approximately same impact as increasing a portfolio’s return by +1.59% per year.
- Interesting Aspects of This Report: The most interesting aspect of this study was that the potential increases in returns are derived from five fundamental financial planning techniques: (1) optimal asset allocation; (2) dynamic withdrawal strategies; (3) incorporating guaranteed income products; (4) tax-efficient decisions; and, (5) liability-relative asset allocation optimization. None of these strategies are dependent upon security selection in a portfolio. Morningstar deliberately designed “Gamma” to measure “the value added achieved by an individual investor from making more intelligent financial planning decisions”.
- Potential Criticisms of This Report: An important aspect to understand in this report is that Morningstar is estimating the increase in economic utility (derived from higher certainty-equivalent income) and equates it to an investment return necessary to generate a comparable gain in utility. Also, as this report is geared towards retirees and many of the tax aspects that greatly affect this demographic are not necessarily as relevant to other individuals.
Envestnet “Capital Sigma: The Advisor Advantage”
Envestnet estimates implementing adviser led financial strategies produces “around +3% of value-added annually”, a statistic very similar to the Vanguard report. The Envestnet study tilts its analysis towards risk-adjusted returns (rather than absolute returns). The five areas that Envestnet highlight in their report are: (1) Financial Planning; (2) Asset Class Selection & Allocation; (3) Investment Selection; (4) Systematic Rebalancing; and, (5) Tax Management. In the Envestnet paper, the greatest area of value added are tax management (+1.0%) and risk-adjusted investment selection (+0.82-0.85%).
- Interesting Aspects of This Report: This report finds that approximately 2/3 of an advisor’s value added is in tax management, specifically tax loss harvesting (+1.00% annual value added), and portfolio construction (active or passive). Tax loss harvesting is the technique of selling investments with losses to offset gains, which reduces tax liability in a given tax year. The Envestnet research concluded that thoughtfully selecting active mutual fund managers can add +0.85% in risk-adjusted returns. Passive strategies, correctly implemented, can add +0.82% to investment returns a year.
- Potential Criticism of This Report: Tax management, which add approximately 1/3 of the estimated value, is a technique that is most effective during periods of high market volatility. This research studied the time from 12/31/1997 – 12/31/2014, a period which contained two large market “crashes”, and therefore may over estimate the value of this strategy in the future. In addition, tax management “takes considerable quantitative skill” to execute. Not all advisors have these resources in-house and outsourcing for this service may increase expenses. The value added of financial planning (+0.50% of annual returns) is supported with only a footnote referencing the Vanguard and Morningstar reports and is not supported with original research.
Wrapping It All Up
I believe that all of these reports suggest that there is considerable value in hiring a financial adviser. However, not all of these categories are relevant to each individual (or adviser). More important, what does the client believe? Where are the areas that you believe an adviser would add the most value for you? Cumulatively there are lots of potential areas that could benefit from thoughtful guidance. The trick is figuring out which ones apply to you.