Do you or your advisor de-alpha portfolio by 3% annually?

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livesoft
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Do you or your advisor de-alpha portfolio by 3% annually?

Post by livesoft »

OK, I hope my thread title caught your attention.

I read a Vanguard white paper meant for advisors which suggests that an '"average" client experience' may lose up to 3% annually relative to a benchmark. Much of the loss may be behavioral which can even happen if a portfolio consists of index funds.

What I found most interesting about the paper is the notion that folks leave advisors only if they underperform benchmarks. We see some of this all the time on the forum. The advice to advisors was basically, don't underperform the benchmark. In the back of my mind I was thinking: Advisors try really hard not to let their clients know what the benchmark is. Other terms for underperforming a benchmark might be "tracking error" and "tracking error regret".

From time to time discussion of benchmarks does come up on the forum with many folks saying they don't need to benchmark because they use index funds. This white paper says that one can use index funds and still fall short of the benchmark. We have evidence for all this in the Bogleheads forum with all the discussion about small-cap and value-tilting. In particular, several folks wondered why they didn't do as well in 2014 as they expected. Their portfolios didn't come close to the S&P500 return (although that was not necessarily the appropriate benchmark).

Anyways, I thought folks might enjoy reading the white paper to see how Vanguard tries to help advisors by advising them to hew close to benchmarks and not drift portfolio style and asset allocation away from them.
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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by kenner »


Conclusion


“Putting a value on your value” is as subjective and
unique as each individual investor. For some investors,
the value of working with an advisor is peace of mind.
Although this value does not lend itself to objective
quantification, it is very real nonetheless. For others, we
found that working with an advisor can add “about 3%”
in net returns when following the Vanguard Advisor’s
Alpha framework for wealth management, particularly
for taxable investors. This 3% increase in potential net
returns should not be viewed as an annual value-add,
but is likely to be intermittent, as some of the most
significant opportunities to add value occur during periods
of market duress or euphoria when clients are tempted
to abandon their well-thought-out investment plan.
It is important to note that the strategies discussed
in this paper are available to every advisor; however,
the applicability—and resulting value added—will
vary by client circumstance (based on each client’s
time horizon, risk tolerance, financial goals, portfolio
composition, and marginal tax bracket, to name a few)
as well as implementation on the part of the advisor.
Our analysis and conclusions are meant to motivate
you as an advisor to adopt and embrace these best
practices as a reasonable framework for describing
and differentiating your value proposition.
The Vanguard’s Advisor’s Alpha framework is not only
good for your clients but also good for your practice.
With the compensation structure for advisors evolving
from a commission- and transaction-based system to
a fee-based asset management framework, assets—
and asset retention—are paramount. Following this
framework can provide you with additional time to spend
communicating with your clients and can increase client
retention by avoiding significant deviations from the
broad-market performance—thus taking your practice
to “infinity and beyond.”

Seems like "buy the appropriate low-cost index funds in a tax-efficient manner for the applicable time frame" solves the potential problem. Like a three-fund solution. Investor behavior is a separate factor, maybe even subject to the latest and greatest television commercial.

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nisiprius
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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by nisiprius »

I don't like it. Vanguard's Figure 1:

Image
Someone at Vanguard wrote: Suitable asset allocation using broadly diversified funds/ETFs ... >0 bps
Cost-effective implementation (expense ratios) ... 45 bps
Rebalancing ... 35 bps
Behavioral coaching ... 0-150 bps
Asset location ... 0-75 bps
Spending strategy (withdrawal order) ... 0-70 bps
Total-return versus income investing ... >0 bps
Potential value added ... "About 3%"
It is, of course, hard to argue with ">0" and "0-x" ranges except to say that you can't get to "About 3%" by adding up zeroes.

The biggest potential gain, 0-150 bps, is from "behavioral coaching," and I. Do. Not. Believe. It. Just how often are there situations
where the behavioral error is definitely an error, the advisor is definitely right, and the client actually follows the advisor's advice?

It is frequently asserted that advisors earn their keep by coaching their clients into staying invested during downturns. I don't know what the full range of "behavioral coaching" encompasses though so I don't want to assume that's all it is, but let's begin with that.

The anecdotal story of Cass Sunstein challenges the effectiveness of coaching. Sunstein says that "In a single day, I hit the trifecta, committing at least three classic behavioral mistakes." The point is not only that he is the coauthor of a book founded on behavioral economics, but that, when trying to decide whether to sell during the 2011 19% correction, he called his co-author for advice and his co-author told him not to do it and he did it anyway.

Published author and professional wealth manager Dan Solin has said that in 2008I did the opposite of what I advise my clients to do: I panicked and reduced my asset allocation to stocks, thereby missing out on a significant portion of the recovery[/url]. Now of course he himself may not have had a coach. But notice what he does not say. He says he advised his clients to stay the course. He does not say whether or not they followed his advice. If they did, he's a hero. If he's just saying after the fact, "I panic-sold, and my clients did, too, but I told them not to do that," then... he's not a hero.

So, I have a big problem with the idea that "behavioral coaching" can add up to 150 bp of alpha. Maybe it can, but I am not prepared to believe it without hard evidence.

And, I have a second problem: do we really know for sure that the advice given by "behavioral coaches" is always sound? One of the disheartening discoveries of behavioral economics is that we cannot personally avoid making behavioral errors even when we know about them. Is it, in fact, the case that a partnership of two people, coach/client or even spouses, can do it?

Vanguard claims advisors can generate a rebalancing bonus of 35 bps. One of the few table entries that isn't a range with "0" at one end, the other being "expense ratios." Remember, this is all relative to "unadvised." What is their rebalancing methodology? Does it really generate a boost of 35 bps that is just as certain as expenses? Can a Vanguard advisor reliably beat a "100% Target Retirement fund" portfolio by 35 bps by rebalancing in a more sophisticated way than the target fund?

I don't want to get into "asset location"--personally I'd be at 0 because virtually all of my retirement portfolio is in tax-advantage and I can't even guess if 70 bps is reasonable for a taxable investor.

The premise that you can get an improvement of 0 to 70 bps through "withdrawal order" is interesting. I don't think it would go unchallenged in this forum. Apparently Vanguard believes that you can get an important improvement by using a bucket strategy, compared to the unadvised strategy of simply spending from one of Vanguard's own "retirement income" funds (Target Retirement Income, LifeStrategy Income, Wellesley Income).
Last edited by nisiprius on Sat Feb 07, 2015 7:44 am, edited 3 times in total.
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livesoft
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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by livesoft »

Behavioral coaching is what Vanguard gives to advisors. :twisted:

As for the rebalancing bonus, here is an experiment to try (even though it might take several years to complete):

Get a large group of investors.
Divide them into at least 2 random sub-groups.
Have one group of investors use the separate Index funds (or their equivalents) found in the Vanguard LifeStrategy Moderate Growth fund (VSMGX)
Have the other group use Vg LifeStrategy Moderate Growth fund directly.
And for a control, just use Vg LifeStrategy Moderate Growth fund.

Let them invest over time

Which of the 3 will have the best after-tax performance? (OK, put these all in a Roth IRA if you like.)

I use VSMGX as one of my benchmarks. I think it is not easy to outperform that benchmark. There are several differences between what I do and what my benchmark does, but we both do rebalancing. Do we both buy on dips? Do we both have decent asset location? Do we both tax-loss harvest? Do we sometimes overweight or underweight the various asset classes in our portfolios on purpose? Do we both "cheat" on our asset allocation by doubling-up on some equities on some days for just a few hours? That is, we change our asset allocation temporarily in a way that is not reportable.
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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by nisiprius »

Actually I shot off my mouth before reading enough of the study. Doesn't matter because I still agree with everything I said :) but Vanguard does address my questions in a respectable amount of detail.
livesoft wrote:I think you might have read the table not as it was intended. Behavioral coaching is what Vanguard gives to advisors. :twisted:
I can't quite tell if you're joking, but Vanguard is perfectly clear on what they mean by it. They mean telling clients to tune out the noise and stay the course. My boldfacing:
Whether the markets have been performing well or poorly, you can help your clients cut through the noise they hear on a regular basis, noise that often suggests to them that if they’re not making changes in their investments, they’re doing something wrong....

Based on a Vanguard study of actual client behavior, we found that investors who deviated from their initial retirement fund investment trailed the target-date fund benchmark by 150 bps. This suggests that the discipline and guidance that an advisor might provide through behavioral coaching could be the largest potential value-add of the tools available to advisors. In addition, Vanguard research and other academic studies have concluded that behavioral coaching can add 1% to 2% in net return.
A pity that those "academic studies" are not cited.
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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by livesoft »

I found the article quite interesting in that it is directed at advisors but has so much for individual investors in it as well. The actions of Sunstein and Solin that you linked demonstrate that advisors need help, too. There are some other mea culpas from advisors out there as well. For Vanguard to garner more business from advisors, Vanguard has to show how Vanguard helps advisors. This white paper is in that direction.
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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by nisiprius »

As for rebalancing, it's pretty interesting. They say several times, and this is THEIR boldfacing, not mine:
Note that the goal of a rebalancing strategy is to minimize risk, rather than maximize return. An investor wishing to maximize returns, with no concern for the inherent risks, should allocate his or her portfolio to 100% equity to best capitalize on the equity risk premium.
They give a nice example of how an unrebalanced portfolio drifted over a period of over 50 years, 1960-2013, and the interesting thing is that even over that long a period--including the bull market of the 1990s--the total drift was only about the difference between LifeStrategy Moderate to LifeStrategy Aggressive. They note that
During this period (1960–2013), a 60% stock/40% bond portfolio that was rebalanced annually provided a marginally lower return (9.12% versus 9.36%) with significantly lower risk (11.41% versus 14.15%) than a 60% stock/40% bond portfolio that was not rebalanced (drift), as shown in Figure III-2.
They repeat, again they put this in boldface,
Vanguard believes that the goal of rebalancing is to minimize risk, not maximize return.
And they then go on to say "That said, for the sole purpose of assigning a return value for this quantification exercise,"
we searched over the same time period for a rebalanced portfolio that exhibited similar risk as the non-rebalanced portfolio. We found that an 80% stock/20% bond portfolio provided similar risk as measured by standard deviation (14.19% versus 14.15%) with a higher average annualized return (9.71% versus 9.36%)
This isn't the worst argument in the world and I give them great credit for explaining clearly where the 35 bps number comes from.

I object strenuously to it being presented as a simple number rather than a range, particularly since I think the true range would extend into negative territory. Furthermore, I don't believe an ordinary human being experiences a standard deviation of 11.41% as "significantly lower risk" than 14.15%. And did you notice that for some reason they fudge just a tiny bit, because the higher-return-rebalanced portfolio they use for comparison still has a hair higher "similar" risk than the their unrebalanced portfolio? I wonder why they didn't try 79% stock, 21% bond or something?

But the big phonus-balonus here comes when you translate their story into what it would mean operationally. It is 1960, you are looking forward to an investment time frame of 50+ years, you intend to maintain the same asset allocation over that 50-year period (!), and you say to yourself:

"My plan is to put 60% into a stock index fund and 40% into a bond index fund and not touch the account in any way whatsoever for 50 years." (There are some minor details like the unavailability of such funds, of course).

Now, in our fantasy, a Vanguard advisor comes to us and says "No, no! I can get you another 35 bps of alpha through a sophisticated maneuver we call 'rebalancing.' Rebalancing reduces risk. You can use a more aggressive 80/20 allocation and by reducing the risk through rebalancing, you can get an extra 35 bps of return without any additional risk. To speak of."

(Pretty good trick to do this in 1960 when the CRSP hasn't been founded and Ibbotson and Sinquefield haven't published the first "SBBI" paper).

They say where the extra 35 bps comes from, but it's a bad joke.
Last edited by nisiprius on Sat Feb 07, 2015 8:27 am, edited 1 time in total.
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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by nisiprius »

livesoft wrote:I found the article quite interesting in that it is directed at advisors but has so much for individual investors in it as well. The actions of Sunstein and Solin that you linked demonstrate that advisors need help, too. There are some other mea culpas from advisors out there as well. For Vanguard to garner more business from advisors, Vanguard has to show how Vanguard helps advisors. This white paper is in that direction.
Yes, you are right. In fact I read the article as indicating a struggle on Vanguard's part on trying to find a way to present advising as valuable without engaging in distortion, exaggeration, or wildly inflated claims.

I am also reminded of the recent story... which I can't seem to find... about some reporters who called a dozen or so advisors, pretending to be clients seeking retirement advise and posing as being invested in TSP funds. Almost all of them said "dump those funds and buy ours." Vanguard was one of the few that said "Well, that's a decent portfolio, why not just stick with it." Or something like that.
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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by livesoft »

I would summarize the entire article as follows:

It contains most of the best points in the Bogleheads' Wiki and addresses many of the Frequently Asked Questions on the forum with answers totally consistent with Bogleheads' Philosophy. In some sense, the article could be re-titled "How to Be Your Own Best Advisor" or perhaps "The Bogleheads' Manifesto" (with apologies to Wm. Bernstein). It covers briefly the main topics covered in longer books by Bernstein, Ferri, and Swedroe, so I would recommend that all investors read this article INCLUDING the Appendix.

For investors that have an advisor or are considering using an advisor, the paper clearly outlines what a great advisor should be doing for the client. For investors who are doing-it-themselves, the paper clearly outlines what a great DIY investor should be doing for themselves.
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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by JW-Retired »

nisiprius wrote: I am also reminded of the recent story... which I can't seem to find... about some reporters who called a dozen or so advisors, pretending to be clients seeking retirement advise and posing as being invested in TSP funds. Almost all of them said "dump those funds and buy ours." Vanguard was one of the few that said "Well, that's a decent portfolio, why not just stick with it." Or something like that.
If this source does come to you let us know. That story would be a good one to be able to reference.
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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by nisiprius »

Alas, as is too often the case, my recollection was imperfect and way I told the story sound better than it was, but nevertheless:

Brokers Lure Soldiers Out Of Low-Fee Federal Retirement Plan
John Turner suspected that brokers were encouraging federal workers to ditch their top-flight retirement plan. So he went under cover.

The former U.S. Labor Department economist called representatives at companies such as Bank of America Corp., Charles Schwab Corp. and Wells Fargo & Co. He identified himself as a potential client grappling with what to do with his own nest egg.

Turner thought he knew the right answer: Leave it alone. As a legacy of his government service, he kept his money in the Thrift Savings Plan, considered the gold standard of 401(k)-type programs for its rock-bottom fees. Yet all but one company told him to roll over all his money into individual retirement accounts...

Vanguard Group, known for its low-cost index funds, stood out for a more balanced approach, Turner said. The company’s representative asked about Turner’s tolerance for risk, he said. If it were low, the representative told Turner, he should stay with the government-guaranteed fund. Otherwise, Vanguard could be a better choice.
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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by JW-Retired »

nisiprius wrote:Alas, as is too often the case, my recollection was imperfect and way I told the story sound better than it was, but nevertheless:

Brokers Lure Soldiers Out Of Low-Fee Federal Retirement Plan
Thanks. The story may not be as quite good as your recollection but it gets the point across pretty well.
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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by itstoomuch »

Yes , I do.
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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by Dale_G »

I do not de-alpha compared to my benchmark of X% Total Stock Market, Y% Total International and Z% of Total Bond Market. My return closely matches my benchmark.

I am sure that if I used certain advisors though, that the portfolio would be de-alph'd by 3% via additional fund expenses of 2% plus an AUM fee of 1%.

The de-alphaization can work in both directions.

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Re: Do you or your advisor de-alpha portfolio by 3% annually

Post by peppers »

Do I de-alpha my portfolio? That's de-beta-ble.
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