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Alpha, Beta, and … More Gamma

How advisors add value through a robust portfolio-planning process.

David Blanchett, CFA and Paul Kaplan, 06/09/2017

In 2012, we introduced a metric we called gamma to quantify the value of more intelligent financial planning decisions—in particular, the benefits of working with an advisor.Since this original paper was released, the body of research focused on quantifying the value to investors of working with a financial advisor has grown. We think movement toward fiduciary best practices and the need to demonstrate that certain financial decisions (such as rolling over a 401(k) into an IRA) are in an investor’s best interests make this type of research especially timely.

Our new research looks at the decisions around building an investment portfolio and estimates the gamma an advisor might provide in this process. We find that an advisor’s reasonably priced robust investment framework can add the equivalent of 2.5% of annual outperformance for an average investor, further evidence that working with an advisor can improve not only investors’ experience but their ability to reach their financial goals. We believe robo-technology can address several aspects of the gamma framework and has the potential to boost advisor gamma rather than detract from it.

Building More-Efficient Portfolios
While our first paper on gamma focused on more general financial planning decisions, the scope of this new paper is narrower and explores the value of building more-efficient portfolios. In this new research, we estimate the benefit of portfolio gamma using a comprehensive framework based on seven questions an investor should consider during the portfolio construction process:

1 Why invest at all?
2 Which type of account is best for my situation?
3 What is the appropriate risk level?
4 Which asset classes should be included?
5 How does the risk of the goal affect how I invest?
6 What investments are right to help me reach my goal?
7 When should my investments be revisited or rebalanced?

These considerations result in a process that is far more comprehensive than simply selecting a few mutual funds. It requires the portfolio to be consistent with the goals and risk objectives of the investor, diversified, efficient (high-quality, low-cost), and, if applicable, tax-aware.

A key concept here is goals. Investing needs to start with the end in mind, and investors and advisors who haven’t done so already should adopt a goals-based approach to financial planning. Goals aren’t just for planning; they can have a significant impact on every decision in the investment process. While it’s certainly possible investors could tackle these decisions on their own, our understanding is that many are not up to, or interested in, the challenge.

To quantify the benefits of these decisions, we performed a variety of empirical tests. Unlike our original gamma research, where we used a retirement income metric2 to contrast the potential value of different services, here we focus on the potential “alpha” benefit of the respective service. That is, we quantify the increase in expected annual return (or equivalent) associated with each decision. This makes it easier to compare the expected benefits of financial advice with its costs, which are typically expressed as annual percentages of assets under management.3

We measure the expected value of financial decisions based on three levels of benefit: low, average, and high. We do this to reflect the fact that sophistication differs significantly across investors, as does the complexity of their needs. The benefits of financial advice vary significantly across these three levels. For example, an investor seeking to fund a single goal (retirement) with a single account (a 401(k) plan) who would otherwise invest in an efficient prepackaged multiasset solution (a target-date fund) is likely to realize significantly less value from working with an advisor than an investor with a variety of goals with multiple accounts who would otherwise build portfolios without the help of an advisor.

David Blanchett, CFA is Director of Retirement Research with Morningstar Investment Management.  

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