Do financial advisers add alpha?

People hire financial advisers for all sorts of reasons.

They can sort out your tax planning, estate planning, retirement planning, and all kinds of other good stuff.

Every financial adviser will provide services designed to add value to your wider financial life, outside of what goes into your investment portfolio. If a financial adviser helps you mitigate your inheritance tax bill, for example, then that’s adding some serious value.

But many will also offer to manage your investments for you – either themselves or through an outsourced investment manager.

But is your adviser likely to add value to your investments? Is your portfolio likely to perform better if you hand it over to a financial adviser?

Let’s have a look at the evidence.

Contents

• ‘The value of advice: Improving portfolio diversification’ by Vanguard
• ‘Putting a value on your value: Quantifying Vanguard Advisor’s Alpha’ by Vanguard
• ‘Alpha, Beta, and Now… Gamma’ by Morningstar
• ‘The Value of a Gamma Efficient Portfolio’ by Morningstar
• ‘Quantifying the investor’s view on the value of human and robo-advice’ by Vanguard
• Summary
• Conclusion

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‘The value of advice: Improving portfolio diversification’ by Vanguard

You’ll notice that three of the studies here are by Vanguard. They’re in a unique position to help answer the question of how valuable advisers can be in increasing portfolio returns, as they operate both a DIY investing platform and an advisory service called ‘Vanguard Personal Advisor Services’ – aka PAS.

Vanguard’s PAS is basically like having an online/virtual financial adviser. As an investor signing up, you meet (virtually or over the phone) with a Vanguard financial adviser, who gets to know you a bit more and comes up with a plan for you and your portfolio. Once the plan is created, you meet with your adviser again before deciding if the plan and Personal Advisor Services are right for you. The service includes ongoing access to a financial advisor, so it’s not a ‘one-and-done’ situation.

Obviously a healthy dose of scepticism is warranted when studies are released by providers who are incentivised to sell their products. In this case Vanguard are plugging their PAS service, so we should expect the results of their studies to support the use of financial advisers in portfolio management.

In this first study, Vanguard wanted to study impact of advice on portfolio diversification.

They examined the portfolios of previously self-directed Vanguard investors who enrolled in PAS between 2014 and 2018. Their enrolment allowed Vanguard to examine how financial advice may enhance portfolio diversification decisions among self-directed investors generally.

The study begins by outlining the various ways advisers can add value. Vanguard split it into three buckets – ‘Portfolio value’, which is the value an adviser can add by managing your portfolio, ‘Financial value’, which is the value they can add outside your investment portfolio, and ‘Emotional value’ which is all the intangible peace-of-mind stuff:

For the purposes of this article, which is all about whether financial advisers add alpha, we’re only interested in ‘Portfolio value’, so can ignore the other two for now. Luckily that’s what this study focuses on.

The first interesting piece of evidence from the study looks at how a DIY investor’s equity allocation changes after they sign up for the PAS:

The main takeaway from this chart is the grey band.

The grey band is the distribution of equity allocations – i.e. how much equity did people in each age bracket have. In the top chart, which is looking at DIY investors before signing up to PAS, pretty much the whole chart is grey. This implies there was a huge variation within each age band of how much equity they were holding.

After signing up to Vanguard’s PAS service, the variation of equity allocations narrowed significantly. Equity allocations for investors in each age group were brought towards more appropriate levels for their circumstances. This suggests that many DIY investors aren’t aware either of how much equity they should be holding, or how much equity they actually held.

The chart below digs a bit deeper into this idea, highlighting the degree of the equity changes made as well as the resulting allocations:

Of the investors in the sample, 31% required only minor changes (a change of 0-9% allocation to equities). 24% required a 10-19% change in equity, and 45% of investors required a change of over 20% to their equity allocations.

A 20% change in equity weight is significant, and the fact that 45% of DIY investors needed changing by at least that much shows how many investors were taking an inappropriate amount of risk beforehand. Annoyingly Vanguard don’t mention whether investors tended to have too much in equity or too little, but still it’s interesting to see how many investors were way off the mark in estimating how much risk they should be taking.

Aside from the levels of equity that investors should be holding, the paper then goes on to the subject of cash.

Vanguard found that certain groups of investors hold excessive levels of cash:

Before advice adoption, 30% of DIY investors held cash positions of more than 10% of portfolio assets, while 11% held cash positions of more than 50% (Figure 4a). After advice adoption, these cash positions were reduced, with most of the monies reallocated to bonds. The average bond allocation increased from 23% to 37% of the portfolio (4b).

As well as altering their cash positions, investors who signed up for PAS also saw their allocation to international markets change (this was a US study, so ‘International’ means investing outside the US):

Prior to advice adoption, 83% of investors held 10% or less of their portfolio in international investments, and after advice adoption, the median international allocation increased to 35% from 0%.

Investors also held more active funds when they were DIY investors, with their allocation to passive funds increasing from 46% to 86% after signing up to PAS:

Before enrolling in PAS, a small but significant group of investors—18% of the total sample—held a substantial portion of their portfolio in individual stocks:

Among this group, more than half (10% out of 18%) held 11% or more of their portfolio in individual stocks; a smaller percentage concentrated at least half of their assets in individual securities (Figure 5a). To better distribute the risk associated with holding such positions, PAS typically suggests investors eliminate them. After advice adoption, individual stock holdings were eliminated for nearly all investors (Figure 5b).

To summarise, Vanguard found that the portfolio benefits of advice include:

• A more disciplined approach to equity risk-taking,
• The elimination of large cash holdings,
• The elimination of home bias,
• A more disciplined approach to active/passive share, and
• The reduction or elimination of individual stock risk.

It should be noted (and Vanguard do explicitly note this in their study) that self-directed investors at Vanguard are a unique population. Many were likely attracted to Vanguard in the first place by their emphasis on strategic portfolio allocation, low fees, and buy-and-hold investing versus tactical allocation and active trading. Their implicit argument by pointing this out is that non-Vanguard DIY investors who didn’t already have a low-fee, buy-and-hold philosophy may benefit even more from financial advice.

So far it seems that DIY investors’ portfolios could seriously benefit from a bit of financial advice.

‘Putting a value on your value: Quantifying Vanguard Advisor’s Alpha’ by Vanguard

The previous Vanguard study showed the many ways in which advice can improve DIY investors’ portfolios.

This next Vanguard study tries to be more specific in estimating exactly how much value those portfolio changes are likely to add.

To cut a long story short, Vanguard estimate advisers can add about 3% to net return.

That 3% is broken down as follows:

Asset allocation. The alpha from suitable asset allocation comes from the creation of an investment policy statement, which helps clients stick to the plan, and that an ongoing appropriate asset allocation also helps clients stay the course.

Implementation. Cost-effective implementation alpha comes from moving to lower-cost funds.

Rebalancing. Rebalancing alpha comes from disciplined annual rebalancing, not allowing allocations to drift too far from the target weights. They assert, quite rightly, that rebalancing is far more about controlling risk than maximising return, so to come to a quantitative approximation for alpha, they take the difference in returns between a non-rebalanced 60/40 portfolio and a rebalanced portfolio of equal risk – they found this to be an annually rebalanced 80/20 portfolio. How that equates to ‘alpha’ for a rebalanced 60/40 portfolio I’m not sure, but I guess they’ve got to come up with some sort of number here.

Behavioural coaching. ‘Behavioural coaching’ is where half of the 3% total adviser alpha comes from. A full 1.5% a year is estimated to come from behavioural coaching. To come up with this figure, Vanguard compared the performances of Vanguard DIY investors who made changes to their portfolio during the 2007-2012 period (i.e. the financial crisis), and compared their returns to equivalent Target Date Funds – these TDFs were used as a proxy for the behavioural coaching an adviser might have been able to provide. They found the DIY accounts which made even one trade over the period trailed the applicable TDF benchmark by 1.5%, and investors who made no changes lagged by only 0.19%.

Another way Vanguard measure this behavioural alpha, is to compare the time-weighted rate of return for their funds to the actual investor returns (i.e. the money-weighted rate of returns). This shows the difference between a fund’s performance, and the amount of money investors actually earned by investing in the fund – a big difference between the two shows investors must have invested when the fund was at its peak, and pulled their money out after the fund had fallen.

Vanguard find that investors tend to time fund purchases and sales badly, meaning they end up earning less than they would have received had they simply bought and held their funds. This result was consistent across geographies – unless you’re an Australian bond investor, in which case you’re apparently amazing at timing the market:

Asset location. Advisers add up to 0.75% in alpha from figuring out how best to allocate an investor’s portfolio between tax-advantaged accounts in order to minimise their tax bill. Alpha is zero if all assets are held in tax-advantaged accounts.

Spending strategy. Another big component of the overall adviser alpha, spending strategy adds up to 1.1% of possible alpha by optimising spending to make it as tax-efficient as possible. This is obviously irrelevant for accumulators, and also irrelevant if all assets are held in tax-advantaged accounts.

Total return vs income investing. For investors wanting to take income from their portfolios, avoiding tilting portfolios towards higher-risk strategies to increase income generated – such as dividend stocks, high-yield bonds, or longer-term bonds – and instead focussing on maintaining diversification and adopting a total return approach can lower risk, increase tax efficiency, and make the portfolio last longer.

Overall, I’m not convinced that most investors will capture anything near the 3% advertised from handing their portfolio over to an adviser.

But the study still raises some interesting areas in which an adviser can add value. Ensuring an appropriate asset allocation, behavioural coaching (although maybe not at 1.5% a year), tax mitigation, and maximising drawdown income all are areas in which advisers can add value. The finding that a higher proportion of the adviser’s alpha relates to those in drawdown (spending strategy and total return vs income investing), highlights the increased value an adviser is able to add in retirement compared to for accumulators.

‘Alpha, Beta, and Now… Gamma’ by Morningstar

One of my favourite things about Morningstar’s research is that they don’t have any dog in this fight. They’re not looking to sell anything – they’re an independent research firm.

So when they set out to try and quantify how much alpha advisers are able to add, it’s always going to be an interesting read.

Here’s their headline guesstimations of how much value an adviser can add to your portfolio:

Importantly this study only focuses on portfolios in drawdown, so isn’t relevant for accumulators.

The factors here are very similar to those assessed in the previous Vanguard paper – primarily focusing on asset location and different withdrawal strategies. Here are their main findings:

Total wealth framework. Asset allocation decisions should be made considering an investor’s total wealth, not just financial assets. Income sources such as pensions or Social Security and other forms of human capital, should be considered when building a portfolio, since each comprises an individual’s holistic wealth and has varying risk characteristics.

Dynamic withdrawal strategy. Portfolio withdrawal decisions should be revisited on some regular basis, ideally at least annually, to ensure the portfolio withdrawal amount is still prudent and reason­able given return expectations and expected remaining length of the retirement period.

Incorporating guaranteed income products: annuities provide a guarantee that cannot be created from a traditional portfolio: income for life. Annuities are a valuable form of insurance, and should at least be considered for each retiree.

Tax-efficient decisions. Taxes are a known drag on performance and the actual return realized by an investor. Therefore, it is very important to consider taxes when designing a portfolio for a client and withdrawing income during retirement.

Liability-relative asset allocation. People tend to save or accumulate wealth in order to fund some kind of goal (or liability). Therefore, it is important to consider the risk attributes of that liability when build­ing the portfolio. Traditional mean-variance optimization focuses entirely on the risk of the assets, and ignores the risks of the goals that the assets are meant to fund.

Overall, they find their ‘gamma’ strategy adds about 1.5% per year in returns above the benchmark, which is a 4% withdrawal rate and a 20% equity allocation portfolio. What I particularly like about the analysis is that there’s no ‘behavioural’ alpha. That always seems a bit wishy-washy, and varies massively depending on both the nature of the individual and the adviser.

It does, however, focus heavily on financial planning alpha rather than pure portfolio construction.

But like Vanguard, Morningstar do find a large chunk of alpha can be earned by ensuring asset allocations are appropriate (especially when including all of an investor’s assets outside their portfolio), as well as by optimising a drawdown portfolio’s withdrawal strategy.

‘The Value of a Gamma Efficient Portfolio’ by Morningstar

The other relevant Morningstar paper on the topic of adviser alpha drills down more deeply into the portfolio benefits of financial advice – so gives a more specific answer to our question of whether financial advisers can add alpha to your portfolio, as opposed to the previous paper which focuses on quantifying the benefits of wider financial planning decisions.

To set the scene, the paper starts with a lovely graphic summarising the state of play in the various ‘adviser alpha’ studies which have been released up till now:

If there’s one takeaway from this chart, it’s that behavioural coaching is a massive part of adviser alpha – ranging anywhere from 1% a year to 4%. Annoyingly it’s also by far the most difficult activity out of all of them to measure, so needs to be taken with a healthy amount of salt.

Morningstar then attempt to estimate the alpha of investment decisions using a framework of seven questions an investor should consider during the portfolio construction process:

1. Why invest at all?
2. Which type of account may be best?
3. What is an appropriate risk level?
4. Which asset classes should be considered?
5. How does the risk of the goal affect how I invest?
6. What investments to implement with?
7. When should the portfolio be revisited?

Here are their findings for each, followed by a summary.

1. Why invest at all?

For relatively sophisticated clients (e.g., with no credit card debt or loans with significant interest rates), Morningstar estimate the benefit of determining whether or not to invest is relatively small— equivalent to an alpha of 0.1% (10 basis points). It is not assumed to be zero given the fact even seemingly intelligent investors often make mistakes, and working with a financial planner can

usually identify and correct some of those errors.

For less sophisticated clients—such as those who do not understand their complete financial picture, have high interest consumer debt, do not have an emergency fund or appropriate insurance, etc.—the benefit of this decision is likely to be significant, and could easily exceed 1% of whatever assets are under consideration. (In reality, the benefit could exceed 5% based on the facts and circumstances of the investor.)

The potential benefits for a moderately sophisticated investor are more difficult to quantify given the potential large continuum of options, preferences, situations, etc. Therefore, Morningstar assume this potential benefit could be worth an alpha-equivalent of 0.3% (i.e., 30 bps) to be conservative, while acknowledging there is likely a significant amount of variation with this estimate.

2. Which type of account may be best?

The potential benefit of account-type optimisation will vary significantly by investor. Investors with a single goal who have access to an employer-sponsored pension plan (e.g., younger investors) may be unlikely to benefit from account-type optimisation.

Morningstar assume the effective benefit is 10 bps although in reality it could be as low as 0 bps. Investors with complex financial scenarios with a variety of goals and account-types who are in a high marginal tax rate (e.g., older and wealthier investors) have the potential to benefit significantly. This benefit is assumed to be 50 bps. For the average investor, they assume the value is 25 bps, which they believe to be a relatively conservative estimate given the range of potential outcomes.

3. What is an appropriate risk level?

Here Morningstar put together a nice couple of charts, similar to the equity allocation charts with the grey shading we saw from the first Vanguard paper, which show the state of DIY investors’ equity allocations:

If we start by looking at the median equity allocations (light blue dots), we can see that most investors regardless of age hover somewhere in the 40-60% equity allocation. This makes pretty intuitive sense, as if you’re not sure exactly what your allocation should be (as many DIY investors aren’t), then going down the middle seems like a safe option.

Unfortunately, if you compare this to Morningstar’s target allocation (red line), the average investors spend the early and late stages of their investing lives either very under-allocated or over-allocated to equities. Younger investors should be owning more equities, older investors should hold less.

The orange dots and the dark blue dots also show how wide the variation in investors’ allocations to equities are – plenty of young investors hold 20% in equity, and plenty of older investors hold almost 100% in equity.

Morningstar’s conclusions from the resulting analysis which attempts to place a value on being in a risk appropriate portfolio are that for investors who use pre-packaged investment solutions (e.g., target-date funds), the benefit of working with a financial advisor is likely to be relatively low, and is estimated at 10 bps. It is not assumed to be 0 bps because even though a target-date fund (for example) might be appropriate “on average” it can’t customise asset allocation for every investor.

For investors in a portfolio which is significantly different than their optimal portfolio (in particular if they should be invested conservatively but are invested aggressively) the benefit is likely to easily exceed 1%, although it’s assumed to be 1% to be conservative. For the average investor, the potential benefit is assumed to be 40 bps, which falls within the average and median value estimated across households.

4. Which asset classes should be considered?

The graph below demonstrates that the most efficient portfolios tend to be those created by investment professionals, on average. These are either from the investment manager building portfolios from the 401(k) menu or target-date funds. In fact, the average difference in efficiency for the advice portfolios and the target-date funds for a given level of risk is 0%. This should be expected since both approaches are solutions investors can use to easily achieve highly diversified portfolios.

The average difference in the median efficiency for those in advice (or target-date funds) and the median self-directors is 20 bps. This suggests that when investors build their own portfolios they are typically not as efficient as when an investment professional builds it for them.

To assess the alpha gained from using advice in asset class selection, the low benefit is assumed to be zero. This reflects the potential efficiency gains for an investor who would use a high-quality, pre-packaged multi-asset investment solution (e.g. a target-date fund) if not a financial advisor. The high benefit is assumed to be 60 bps, which is consistent with the difference in the 90th percentile. The average benefit is assumed to be the difference in the median professionally managed investments and the median self-directors, which is 20 bps.

5. How does the risk of the goal affect how I invest?

People generally invest to fund a specific goal, e.g., retirement or tuition fees. Morningstar try to see how much value can be added by including the riskiness of the investor’s goal in the portfolio optimisation process.

Their conclusions were that while the results noted in this section were significant from a risk/return perspective, the potential benefit will vary across investors and goals. Therefore, they assume the average investor would benefit by 20 bps in a portfolio that incorporates the risks of the liability. For investors who understand the liability, they assume 5 bps. For an investor who could benefit more from this type of portfolio (e.g., a retiree), they assume 50 bps.

6. Which investments to implement with?

i.e. does an investor hold ETFs, mutual funds, active funds, passive funds, etc.

Morningstar conclude that investors who have the appropriate knowledge and ability to make decisions in taxable accounts on their own (e.g., buy index funds) would realize little to no benefit from working with a financial advisor.

Investors who purchase actively managed investments, or any other tax-inefficient vehicle, could realize a significant benefit from financial advice investment selection for a taxable portfolio. They assume the benefit to be 60 bps. For the average investor, they assume the benefit to be 15 bps, which is the approximate return impact difference from a tax-efficient and moderately tax-efficient investment assuming a short-term capital gains rate of 25% (NB: this is using US tax methodology and US tax rates, which are different to the UK’s).

7. When should the portfolio be revisited?

Since many solutions rebalance automatically, especially pre-packaged solutions such as balanced funds with a given risk target, Morningstar assume that the benefit of rebalancing in the low benefit case is 0%.

For the high benefit case, they assume that the benefit of rebalancing is 10 bps, which would be for a relatively conservative investor. For the average case, they assume 5 bps, which is partially driven by behavioural effects.

In terms of the behavioural coaching figure we’ve seen quoted before, Morningstar add an interesting nuance. They show that while the gap between time- and money-weighted returns over the 1991-2016 period has been large (c. 1.5%) for the main asset classes…

…Over the rolling 5 year periods for the same timeframe, the return gaps were much smaller – -0.32%, -0.16%, and -0.23% for equities, fixed income, and allocation respectively:

They note that

“This is not to suggest advisors cannot add value helping investors stay the course, just that the potential benefit of staying invested may be overstated. This is especially true if advisors are subject to the same behavioral market timing problems as the average investor.”

Overall, the Morningstar paper splits out the adviser alpha as follows:

Their conclusion is:

“Overall, we estimate that the “average” investor is likely to benefit significantly from working with a financial advisor, even if the services are entirely related to building and monitoring the portfolio, so long as the advisor provides comprehensive, high-quality portfolio services for a reasonable fee.

Providing other financial planning services (i.e., financial planning gamma), such as savings guidance, pension optimization, insurance planning, withdrawal planning, etc. are likely to result in even more value for the client, and while very important from an outcomes perspective, are not considered here.”

This is probably my favourite of the studies I’ve looked at for this post. It provides a sensible range of potential alphas, and shows that disciplined DIY investors aren’t likely to benefit much from employing a financial adviser to manage their portfolio (wider financial life notwithstanding). But those with more complex, higher value portfolios which spill over into taxable accounts held by those who haven’t sought financial advice in the past and may have inappropriately risky portfolios or perhaps aren’t even investing at all, the value could be significant.

‘Quantifying the investor’s view on the value of human and robo-advice’ by Vanguard

In this final paper, Vanguard quantify how much investors value financial advice and where they believe advisors add value. Using a survey of more than 1,500 investors who reported having a human advisor, a digital service, or both, they looked at where humans and robos both added value.

Again, as in the other Vanguard studies, they split ‘value’ into three camps:

We’ll be focusing on the ‘Portfolio value’ here (as we’re looking at alpha), but there are also some interesting stats on financial and emotional value which I’ve also included here.

Starting off with the split of portfolio/financial/emotional value – the pie charts below show how much of each type of value investors derive from human vs robo advisers:

Pretty unsurprising stuff – those who use human advisers derive more emotional value, those who use robo-advisers believe they gain more portfolio value.

Delving deeper into the portfolio value, Vanguard make the very valid point that, “it is difficult to observe the value advisors add to a client’s investment performance: “The difference in your clients’ performance if they stayed invested according to your plan, as opposed to abandoning it, does not show up on any client statement.””

Rather than attempt to figure out the realised portfolio alpha, Vanguard’s survey instead looks at the perceived alpha generated by advisers.

They asked investors what they believe their performance was with a financial advisor and what they believe it would have been without an advisor. By calculating the difference, they measure investors’ perceived portfolio value of advice.

The chart below shows the investors’ perceived average return with an adviser, the perceived average without an adviser, and the calculated perceived portfolio value of both human and digital advisers:

Annoyingly this is as deep as Vanguard go in this study on portfolio alpha – so their estimate of adviser alpha based on these survey responses (i.e. how much alpha investors believe their adviser is adding) is 3-5% per year.

This is far higher than we’ve seen in any other studies, and shows the contrast between how much alpha advisers believe they can add compared to how much invetors believe they’re receiving. On the one hand, it seems investors are being short-changed – they believe their adviser is adding more alpha than they actually are. But on the other hand, any excess perceived alpha above the actual alpha generated is free “emotional alpha” for the investor!

Moving on to financial value, Vanguard again state that given financial value can best be defined as the ability to meet one’s goals as articulated in a financial plan, since the job of financial advisers is to articulate this plan, it is naturally hard to observe how clients would have fared without an adviser.

So they adopt a similar approach to estimating portfolio alpha.

First, Vanguard ask the investor’s financial goal in dollar terms; second, they ask how far they are in percentage terms in their journey toward their goal; and third, they ask them to imagine how far they would be if they did not have a financial adviser. By subtracting the percentages in the second and third questions, they can provide an estimate of their perceived financial value of advice. By determining the investor’s financial goal in dollar terms, they can also quantify this value.

In percentage terms, human-advised clients have, on average, achieved 59% of their financial goals. However, they believe that if they did not have an advisor, they would have only achieved 43%. Therefore, these clients believe that advisors have contributed to 16% of their financial goals. For digital-advised clients, the estimate is 5%.

In other words, both human- and digital-advised clients believe that their advisors add substantial financial value in helping them achieve their financial goals, but human advisers (understandably) are believed to add much more value when assessing a clients holistic financial needs outside their portfolio.

Now we turn to the third pillar of value – emotional value.

And when you think of emotional value, you think “peace of mind”. That’s certainly the phrase trotted out by advisers arguing for their value. So Vanguard tried to quantify peace of mind.

First, they asked whether investors had peace of mind knowing that a human (or digital) advisor was looking after their investments. Then they asked the investors whether they would have peace of mind if they were managing their own investments:

Only 24% of human-advised clients would have peace of mind if they were managing their investments on their own. However, three times as many, or 80%, report having peace of mind with the help of their advisers. In absolute terms, human advisors increase investors’ peace of mind by 56%.

On the other hand, the increase in peace of mind of digital-advised investors is only 12%. There are two reasons for this. First, most of these clients believe that they would have peace of mind even if they were investing their own money, thus giving them a higher starting baseline. Second, even after receiving financial advice, digital-advised clients report lower levels of peace of mind than human-advised clients do.

The analysis now broadens out, moving away from the three pillars of value, and begins to look more generally at how satisfied investors are with human vs robo-advisers:

Vanguard find 84% of human-advised investors report being satisfied with their advice, as compared to 77% of digital-advised investors.

Given the difference in level of satisfaction and perceived value of advice, one may wonder why the needs of human-advised investors are seemingly better addressed. One plausible hypothesis is that digital-advised investors may have different levels of need for advice in the first place.

Vanguard investigated this hypothesis by asking investors whether they would have time, willingness, and ability to manage their own investments without an advice service. The chart below shows the results by type of advice delivery:

This paints a clear picture – the majority of digital-advised investors report having time, willingness, and ability to manage their own investments, whereas human-advised investors report having less of each of these characteristics. This discrepancy suggests that the two sets of clients may have different needs.

One potential reason for these differences is that digital-advised investors may have less complex financial needs. These clients tend to be much younger and thus potentially have fewer financial goals.

This idea could well reconcile the findings that digital-advised clients are more likely to consider switching to a human advisor in the future (but not vice versa), presumably once their financial situation becomes more complex:

Overall, Vanguard’s conclusions were:

Advice adds value across the board. Regardless of the method of delivery, investors believe advice provides higher incremental portfolio value than going it alone. The perceived value-add to annual performance was 5% for human advice and 3% for digital-only advice.

The loyalty to human advisors is enduring. While more than 90% of human-advised clients say they would not consider switching to digital, 88% of robo-advised clients would consider switching to a human advisor in the future.

Clients prefer emotional support from human advisors. Investors using human advisors estimate being $160,000 closer to achieving their financial goals. Three times as many investors report having strong peace of mind when working with a human advisor as compared to going it alone.

Digital advice also serves a role. Investors prefer digital advice for certain portfolio-management services such as diversification and tax optimization.

Summary

The studies indicate potential alpha generation of anywhere between around 0.5% and 3%, dependent on what the portfolio looks like before receiving advice. Investors perceive their realised portfolio alpha to be around 3% for robo-advisers, and 5% for human advisers.

The studies I’ve looked at here found that advisers were able to add alpha to investors’ portfolios in the following ways:

• Ensuring risk levels in the portfolio are appropriate,
• The elimination of large cash holdings,
• The elimination of home bias,
• A more disciplined approach to active/passive share,
• The reduction or elimination of individual stock risk,
• Behavioural coaching to avoid costly market timing mistakes,
• Tax mitigation,
• Optimising income drawdown strategies,
• For those who weren’t already, getting clients invested.

They also highlighted other sources of alpha for advisers, including both financial alpha (the value derived from managing wider financial needs beyond portfolio construction), and emotional alpha (the peace of mind from hiring an adviser) – both of which have the scope to add value to clients, but which I’ve focused less on for this post.

Regardless of the method of delivery, investors believe advice provides higher incremental portfolio value than going it alone. Three times as many investors report having strong peace of mind when working with a human advisor as compared to going it alone. Digital advice also serves a role, with investors preferring them for certain portfolio-management services such as diversification and tax optimisation.

Conclusion

Disciplined DIY investors who have the time, willingness, and ability to learn about investing and manage their own portfolios aren’t likely to benefit much from employing a financial adviser to manage their portfolio. They’re able to achieve almost every step in that bullet point list above – except for the slippery “behavioural coaching” idea.

However, that’s not to say financial advisers add no value to this particular group, given the wider array of services offered by advisers. Even for experienced investors, advisers are still able to add financial value (as opposed to portfolio value) to an investor’s wider financial life outside of their portfolio content.

Where financial advisers really shine, though, is in providing their services to those investors who aren’t as experienced. Most people (let’s face it) aren’t that interested in investing or personal finance. Most people are therefore much more likely to have portfolios which may not match their risk profile, may hold too much in cash/home country equity exposure, may hold too much in active funds or single stocks, may not be tax optimised, or may not have a sensible drawdown strategy. This is particularly true for investors who are either approaching or are already in drawdown, as advisers are able to add considerable value in formulating a sensible portfolio drawdown strategy.

And this is only for the portfolio alpha. Investors may further benefit from financial advice if they have more complex wider financial affairs beyond portfolio construction needs. This gives considerable scope for advisers to add tangible value to investors.

On the intangible side, the studies show the emotional value advisers are able to provide clients, through providing peace of mind on top of the portfolio and financial value they provide.

But although these studies paint a rosy picture for financial advisers, we still need to be careful in generalising their conclusions, as Derek Tharp of Kitces.com notes:

“In some cases, the “best” advice may require sacrificing financial gains for other ends (e.g., psychological comfort), which means the best advice could be wealth-reducing! And in any case, it is difficult to identify the appropriate benchmark that it is best to compare against in the first place (since we don’t necessarily know how the client would have acted in the absence of an advisor). Further, in some cases, such as the value that is assumed to be provided by advisors recommending low-cost investments, the reality is that not all advisors actually advise clients consistent with the assumptions of the models.

Fortunately for advisors, as was discussed previously, there is a lot of non-financial benefit that is either not being quantified in these types of analyses, or may actually be wealth diminishing (but desirable for the client anyway). In the end, such benefits, combined with the financially measurable ones, may well be large enough that the advisors are easily delivering more value than their cost. But it is still important to note that studies of the value of financial advisors do have considerable limitations.”

So yes, advisers can add alpha.

In some cases, it’s minimal, and unlikely to offset the adviser’s costs. If you’re a savvy DIY investor with a simple portfolio/target date fund and no further financial planning needs, then you probably don’t need an adviser.

In some cases, though, the alpha is likely to be significant. For those investors who don’t have the time or interest to stay on top of managing their finances, are in drawdown, or also have more complex planning needs, then an adviser can add some serious alpha. That’s without even mentioning the fluffy “peace of mind” factor.

But the amount of value the adviser is able to provide is highly dependent on not only the investor, but also on the adviser. All the research we’ve been looking at so far has assumed the adviser knows what he’s doing and is acting in your best interests.

Sadly this isn’t always the case.

If you hand your portfolio over to a sub-standard adviser, then the alpha may not only be negative – it could be seriously negative. The benefit of good financial advice is high, but the cost of poor financial advice is much, much higher.

Which is why it’s so important to choose the right adviser.

Luckily, a post on how to choose a financial adviser is already in the works…