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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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Some thoughts on advisor alpha

Posted by Muthu on January 15, 2017

”The enemy of investment success is activity.”- Warren Buffett

I’ve written last year, based on Vanguard studies, how a good advisor creates Alpha. Alpha is the extra returns made possible by engaging the services of an advisor.

This advisor alpha is created by proper portfolio construction, asset allocation, regular rebalancing, planning for tax efficient withdrawals and behavioural coaching.

Vanguard studies say an advisor creates an alpha of around 4% a year. Since the advisors also charge or earn as commission of 1% every year, the net value addition for a client by engaging an advisor is 3%.

Behavioural coaching alone creates an alpha of 2% every year.

There are some advisors in the market who claim to create alpha by chasing performance and doing lot of activities in the portfolio.

They change the funds based on recent negative performance and move the money to the funds with recent positive performance. I’ve explained in the past how futile this exercise is.

Last year’s top performer can be this year’s bottom performer. Last year’s poor performer can be this year’s best performer. We’ll come to know this only in hindsight.

Anyone who claims he can predict the next year’s or next three year’s best performer is simply lying. Even the fund manager would not know it.

I’m not saying that past performance is not important. When we choose funds with over a 10 year track record, we do see how it has performed over various market cycles, how consistent it has been in beating the benchmark and various other qualitative factors. At the same time, we do not forget that all funds go through rough patches. In a ten year period, there would be 3 or 4 years of underperformance. Again the periods of underperformance need not be linear, it can be in bouts as well. So an advisor cannot time the underperformance and outperformance. Only liars can claim to correctly time these.

Advisors who keep churning the portfolio, always keep looking at last performance. Last performance and past performance are not one and the same.

These advisors claim that clients would see value and stick with them only if they keep showing activities by regularly churning the portfolio. They conveniently overlook that activity is the enemy of investment success. They sacrifice client interest for the sake for their own self interest and revenue.

Peter Lynch, one of the best mutual fund managers, has mentioned that 50% of his investors lost money because they invested after few good quarters and redeemed after few bad quarters. If investors chase performance, even hopping in and out of the best fund, would still give only negative returns.

We cannot go against our conscience and investment philosophy for retaining clients. We keep articulating our investment philosophy and how we add value. Hope it matches with our clients’ experience. We sincerely hope clients also would see how we bring that extra 3% (after commission) to the table. If some clients, preferring activities over outcome, leave us, we would consider that our misfortune. But we would never change our principles and values.

To repeat, advisor’s alpha is not created by chasing performance or frequent portfolio changes. It is created by proper portfolio construction, asset allocation, periodic rebalancing, planning for tax efficient withdrawals and above all behavioural coaching to stay the course.

We would continue to do less activity on clients’ portfolio, because we are very much convinced that more activities are enemy of investment success.

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