Is it a good idea to have an investment advisor? The answer usually hinges on intangibles. For those that answer “no,” often the rationale reflects confidence in their own capabilities, and a tinge of suspicion toward investment professionals. For those that answer “yes,” often the rationale reflects confidence in an advisor’s ability to beat the market, appreciation for answering questions whenever they come up, or the most nebulous of all, “discipline.”
Are there tangible benefits? I don’t mean pretty pie charts. A quarterly report, although real, doesn’t put money in the bank. Can advisors create value that is as tangible as the money you pay them?
At synthiumcapital.com, we quantified the value of five investment techniques, and concluded that together they can increase returns by up to 26%. Few investors implement all five techniques, and many advisors don’t either. Is it realistic for an investor to implement the techniques on his or her own? That depends on the investor, and on the technique. But our analysis does build a foundation for quantifying tangible benefits to having an advisor. Here we go through the five techniques again, assessing whether individual investors can implement each technique their own.
Technique #1: Optimal asset location
Value: up to .33% per year
Rating: Easy
Taxes can be reduced by placing high yield bonds, which produce a lot of income taxed at higher rates, into nontaxable accounts (IRAs, 401(k)s, etc), and placing tax efficient equity investments in taxable accounts.
Do you need an advisor to do this? Not really. Just sort your assets according to their tax efficiency. To the extent you’re able to place assets in nontaxable accounts, the assets you should place there are the less tax efficient ones. The rest of your assets, which would presumably include the most tax efficient ones, should go in your taxable account. Your overall asset allocation will be the same, but your after-tax returns will be higher.
Technique #2: Overweighting toward small and value
Value: up to .50% per year
Rating: Easy
Many academic studies indicate that small capitalization stocks and value stocks produce greater returns over the long term, albeit at higher risk. For a long term investor, this can be a boon – assuming the effect persists.
Tilting your portfolio toward small/value equities is fairly straightforward. Since the effect is difficult to see at low levels of diversification, most small/value aficionados invest in mutual funds or exchange-traded funds. You just need to look for funds with acceptable expense ratios that invest in small or value equities, although an advisor familiar with this technique probably already has done that research.
Technique #3: Whole portfolio, tax-sensitive rebalancing
Value: up to .55% per year
Rating: Difficult
To recap, rebalancing a portfolio means maintaining a specified asset allocation over time in order to maintain a consistent level of risk. Most investors have multiple accounts, both taxable and non-taxable (e.g. IRA, 401(k), etc.). Many investors – and even some advisors – rebalance account by account. This achieves the desired level of risk, but leads to higher taxes. Whole portfolio rebalancing considers the tax consequence of the trades — buys and sells — required to get a portfolio back in balance so maximum tax advantage is achieved.
If you have more than one account, whole portfolio rebalancing gets very complicated. Some advisors pay thousands of dollars per year for rebalancing software; we sensed an opportunity to do a better job, so we wrote our own. Only advisors can justify this kind of investment. Properly doing it by hand, even with the help of a spreadsheet, is a nightmare.
Technique #4: Tax loss harvesting
Value: up to .46% per year
Rating: Moderate
Tax loss harvesting means selling assets that have incurred a capital loss. The investor can either use this loss to offset current capital gains, or, if there currently are insufficient gains, ‘carry forward’ (indefinitely) the losses, using them to offset future gains. If there is not an offsetting capital gain, $3,000 can be deducted every year from ordinary income until the loss has been used up.
After selling an asset, investors will frequently purchase a ‘proxy’ asset that is expected to behave in an analogous manner, but is not similar enough to the original asset to trigger the “wash sale” rule, which would nullify the tax loss.
Conceptually speaking, tax loss harvesting is not hard. But to do it on your own, you had better enjoy putting the “green eye-shade” on. There’s a lot of record keeping, both to keep track of your cost basis and to avoid accidentally triggering the wash sale rule, especially if you have multiple accounts and proxy assets. And to minimize your taxes, you should be using specific tax lot accounting, which involves more record keeping. If you’re comfortable with accounting, you might consider tax loss harvesting easy; if you’re not, you’ll probably consider it difficult.
Technique #5: Enhanced index funds
Value: up to .48% per year
Rating: Difficult
Enhanced index funds use a variety of techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies to achieve better returns than traditional index funds. The pioneer of enhanced indexing is Dimensional Fund Advisors (DFA), but other firms now offer them, including researchaffiliates.com, wisdomtree.com, and revenuesharesetfs.com.
Individual investors must sign up with a DFA-approved advisor in order to invest in DFA funds, which is why we labeled this technique “difficult.” Individual investors should be able to invest in one or more of the alternatives listed above, but we feel they do not have enough of a track record yet.
Conclusion
Should you sign up with an investment advisor? For most people, the answer revolves around intangibles, which we think is unfortunate. Here’s a simple way to focus on tangible benefits. Tally up the tangible benefits above that, for whatever reason, you can’t or probably won’t have the time to implement. Assuming the advisor implements those techniques, and the tangible benefits exceed what the advisor charges, then maybe signing up is a good idea. If they don’t cover what the advisor charges, maybe it isn’t such a good idea.
Finally, since most advisors don’t implement all the techniques, we hope our analysis will lead to some enlightening conversations between clients and advisors.
No comments:
Post a Comment