Capital Sigma: The Sum of the Various Sources of Advisor-Created Value

An ongoing debate among investment advisors and their clients centers on value: creating it, preserving it, and perpetuating it. Each faces a different challenge: Advisors are tasked with delivering worth to their clients, and clients need to understand what they can expect for the dollars they spend.

Capital Sigma is Envestnet's term for the sum total of advisor-created value, and includes financial planning, asset class selection and allocation, investment selection, systematic rebalancing, and tax management. Under this aegis, this white paper embraces five areas that engender measurable value to the client. Beginning with the baseline of financial planning, we then examine asset allocation, investment selection, systematic rebalancing, and tax management. Each element can contribute “alpha,” or excess return over a given benchmark—the traditional mark of gauging advisor value. According to our research, the combination of successfully implementing these sources has produced around 3 percent of value-add annually (see Table 1 below). We explain each one, and assign a figure to quantify the value it generates.

The first pillar of value, financial planning, starts with a deep dive into understanding who the client is and what he seeks to accomplish. When properly grounded in trust and transparency, it serves as the roadmap to achieving the client’s goals—ranging from short-term income needs and extending to estate planning and philanthropy. Getting from here to there requires attention be paid to all aspects of a client’s situation: risk tolerance assessment, taxes, insurance, retirement, and estate planning. Knowing your client is more than a regulatory hurdle. Rather, it is the first link in the advisor value chain, and when done properly, can result in a winning partnership that produces solid results. Although the value of financial planning derives mostly from its qualitative nature, its all-important role in serving as the cornerstone for the subsequent parts of the advisor/client relationship must be considered in the value equation. The potential added value is difficult to quantify precisely for all sub-components of financial planning, but for asset location advice alone it is in the range of 50 basis points of value annually.

The second pillar of advisor-added value is based on crafting an appropriate asset allocation portfolio that positions the client to achieve his goals. The process begins with determining the proper level of portfolio risk to suit his comfort level, an exercise performed in the financial planning stage, as outlined above. That decision then drives asset class selection. Molding a suitable asset allocation harnesses both diversification and exposure to a range of investments that can deliver value across a complete market cycle. It also combines a sophisticated, institutional methodology that can be tailored to meet a client’s personal objectives. That approach may include alternative asset classes, strategic portfolio tilts that apply over- or underweights to capitalize on pricing anomalies, and an array of risk mitigation techniques to respond to changing capital markets and economic conditions. We present examples, explain their advantages, and offer suggestions on how to use them in a portfolio to minimize risk. We demonstrate that a thoughtfully developed asset allocation that is both diversified and consistent with the client’s risk profile and investment objectives can add 28 basis points of value annually.

Once the asset allocation is set, the advisor is tasked with choosing how best to implement it—which specific investments he should select to create a customized portfolio for his client. This constitutes the third pillar of advisor-added value. An array of investments is available, ranging from actively managed portfolios to finely tuned and deftly sliced passive strategies. Active asset class managers need to generate excess returns over a benchmark to justify their fees, and methods exist to measure how these managers perform. On the passive side, tracking error, portfolio liquidity, and delivery of cost-efficient beta are among the issues the advisor needs to consider in his investment selection process. Our research has determined that employing a strategy of selecting active mutual fund managers according to certain risk-adjusted return characteristics can add 85 basis points of value annually to a diversified portfolio, and implementing the portfolio with passive investments can add 82 basis points of value each year.

We then address the fourth pillar of advisor-added value—systematic portfolio rebalancing. We demonstrate the advantages of regular, systematic rebalancing and how it can help both to control risk by reducing portfolio volatility and also enhance returns. We contrast the effects of more- and less-frequent rebalancing, and offer a rationale to explain why an annual rebalancing frequency is optimal. The process of systematically rebalancing a diversified portfolio annually can add 44 basis points of value each year, compared to a naïve strategy of rebalancing once every three years.

The fifth and final pillar of advisor-added value to the client is tax management. Although various tax optimization methods and applications exist (see Financial Planning section for more detail), in this section we focus on potential after-tax benefits an investor can achieve from informed tax management in an all-equity portfolio. A good starting point from a tax-efficiency perspective is a buy-and-hold portfolio. However, it does not accommodate offsetting realized capital gains outside the portfolio, the heart of the “tax-loss harvesting” approach to tax optimization. Also, it takes considerable quantitative skill to build a portfolio that tracks a benchmark when only a fraction of that benchmark’s holdings can be used. We demonstrate how a sophisticated tracking portfolio that can track a benchmark and accommodate tax harvesting can add considerable after-tax value, about 100 basis points of annual value-add.

Table 1

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