Total-return investing and asset location can offer results

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Key highlights

• Importance of total-return investing, even for retired clients.
• How to improve after-tax returns.
• Vanguard Advisor’s Alpha™ helps you explain your value to clients.

This is the first in a series of articles that explain how some financial advisors are using Vanguard Advisor’s Alpha, a collection of wealth management best practices.Vanguard research¹ has found that by implementing the principles, advisors can add value to their clients’ portfolios over time. This article highlights the first part of advisor’s alpha, portfolio construction.

Chris Cordaro couldn’t believe what he saw when a prospective client handed over his brokerage statements.

The prospective client, a recently retired dentist, had sold off all his stocks and put his life savings into long-term bonds, high-yield (‘junk’) bonds, mortgage REITs, and similar securities in an attempt to generate sufficient income to live on, said Cordaro, a financial advisor with RegentAtlantic Capital, an RIA firm in Morristown, New Jersey, that manages $3.2 billion in assets.

“‘If you don’t hire me, that’s fine, but you have to do something about this,'” Cordaro said he told the prospect. ” ‘You need to reduce your interest rate exposure. It’s scaring me, because I know what will happen to your portfolio if rates go up 100 basis points.’ I estimated his portfolio’s duration² at over 10 years, and he was somewhat shocked at his portfolio’s sensitivity.”

Through conversations like this, Cordaro carries out the portfolio construction best practices outlined in Vanguard Advisor’s Alpha. The research paper Putting a value on your value: Quantifying Vanguard Advisor’s Alpha estimated that advisors can add to clients’ net returns through portfolio construction methods and add more value through other means.

Vanguard first described advisor’s alpha about ten years ago. Quantifying the value of advisor’s alpha is not an exact science. For some clients, advisors’ value-add results in greater returns. For others, less. The return is not added over a specific time frame and varies according to client circumstances.

Best Practices

Portfolio construction best practices include choosing a suitable asset allocation using broadly diversified mutual funds and ETFs, using low-cost index-based products, implementing tax-efficient asset location, and employing a total-returninvestment strategy. These practices are not new, as good advisors have used them for years, but many may not fully understand their value.

In his conversation with the retired dentist, Cordaro suggested the dentist implement a total-return strategy, so his portfolio should hold diversified stock and bond investments. Income could come, in part, from capital gains.

“It happens all the time that prospective clients come to us and say, ‘I can’t get enough income out of my portfolio. Do you have higher-interest-bearing securities that you can recommend?’ ” Cordaro said.

“That’s a common mistake,” he added. “In retirement, they’re trying to generate income from their investments. But it’s not that they need income. They need cash flow. Cash flow can come from income. It can come from appreciation. What I always tell them is, ‘If you’re of the mindset that your cash flow only can be produced from income on your investments, you’ve just constrained your asset allocation in such a way that you’re really going to have a poor outcome. When interest rates go down, that means you need to allocate more and more to income-producing investments at absolutely the wrong time.'”

The following table summarizes the risks of an income-centric approach.

Source: Kinniry Jr., Jaconetti, DiJoseph, and Zilbering, 2014. Putting a value on your value: Quantifying Vanguard Advisor’s Alpha.

Cordaro said he believes in the other advisor’s alpha best practices as well. He is such a proponent of tax-efficient investing that in 2005 he coauthored an academic article on the subject, “Asset Location: A Generic Framework for Maximizing After-Tax Wealth.^“3

Cordaro said he focuses the most on asset location, because he wants to make sure the assets that are the highest-returning and least tax-efficient are held in tax-advantaged accounts.

Therefore, REITs and taxable bonds should go in tax-deferred accounts, such as a conventional IRA, so the client does not have to pay taxes on the income. Emerging markets stock funds are a good pick for a Roth IRA, Cordaro said, because the returns are expected to be high and a client would never have to pay taxes on the gains.

Meanwhile, Cordaro uses index-based products for large-capitalization stocks in taxable accounts. That’s because such products issue relatively few capital gains and are not income-focused.

In the following figure, Portfolio A shows how advisors can add value through tax-efficient asset location.

Cordaro said that he advises his clients to consider additional ways to avoid or defer taxes.

“If a client has just retired, and he or she dropped down a tax bracket, then the client should be looking at Roth conversions,” he added. “If the client is making charitable contributions, and they’re all cash even though the client has appreciated securities, then the client should be looking at giving the appreciated securities and using a donor-advised fund to make it more tax-efficient and easier.”

As for asset allocation, Cordaro said his firm has an investment committee that examines the markets and then makes recommendations for client allocations, based on the client’s circumstances. Cordaro said he explains it this way to clients: “There’s only one strategy that consistently adds value over time. That’s buying things low and selling them high. But that comes with certain caveats. I know I’m going to get the timing wrong on it, and I know I’m not going to get every call correct. So I need to diversify that decision as much as possible. That’s why we allocate globally, because all the markets are not in lockstep with each other. Then we want to decide how to allocate among the asset classes given the client’s goals, time horizon, and risk tolerance.”

Cordaro said he favors using lower-cost products because they help clients keep more of what they earn.

Explaining it to clients

Cordaro, who has been with RegentAtlantic since 1987, said he has long understood that he adds value to clients’ portfolios, but he was unable to put a number on that value until the Quantifying Vanguard Advisor’s Alpha white paper came out last year.

He wrote a blog about it on the firm’s website and tells his clients about advisor’s alpha regularly. Beyond that, Cordaro said he expresses his value to clients with a simple analogy.

“I tell them, by hiring us, you’ll get the feeling I get on Thursday when I come home from work,” Cordaro said. “That’s the day the landscapers come. The lawn looks great. Everything is done perfectly. It’s clean. I didn’t have to do any of it. They do it ten times faster, and ten times better, than I could do it. Then I have my Saturday and Sunday to myself and I don’t have to worry about it.

“We’re experts at it, and we have all the right tools. We’ll free up your time, and you can spend your time with your family or whatever your passion is.”

1 Francis M. Kinniry Jr., Colleen M. Jaconetti, Michael A. DiJoseph, and Yan Zilbering, 2014. Putting a value on your value: Quantifying Vanguard Advisor’s Alpha. Valley Forge, Pa.: The Vanguard Group.

2 Duration is a measure of the sensitivity of bond—and bond mutual fund—prices to interest rate movements. For example, if a bond has a duration of two years, its price would fall by about 2% when interest rates rose 1 percentage point. On the other hand, the bond’s price would rise by about 2% when interest rates fell by 1 percentage point.

3 Gobind Daryanani and Chris Cordaro, 2005. Asset Location: A Generic Framework for Maximizing After-Tax Wealth. Journal of Financial Planning 18(1):44–54.

Notes:

• Chris Cordaro is not affiliated with Vanguard, and Vanguard does not make any representation regarding his views.
• All investing is subject to risk, including possible loss of principal.
• Diversification does not ensure a profit or protect against a loss.
• There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
• Investments in stocks issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.
• We recommend that you consult a tax advisor about your individual situation.