Morningstar Magazine - June/July 2017 - 54

Spotlight: The Future of Investing

Alpha, Beta, and ... More Gamma
How advisors add value through a robust
portfolio-planning process.

GAMMA

David Blanchett and Paul D. Kaplan

In 2012, we introduced a metric we called gamma
to quantify the value of more intelligent
financial planning decisions-in particular, the
benefits of working with an advisor.1 Since this
original paper was released, the body of research
focused on quantifying the value to investors
of working with a financial advisor has grown. We
think movement toward fiduciary best practices
and the need to demonstrate that certain financial
decisions (such as rolling over a 401(k) into
an IRA) are in an investor's best interests make
this type of research especially timely.
Our new research looks at the decisions around
building an investment portfolio and estimates
the gamma an advisor might provide in
this process. We find that an advisor's reasonably
priced robust investment framework can add
the equivalent of 2.5% of annual outperformance
for an average investor, further evidence
that working with an advisor can improve not only
investors' experience but their ability to reach
their financial goals. We believe robo-technology
can address several aspects of the gamma
framework and has the potential to boost advisor
gamma rather than detract from it.
Building More-Efficient Portfolios
While our first paper on gamma focused on more
general financial planning decisions, the scope

of this new paper is narrower and explores the
value of building more-efficient portfolios.
In this new research, we estimate the benefit of
portfolio gamma using a comprehensive framework
based on seven questions an investor should
consider during the portfolio construction process:
1 Why invest at all?
2 Which type of account is best for my situation?
3 What is the appropriate risk level?
4 Which asset classes should be included?
5 How does the risk of the goal affect how I invest?
6 What investments are right to help me

reach my goal?
7 When should my investments be revisited
or rebalanced?
These considerations result in a process that
is far more comprehensive than simply selecting
a few mutual funds. It requires the portfolioto
be consistent with the goals and risk objectives of
the investor, diversified, efficient (high-quality,
low-cost), and, if applicable, tax-aware.
A key concept here is goals. Investing needs to
start with the end in mind, and investors
and advisors who haven't done so already should
adopt a goals-based approach to financial
planning. Goals aren't just for planning; they can
have a significant impact on every decision
in the investment process. While it's certainly
possible investors could tackle these decisions on
their own, our understanding is that many
are not up to, or interested in, the challenge.

To quantify the benefits of these decisions, we
performed a variety of empirical tests. Unlike our
original gamma research, where we used a
retirement income metric2 to contrast the potential
value of different services, here we focus on the
potential "alpha" benefit of the respective service.
That is, we quantify the increase in expected
annual return (or equivalent) associated with each
decision. This makes it easier to compare the
expected benefits of financial advice with its costs,
which are typically expressed as annual
percentages of assets under management.3
We measure the expected value of financial
decisions based on three levels of benefit: low,
average, and high. We do this to reflect the
fact that sophistication differs significantly across
investors, as does the complexity of their needs.
The benefits of financial advice vary significantly
across these three levels. For example, an
investor seeking to fund a single goal (retirement)
with a single account (a 401(k) plan) who would
otherwise invest in an efficient prepackaged
multiasset solution (a target-date fund) is likely to
realize significantly less value from working with
an advisor than an investor with a variety of
goals with multiple accounts who would otherwise
build portfolios without the help of an advisor.
Overall, we estimate that the "average" investor is
likely to benefit significantly from working with
an 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, such
as savings guidance, pension optimization,
insurance planning, and withdrawal planning, will
likely result in even more value for the client.
While the gamma from this sort of planning advice
is very important from an outcomes perspective,
it is not considered here.
An Assessment of Portfolio Efficiency
Building a gamma-efficient portfolio is more than

1 The original working paper, "Alpha, Beta, and Now...Gamma," was released in October 2012 and was published in the Fall 2013 issue of the Journal of Retirement.
2 To be more precise, in our previous research we estimated certainty-equivalent income using a nested utility function. This higher certainty-equivalent income, resulting from the more efficient
strategies, was then converted into an alpha-equivalent value using a separate model.
3 Viewed differently, the financial advisor fee is negative alpha (i.e., the cost). In this research, we explore the potential value associated with the decisions a financial advisor can help an investor
make (i.e., the benefit), the net of which would be the value of the advice.

Morningstar June/July 2017

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