Rethinking measures of financial planner performance

Michelle Kruger PHOTO CREDIT: Contributed

Researchers in the field of financial planning have been questioning how to quantify the value of the advice provided by a financial planner.

Financial planning is a multifaceted field concerned with helping people to achieve optimal financial outcomes, particularly in areas such as investments, insurance, estate, tax and retirement. Financial planning as a field of research has only existed for a few decades and is not as well established as some related fields that have been studied for hundreds of years.

It is important to know how much value different financial techniques provide or whether certain planning strategies or communication techniques are more helpful than others.

Within this context, it is not difficult to see how using portfolio returns as a proxy for quality of advice would be ill-advised. At best, portfolio returns could be used as a proxy for quality of investment advice.

However, financial planners, particularly financial planners who create comprehensive financial plans, should be providing valuable advice in areas other than investments such as estate planning or tax planning. Trying to measure the value of advising a client to create a special needs trust and evaluate the quality of the recommendation based on the investment returns in that account would be futile as the desired outcome is not related to investment returns.

Even as a proxy for measuring the value of investment advice, portfolio returns would not be an optimal measure. Market returns are variable and depend on economic factors, current events, confidence of investors in the market and a myriad of other factors.

Due to these factors, it is possible for a client to have a financial planner that made good recommendations that truly are optimal for the client and earn a negative rate of return in his or her investment portfolio.

Alpha is an alternative to using portfolio returns as a measure of quality of advice. Alpha is calculated by subtracting the return of the market from the return generated by a given financial planner. Another way to think of alpha is as the premium generated by the investment adviser above and beyond the return that the investor would have earned if he or she had just invested into the market.

Investment managers always aim to generate alpha as a means to justify the fees they charge for their advice. Although it is possible to generate alpha, it is rare for investment managers to consistently generate alpha. Those familiar with the Efficient Market Hypothesis will not find this surprising.

The Efficient Market Hypothesis suggests that, if markets are strong, investors cannot beat the market because new information that will affect portfolio returns already will be factored into the prices. Even if markets are semi-strong, it is only possible to beat the market with inside information, which bears strong consequences in the United States.

In addition, with the rise of technology, computers and trading algorithms have taken over most of the trading that occurs. These computers are immensely powerful and can purchase millions of dollars of investments within fractions of a second. No human being can make investment decisions or process vast sums of new information as quickly as these computers.

An important concept related to portfolio returns is risk. Beta is a measure of risk in the market. It is one of the inputs in the Capital Asset Pricing Model, which is used to construct efficient frontiers within Markowitz’s Modern Portfolio Theory.

Returns for two different portfolios would not be comparable unless they are compared on a risk-adjusted basis. Increasing the amount of risk in a portfolio increases the potential for greater returns; however, increasing risk also increases the potential magnitude of losses.

This brings up another reason why portfolio returns are not a good measure for the value of advice. A financial planner could provide the same advice to two clients, use the same investment philosophy and the same investments (although not the same allocation to each investment), and use the same risk tolerance measure for both.

If these clients have different risk tolerance scores and the adviser acts in the clients’ best interests by allocating their portfolios in accordance with their risk tolerance scores, the returns of these portfolios will be different given the different levels of risk exposure within each portfolio.

A more appropriate measure than portfolio returns for quantifying the value of a tax recommendation would be the amount of money the client saved on taxes by implementing the recommendation.

Financial planners provide value in counseling their clients and managing their clients’ behaviors. Vanguard’s research has shown that behavioral management is the most valuable service a financial planner provides, even more valuable than key functions such as asset allocation and asset location.