While we argue that alpha/beta separation will have a broad-ranging impact on the world of asset management, we are often hard-pressed to find articles or papers written by or for financial advisors.  However, this article in April’s issue of Financial Advisor illustrates clearly how an alpha-centric view of the world can be a powerful differentiator for financial advisors.  As many advisors have told us, this is particularly important in an era of increased competition (saturation?) of the advisory industry.

So to determine how these ideas are playing on “Main Street”, we look to Columbus, Ohio and Matthew Brandeburg a planner with John E. Sestina and Company, a fee-only planning firm.  He writes in Financial Advisor that financial advisors can’t just look to the mutual funds they recommend to produce all the alpha.  They too must produce the good stuff:

“Recently I examined my technique for constructing investment portfolios to ensure I was adding the most value possible. To begin my review I turned to alpha…”

“In trying to assemble the highest alpha portfolio, I may erroneously try to combine mutual funds with the highest individual alpha and maximize their percentages in the portfolio. This, in theory, should add the most value possible. However, if I rely only on each fund’s alpha to assess which are the best fit, I’m likely not adding any value at all. The highest-alpha funds I select may impede the returns of others, cause overexposure to particular sectors or style boxes or negatively affect the portfolio if market conditions change. Very simply, the alpha of each fund says nothing as to how it will fit into a portfolio with others.”

Brandeburg points out that Morningstar style boxes and ratings can provide guidance, but do not measure eventual success.  He continues:

“I consider the evaluation of sector weightings, style boxes, historical returns, fund manager tenure and the Sharpe ratio to be critical when I construct a portfolio, but I also want to know how much of the overall performance is attributed only to skill (alpha), which can be a valuable and scarce commodity.”

Once an overall portfolio alpha is calculated, Brandeburg says it’s difficult to attribute portions of it to the mutual fund manager and the financial advisor (he’s even called Morningstar about it – to no avail).  But if and when the tools are readily available to determine “financial advisor alpha”, he says fees can better reflect true value-added (a proposal we too have advocated):

“In the years to come I predict advisors will use alpha as a basis for charging client fees. Under this system advisors with the highest alpha will command the highest fees and those with lowest amount of skill (the lowest alpha) will not be able to sustain themselves in the profession. In addition to the CFA and CFP® mark, the public will know if they’re hiring a competent advisor based on their alpha rating.”

Note that as a fee-only planner, Brandeburg has immunized himself from the common pitfalls of passive management – the lack of trailer fees or fund commissions on ETFs.  Being fee-only allows him to cook up any portfolio he wishes without fear of losing the high-priced mutual fund goose that lays a golden egg in his bank account every month.

Perhaps it’s an encouraging sign that John E. Sestina and Company is based on Columbus, Ohio.  American readers will know that Columbus is a bellwether city that often used for market research and product introductions because it’s representative of generalized American tastes.  It is, quite literally, “Main Street USA” (with apologies to Walt Disney).  So we hope this is a sign that alpha-centric investing is making its first tentative moves from Wall Street to Main Street.

Related Postings…

• Mellon: Retail investors showing a lot of interest in what institutions are doing with hedge funds
• Next Up for Advisors is Porting Alpha
• Many Registered Representatives Would Prefer to Be Fee Only
• UMAs: Base Camp for Wealth Managers to Scale Mt. Alpha