How to offer advisor alpha to clients

Advisors who shift away from stock-picking must create value from a client perspective. How to do that was recently discussed by Graham Westmacott, a portfolio manager at PWL Capital in Waterloo, Ont. He spoke at the ETF Summit presented by Advisor’s Edge and Investment Executive last week.

Westmacott said focusing on advisor alpha means meeting clients’ goals, not beating the market. To do that efficiently requires mass customization, which comes with its own challenges.

“We have to […] scale not just our choice of securities, but our portfolio design and the way we balance portfolios,” said Westmacott, as well as cash management, client communication and financial planning. “All these wrap up to be the total client experience.”

The problem is these things are susceptible to noise, or tracking error.

Noise must be managed because clients want to know they’re receiving a similar level of service to other clients in similar situations, said Westmacott.

For securities selection, using ETFs is a way to cut the noise, he said—specifically advisor tracking error. For example, he said advisors are affected by such things as when they last ate, whether they’re late for an important meeting or whether they had lunch with a favourite fund salesperson.

Beyond security selection, cutting noise increasingly means relying on algorithms, he said, referencing a Harvard Business Review article. As formal rules, algorithms reduce the noise problem in decision making.

“The high-level viewpoint here is not that ETFs are coming, but that algorithms are coming,” said Westmacott. Using algorithms effectively allows advisors to focus on client goals, he said.

Westmacott also considered portfolio withdrawal rates, asking whether a standard withdrawal rate is the best that algorithms have to offer clients. As an alternative, he uses a dynamic spending rule (the technical term is ARVA), whereby the withdrawal rate varies based on portfolio value, mortality and real interest rates.

The result: “You’re transferring some of the asset volatility to income volatility,” he said. “You’re asking the client to tolerate some variability in their annual income.”

Clients buy in to the process, accepting ongoing guidance—on budgeting, for example—instead of focusing on products, he said. “A key part of this process is to shift the conversation from assets to income.”

At the same time, advisors must be sensitive to changes in client circumstances that alter income needs. (To reduce income volatility, asset liability management can be employed using bond ETFs to match future liability—that is, income.)

Using a client example, he showed how a variable withdrawal rate reduces the risk of having insufficient funds over a client’s retirement years and makes portfolio outcomes more predictable.

For more on managing withdrawal risk, see Westmacott’s paper, co-authoured with University of Waterloo academics.