How Evidence-Based Advice Adds Up to 3% In Net Returns With Fran Kinniry (EP.218)

0:28We all need to make smart decisions with our money. someone who has had just an absolutely huge impact on the financial advice profession. And I say he's coming back again because it was really just a few months ago that he joined us to talk about private markets in episode 202. But I found out that this year was the 25th anniversary of Fran's research and leadership behind Vanguard's infamous Advisor Alpha Study. Fran currently serves as the head of the Investment Advisory Research Center within in Vanguard's Financial Advisors Services Department. And in this episode, we talk about all the different ways in which financial advisors can add value, as well as the differences in the study and the framework that Fran and his team put together 25 years ago versus what it looks like today.

1:14If you are listening to the episode and some of these things are resonating with you, you can go to the top of the episode description in your podcast app, and there you will find a link with a special PDF of how to interview an advisor. a special process that tries to remove some of the bias as well as points out what the key questions are that you ought to be asking before making the important decision of hiring an advisor. And now, without further ado, here is my conversation with Vanguard's Fran Canary.

1:46Welcome to the Long-Term Investor. I have a very special guest making a very special milestone in the podcast. I've had lots of repeat guests, but I've never had somebody come back so quickly after their previous interview. Today, I'm joined with Fran Canary, Senior Investment Executive at Vanguard, where he is also the head of the Investment Advisory Research Center. And what I like to say is the father of the Advisor Alpha Study. Fran, thank you so much for coming back to the show. Thank you for having you, Peter. I'm glad to be back again. Well, for those of you who missed Fran's last episode, it was episode 202.

2:27We were talking about private investments. Are private markets worth it? And in the email correspondence, I'm told, hey, it's the 25th anniversary of the study that Fran put together, Vanguard's advisor alpha. We have to talk about that. So that's why I've invited Fran back today. If you're watching us on Cheddar or on YouTube, you can go to the longterminvestor.com. You can see detailed show notes. You can get links to all the resources mentioned. But Fran, let's just start at a very high level 25 years ago. What was your goal when you first published or even dreamed up the Advisor Alpha framework?

3:05Appreciate the kind words there, Peter. Maybe a little context even before the goal. So I had been an RIA. I was at a multifamily office. So I was an advisor. I was in the shoes that you sit in and a lot of our audience sits in. And so I really believed in the value of advice. And this was pre-Vanguard. I was there for six years. I was an RIA, multifamily office. And I joined Vanguard to help Vanguard start advice, our own advice offer. And at the time, I had just the greatest fortune because I had Jack Bogle, who was still here, and Jack Brennan. And they challenged me as we were starting advice because both Jacks were very, very fee conscious.

3:46And they were asking me, so let me get this straight. You're bringing advice to Vanguard. And at the time, we were charging 85 basis points for our advice. And it was largely indexed. It didn't do tactical asset allocation. And so they challenged me to figure out the value. And so big credit to both Jack Vogel and Jack Brennan, because they really challenged me to say, well, why would we be charging our clients a fee on top of a, let's call it a diversified portfolio that's low cost? And where is that value coming from? So we really put that value proposition together. A lot of it is outside of investment management.

4:26It's all the wealth planning, financial planning, behavioral coaching areas. That was the original inspiration of the work. Now, the work itself, I think, also evolved over time as the industry. I think everybody who is in this profession is aware of or has read some of the work that has come out of the Advisor Alpha framework or study. I don't know which to call it because it's not like it was a one and done situation. But basically, you introduced the concept of Advisors Alpha in 2001. It's in 2014 that you started to quantify it, or at least publish your findings in quantifying it. Can you tell me a little bit about that?

5:0825 years ago was the inspiration of the work. However, we've been iterating on it all along, right? So we've been iterating on that. So in 2001, it was really just the framework beyond just investments to financial planning, wealth planning. And then in 2014, as you mentioned, we quantified that, which we put numbers to that value. So it went from a conceptual framework to a value-added framework. We're going to go through some of those things eventually where the value-add is, but just recognizing how much the industry and the profession has evolved over the last 25 years. One of the things that I liked about the paper that you put out celebrating the 25th anniversary was that you highlighted three different things where there were the biggest developments.

5:59I mean, I think in general, we should broadly say that a lot of the advisory world has adopted the framework that you put out there when it comes to asset allocation and rebalancing, tax loss harvesting, asset location, behavioral management. But there were three things. I'm just going to list them real quickly and we can dive in each one one at a time. But you note that these things have changed the most. The first is minimizing return leakage. The second is the shift in focus from maximizing pre-tax returns to maximizing after-tax returns. And the third is advisors becoming more proactive as a behavioral coach.

6:36So let's start with that first one, the return leakage. What is that and why has it shifted over the years? Yeah, it's pretty incredible to see. I mean, when we set out, we had to hope that this would transform the advisory business. You mentioned just how many people have read it. It has over 8 million downloads. And so as it relates to action or people actually taking action, I have a couple of examples here. Prior to this work being done, and let's call it up until let's say 2012, 2013, most cash flow was based on trailing performance. Let's say Morningstar, five-star rating, four-star rating.

7:16And that's how the industry really was when we looked at cash flow. Within the paper, what we saw though is around 2012, 2013, a huge shift. And what I mean by that is now 100 % of cash flows are based on the lowest cost quartile of funds, both on the equity side and the fixed income side. That means quartile two, three, and four, both on the equity and fixed income side have had negative cash flow. That's pretty incredible. What I call investors voting with their feet, advisors voting with their feet to an area that used to be about trailing returns and let's say Morningstar ratings to things that we know are evidence-based, which are cost-related.

8:02Just to throw out a number or two for the audience, in 2001, Peter, the asset-weighted expense ratio for equities was 97 basis points. It has come down to 34 basis points. Just an incredible movement of asset-weighted returns, asset-weighted expense ratios. So that's what we would say is removing the leakage of costs. Indexing on the equity side was at 13%. It's now at 58%. So again, I would say the advisor community using an evidence-based based process to select their funds. And great to see the fixed income side, just to give you the numbers, went from 79 basis points to 32. Indexing went from 4 % to 39 % on the indexing side.

8:50So just incredible, pretty much transformation of how advisors select funds. The last stat, I know I'll throw a couple of stats out there. The last stat I would throw out there is had fee levels remained the same in 2024 that they were in 2001, investors would have paid$144 billion more annually in their fees. So when we talk about reducing leakage in investment costs, we're saving investors, advisors, you all on this call, listening to this, saving investors over $140 billion a year by using costs as your central tendency to select funds. It really is unbelievable. And if you want to see the paper, the graphics, the tables are really easy to read, really easy to digest.

9:42I'll have a link in the show notes at thelongterminvestor.com where you can see that and go to the page where you download this report. I started in the profession in 2007. And I feel like, yes, that acceleration, it was questioned during the financial crisis, whether this evidence was real. And sometime after the financial crisis, it was a trickle. And then it was an avalanche of people really believing, at least anecdotally, from my point of view, and seeing these numbers are so interesting. Looking at the average weighted expense ratio for equity mutual funds being 0.34%. I think if you're watching or listening to us, and you're trying to figure out, are my fees expensive?

10:23Maybe that's a good starting point. You know, if your portfolio costs more than that, that doesn't have to be a bad thing, but there really ought to be good reasons tied to it. Because the more you pay, the less you keep, which I think is something Bogle said. It probably came from Vanguard. It's the only place where the more you pay, the less you get. Typically, it's the reverse. Let's shift our focus to the second trend that's mentioned within the paper, which is this focus that went from maximizing pre-tax returns to maximizing after-tax returns. So I think very much like an emphasis on costs, the better financial advisors have really moved towards financial planning as their value proposition, the wealth planning, if you will.

11:05For the most part, we're not working with endowments and foundations. We may have some, but for taxable families, what really matters is the after-tax returns. And so I think what we have seen there is things like indexing versus active. It's just not a cost and performance delta, but there's a huge after-tax advantage in indexing and ETFs. Second, things like asset location, like where you place your assets, making a real big difference. And when I first started using the word asset location 15, 20 years ago, many advisors had not even heard the term. They were saying, you mean asset allocation.

11:45Now, when we say asset location, it's pretty common that the advisor community knows exactly what we're talking about. But it's not just what is your asset allocation. It's then where do you place those assets between your taxable, tax deferred and tax free registrations that really can make a difference. You know, the third thing I'd mentioned, well, that the paper mentioned, but I called out, it's just the advisors have become more of a proactive behavioral coach. And I don't want to bury the lead here and steal your thunder. But a lot of that has to do with the idea that when markets are bad, people panic.

12:19And when things are looking really good, they get euphoric and greedy. And risk management isn't a term that people are interested in hearing. Most of our listeners are going to be familiar with that idea that maybe we're here. You used the phrase behavioral circuit breaker, which I really enjoy. I've always used the term behavioral babysitter. Maybe that's too belittling. I like behavioral circuit breaker. I do hear from a lot of do it yourself investors, however, that, hey, I didn't panic in these markets. I don't know that I need any behavioral coaching. So let me challenge. I mean, I know you've done other work.

12:52Could you give us some anecdotes or narratives around other ways that an advisor will do behavioral coaching other than missing on what we'll call the big mistake during a crash or a rally? It's not surprising to me, Peter, that many clients that you would talk to say, oh, no, it's not me. It's kind of like how we all hear that we're all better than average drivers. And I think it's one of the challenges with survey-based research. When asked, it's hard to admit that you panicked and sold out, let's say, after Liberation Day when the market was off 5%, 5%, 5 % or in the COVID crisis. So it doesn't surprise me that clients say that.

13:33However, when we look at cashflow back to evidence-based versus survey-based, we do see cashflow following performance. And that creates this drag, if you will, we call it a behavioral drag. And it's part of our advisors output when we get to that 3%. And the drag has shown to be about 1 % to 2%. It means that investors trail the markets and the funds that they invest in by 1 % to 2%. So we may be talking to a few investors who never panic, but it's also not just the panic moments. There's also the FOMO moments, right? I think a lot of us focus on downside risk like the global financial crisis or COVID or the first couple days of April.

14:15But we easily see it on the other side when markets are really elevated or even sectors, certain sectors. We see investors chase returns or I don't know what's going to happen to Bitcoin, but you see a lot of late entrants into that asset class. So it's not just selling on the most volatile down days. We see it at the sector level. We see it at the style level. So it's something that's there, even though clients may have a hard time admitting it's them. It's always the other investors. But when we put all investors together and we examine cash flow, we see what is known as a time-weighted return and a dollar-weighted return.

14:58And the delta between those has been between 1 % and 2%. And that means that all investors, maybe not every investor, but collectively investors have trailed the market by that 1 % to 2%. that. You know, I'm glad you mentioned that. And I probably could have emphasized the point I'm about to make with the fees that when you compound that 1 % or 2 % over multiple decades, it's a big number. And the fees, you know, earlier you mentioned the change in fees, you know, that half a percentage point difference in fees compounds to just be a massive number. But the framework, I've kind of danced around what the different aspects are and the value add ranges that you assign to the average client experience.

15:40And basically what the study concluded in 2014, and I think sort of reaffirms now in 2025, is that an advisor can add up to and sometimes even exceed 3 % in net returns. This isn't really from trying to time the market. This isn't trying to pick which stocks are gonna go up or down or try to guess where interest rates are going or what's gonna happen with the economy or tariffs or the dollar, anything. I'm going to list them off. You have eight different modules that you both summarize and you describe in great detail for anyone who's going to download this. Again, the long-terminvestor.com. But you have the suitable asset allocation using broadly diversified funds and ETFs.

16:22You have investment selection, you have rebalancing, behavioral coaching, asset location, tax-efficient retirement strategy, total return versus income investing, and tax loss harvesting. I know we don't have time to dive into all these. So we talked about fees, but we haven't really gone into investment selection. And there is actually something in the white paper that I was a bit curious with. It seemed this thing doesn't look like everything else where you're mentioning education and educating clients about market capitalization and how they can make more deliberate decisions about deviating from market capitalization approach.

16:57So let me ask you, is that part of the investment selection thought process. And rather than me kind of referencing something, maybe you can explain it more in full for the audience of what exactly it is that I'm talking about. I would love to go a little bit deeper on there because I think it is something that maybe a lot of investors and even advisors may not fully comprehend. I would first start off by how does the market capitalization get formed? I'll always hear that maybe the MAG-7 or MAG-8 is overvalued or too concentrated. And not to laugh at that, but we operate in an auction market, which means that every security trades every day with millions of investors, with price transparency and bid-ass spreads.

17:42And what that means is that the The capitalization of NVIDIA or Apple or the MAG7 or the US to Europe is set by active managers. And what that means is if active managers believe that the US should be larger than its 60 % weight, they will place more buy orders for the US and it will push the price up. So what the market cap is globally and locally is the consensus best guess of all buyers and sellers. So that is should be the reference point or the starting point of portfolios. Deviating from that is fine. But what we would recommend or at least make sure investors know that if you are deviating from the market cap portfolio, you are making an active bet against all other sophisticated investors who have set the market cap and they set it second by second.

18:45So it's fine if someone wants to underweight, let's say, growth or the MAG-7 or even the U.S. market, but they should do so with eyes wide open. They are saying that I, John Doe or Frank and I have more knowledge than the collection of all investors put together. So that's a really tough bogey. So when you think about Vanguard's portfolios, our portfolios are market cap weighted. If you look at our ETF model portfolios, if you look at our target retirement funds, so the case for indexing is not just low cost. Now I want to be clear, the case for indexing is low cost and they are market cap weighted portfolios.

19:25The S &P 500's market cap weighted, the total stock market, the total world, they are all market cap weighted. And so it is a great reference point for investors to think about. And if they want to deviate, which that is totally up to them, they should deviate knowing that they're going against the consensus of all investors and then potentially right size that bet because it is an active bet. They should think about how different do I want to be from the collective dollars of all assets that are being invested at that point in time. It's been a real hard bogey to meet, Peter. When we look at market cap versus active, tends to be that market cap weighted indexing has outperformed anywhere from 70 to 90 % active managers across all different styles, sectors, asset classes.

20:18So it's not just low cost, it's low cost and market cap weighted. Well, that's a good delineation. As you look at some of the tables within this section of investment selection, it is highly focused on low cost. Part of the reason I asked you about the market capitalization is because I saw it called out in a different portion of the paper. And one of the things that I think gets missed a lot in the conversation of active versus passive is it's really less about active versus passive and more about high cost versus low cost and prediction based versus non prediction based, or I sometimes say rules based or transparent versus not tax efficient.

20:55If not, ultimately, the paper finds that the typical added for a value can range between zero to 100 basis points or one percentage point. Obviously, that's variable, but a lot of that evidence is finding a lower cost way to do it. And there are a lot of ways to build an index portfolio. I take a lot of pride in the knowledge of the difference between Russell and S &P and CRISP. When you compare all the different US large cap indexes, they all perform differently. and understanding the trade-offs is important. Without geeking out too much on one line item, I'm not gonna go through all these, like rebalancing asset location and tax loss harvesting.

21:31What I'm gonna do is link to more information on those. I was really pleased that tax-efficient retirement strategy is in there, something that you quantify as being up to 100 basis points or more of value. And Fran, I just feel like the playbook for accumulating wealth is pretty well-known and pretty highly agreed upon where you try to keep costs low, you try to maximize your tax deferred accounts, and you don't time the market. You just let it ride out. But then when you get to retirement, everybody's situation is different. And there isn't a single one size fits all playbook to that process of getting a tax efficient retirement strategy.

22:08So maybe share some insights here on what your studies found that the value of an advisor was. Yeah, I agree with everything you said there, Peter. I think in the accumulation mode, there's some pretty simple rules, right? Save as much as you can, save it in the tax deferred way, have it a low cost, diversified portfolio. But just think of all the decisions that one needs to make in decumulation or retirement income. Most of these decisions are unknown. This is where I believe even the value of advice could, if you did nothing else other than generate a retirement income stream, you would probably cover your fee because it's extremely complex.

22:43and it's also counterintuitive. So you don't know how long you're going to live. You don't know necessarily what your expenses may go because there's a lot of wild cards there, such as healthcare costs and others. So you're working with a time horizon that's not known. Your expenses are not known. You kind of know what your assets are. So you have to figure out what is my spending strategy. There's various strategies you could do. Some do percent grown by inflation. Some will do an endowment model type where you take 5 % of three-year balance. We developed organically like 15 years ago, something known as dynamic distribution, which was the first of its time.

23:24And we use that here for our own advice. And it really takes into account that the markets are volatile. So you have to have some spending flexibility. The 4 % grown by inflation and the endowment model lead you to high spending and runout rates when the markets are high. so we created dynamic distribution. So you have to figure out what is your spending strategy, your asset allocation, your asset location, and then how are you gonna spend those assets in the most prudent way? And then after you're done all that, rebalance the portfolio back to the asset allocation. So there is a lot of moving parts.

24:01I know a lot of times investors will say, I have to show transactions or tickets or trades. Any client in distribution generating retirement income is going to generate a lot of trades, even if you're using a handful of index funds, because you're trying to sell, let's say, taxable assets at HIFO lot accounting to minimize taxes. And then you have to rebalance elsewhere, trying to avoid wash sale rules. So it's pretty complex. And the difference between doing this well and doing it average and poor can be extreme. And so it's also, I don't think a lot of the DIY investors would understand to do it well.

24:42And so here, again, it's where I think financial planning and wealth planning is going to be the differentiator going forward. Those who really understand best practices, if you will, of financial and wealth planning, I think are going to be set up to deliver value for their clients. That's beyond, as you mentioned, the investment part, right? Like back to why I developed this, we were using index funds and not doing tactical, but we still believe we would cover the 85 basis points through areas like retirement income drawdown. Well, and it's certainly a part of the planning process you can quantify because as your original work says, you don't attempt to quantify a lot of financial planning work because just because oxygen is beneficial.

25:27We know oxygen is beneficial without measuring it, something like that. I know I'm butchering that, but this was truly one of the parts of the paper where I said, yes, exactly. I mentioned the accumulation doesn't have to be that complicated. A lot of times I find our firm and other firms saying, hey, we help when life gets a little bit more complex. And people think, well, how can withdrawing my money be that complex? And it doesn't have to be if you don't want it to be optimally done. And so really, you guys did a nice job here of quantifying that. But one last piece of the module that I want to touch on, even though the value add wasn't material relative to everything else, you basically said it was greater than zero, is a total return versus income investing approach.

26:07And part of what was interesting is I was thinking about the past 25 years is in 2001, you probably would have said interest rates were not particularly high and you might have even said they were low. But for the vast majority of these 25 years, relative to history, interest rates have been very low. And this approach became very important as interest rates tick higher. I think, though, it's not just the return that's higher via total return. It's the diversification. It's the flexibility that makes such a big impact. I had an episode. Actually, I'm looking at the episode list. Very next episode after 202 was 203 total return versus income.

26:44So I'll link to that. But maybe share your thoughts here on how this found its way into Advisors Alpha in the first place. It's another what I would call somewhat related to behavioral biases or behavioral preferences. A lot of clients do not want to touch their principal. They don't want to touch the corpus or the wealth. And so they try to live off of, if you will, the cash flow that's generated either through dividends or the yield. And the danger then you see is clients, especially as you mentioned, the last 25 years in a low return world where interest rates were between zero and one. I see this affinity why clients then try to potentially buy equities that have higher dividends and or buy bonds that have higher yields.

27:31And in doing so, a couple of things happen. And one, you've kind of given away some of the properties of diversification, because if you have all high dividend paying stocks and are avoiding low dividend stocks, that would have actually worked out terrible over the last 20 years, right? Because it's been a very growth oriented market. Second is it's very tax inefficient because all of stocks and mutual funds that hold stocks go ex-dividend. If you have two funds, one with a 4 % dividend and the other two, this one, you're getting the 4 % on$100 ,000, but it goes X dividend, drops by 4%. This one only drops by 2%.