Investors Should Focus on Planning Alpha, not Investing Alpha

Financial Planning, Attorneys
Planning alpha is abundant, available, and non-scarce. Unlike investment alpha, planning alpha is not a zero-sum game.

Planning alpha should be primary objective of every investor.  However, because of the way the business of investing is structured, it isn't.  Why is that?  Because investing is a strange business.  For the vast majority of investments, the cheaper they are, the better they are.This flies in the face of just about everything we've ever seen, been taught, or experienced with any other product or service.Does anyone think a Hyundai is better than a Bentley?  How about a sandwich at the local deli versus a dinner at Per Se?  Do you think a $1,500/hour attorney is better than a $300/hour attorney?  (Before you get cute with this one, ask yourself who you want representing your firm in a bet-the-company litigation.)  A room at the Holiday Inn or a suite at the George V?  Bleacher seats or seats next to the dugout?You get my point, in almost all avenues of life, the more expensive something is, the better it is.However, this is not the case with investments.  Indeed, for the most part, the more expensive an investment is, the worse it is.

Index Funds and “Average” Performance

The prime example of low cost investing being better is with mutual fund management.  I often hear people selling active mutual funds describe buying indexes as settling for "average" performance.Nothing could be further from the truth.While index funds often mimic an index such as the Dow Jones Industrial Average, it does not mean the returns they generate are average.Most index funds rank in the 75th to 80 percentile over the trailing five year period.  This means they are beating 75 to 80 percent of all the active managers in their category.This is not just beating the competition, it is a beat down.  And they do it year after year.  And you never have to worry about the manager who generated the great track record leaving.Perhaps the greatest advantage of all is the tax-efficiency of index funds.  Most of them generate no capital gains, and if they do, it is almost always a de minimis amount.If you evaluate the index funds versus active managers on an after-tax basis, it is complete domination by the indexes.  Almost no active manager can outperform their benchmark on an after-tax basis for a five-year period.If have discussed the negative effects of taxes on returns in my Taxes – Another Killer of Attorney Returns blog post.

Table 1: 5-Year Percentile Rankings of Selected Index Funds

bantam inc. jack duval - planning alpha

I frequently see ultra-high net worth investors paying one percent, or more, for managers who underperform the market and generate capital gains taxes. This is a bad trade that no one should make, or tolerate.

Planning Alpha

The good news is that there remains a tremendous amount of alpha to be had on the planning side of the investment advisory relationship.Many simple structural, tax, and risk management strategies can add instant performance to the bottom line. More importantly, many of these strategies can be accomplished at very low (or no) cost.Some of these strategies include how assets are owned, as well as what they are invested in. They can often result in immediate benefits from tax or fee reductions, as well as longer-term benefits, such as the reduction or elimination of estate taxes.The ROI on a strategy that helps minimize income taxes on investments during a clients peak earning years is likely extremely high. The ROI on a strategy that helps a client avoid estate taxes is likely even higher.

Risk-free Returns

In essence, the benefits of these strategies are risk-free returns. That is, the alpha generated does not involve taking on more risk.According to the laws of economics, this is not available in the investment world.  If you want to get higher returns, you have to take more risk. There is no free lunch.However, these laws do not apply in the planning world. Planning alpha is abundant, available, and non-scarce.  Unlike investment alpha, planning alpha is not a zero-sum game. Everyone can generate planning alpha and one person having it does not require someone else losing theirs.A classic example of this (that I still see everywhere) is the allocation of incorrect asset classes between taxable and tax-advantaged accounts.For example, assume an investor in their prime working years has $10 million of financial assets, with $2 million of it in a 401(k) account. Secondly, assume her target asset allocation is 60/30/10 (stock/bonds/cash). The obvious strategic allocation move is to have all the 401(k) account assets invested in taxable bonds. However, I usually see investors in this situation with all their taxable and tax-advantaged accounts invested the same, each according to the overall target allocation. This is a rookie mistake. If the 401(k) account was invested entirely in fixed income, the client could almost certainly generate a higher after-tax return than the same fixed income investments held in a taxable account. This is because they could be invested in taxable bonds of the same quality and compound their growth on a tax-deferred basis in the tax-advantaged 401(k) plan.The $2 million that was in bonds in the taxable account could then be invested in equities, which will likely grow at a much higher rate and should be taxed at long-term capital gains rates, instead of ordinary income tax rates as on the bonds the money had been invested in. Furthermore, because the bonds in the 401(k) would grow at a lower rate than the equities in the taxable portfolio, they create less of a tax burden later on for the owner’s beneficiaries. (The stocks held outside of the 401(k) will grow more over the long-term and get a step-up in basis at the owners death.)


Bantam generates planning alpha through the creation of our Family Strategy Books and other bespoke analyses.In my next post, I’ll examine why the investment industry has not focused on planning alpha.

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