Portfolio Ideas. How to evaluate your advisor’s alpha

Do you have an investment advisor to manage your personal finance? Or are you planning to hire one? If so, you should also know how to assess your advisor’s performance. In this article, we discuss how to evaluate an investment advisor. Understanding the evaluation process will help you draft a suitable agreement with your advisor.

Advisor evaluation

We assume that you have hired an advisor to help you achieve your financial goals. You could alternatively hire an advisor to simply earn higher-than-bank-deposit returns.

Suppose one of your financial goals is to send your child to a foreign university. Two factors that will shape the investment portfolio are your monthly savings and the time horizon to achieve the goal. Based on these two factors, suppose you need 9 per cent post-tax compounded annual return on the dedicated portfolio to accumulate the required money. This required return is called the Minimum Acceptable Return (MAR).

MAR is the benchmark return to evaluate your investment advisor against. Why? Your goal to educate your child can be achieved only if you earn a 9 per cent post-tax compounded annual return over the given time horizon.

So if your advisor fails to help you earn less than the MAR on the portfolio in any year, you could fail to achieve your investment objective.

A typical investment portfolio contains equity and bonds. So MAR is the weighted average of the expected return on both these asset classes.

Assume, you invest in equity and bond funds. You and your advisor could agree that 7 per cent should be the expected return on bonds with 20 per cent capital gains tax.

Also suppose, the expected return on equity is 12 per cent with 10 per cent long-term capital gains tax. Then, 65 per cent allocation to equity and 35 per cent to bonds will result in an MAR of 9 per cent. Note that your asset allocation is a function of your monthly savings and the time horizon for the goal.

What if you invest in bank deposits and ask your advisor to manage only your equity investments? In this case, the benchmark for evaluating your advisor’s equity investments is the mutually agreed upon expected return on equity.

Advisor alpha

The excess return your advisor generates over the pre-determined MAR is the advisor alpha. Your agreement with your advisor should be based on this parameter.

Evaluating an investment advisor is different from evaluating a mutual fund manager. A fund manager’s alpha is the excess return the manager generates over an appropriate benchmark index. For instance, if a large-cap active manager generates 14 per cent and the NSE 50 index returns 12 per cent for the same period, the manager’s alpha is 2 percentage points. You cannot adopt this approach to evaluate your advisor. Why? Suppose the Nifty index generates 6 per cent return and the advisor generates 8 per cent return.

Despite the positive alpha, your advisor’s total return that year is well below the MAR of 9 per cent needed to achieve your financial goal. So generating a higher return than the index will not suffice.

Your advisor’s alpha is a function of: the advice he/she gives you on the quantum of monthly savings, the consequent asset allocation and the choice of investment products, given the expected return on equity and bonds.

The writer is founder of Navera Consulting. Send your feedback to portfolioideas@thehindu.co.in

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