J U LY 2 0 2 2

Putting a value on your

value: Quantifying Vanguard
Advisor’s Alpha®

Summary
• The advice industry has changed tremendously over the last 15 years. As a result, investors are in a better
position to reach their desired outcomes and the advisor’s value proposition has never been stronger.

• In 2001, we outlined how advisors could add value, or alpha, through relationship-oriented services, rather
than by trying to outperform the market. We have since expanded the Vanguard Advisor’s Alpha concept to
quantify the benefits that advisors can add by following wealth management best practices.

• We believe implementing the Vanguard Advisor’s Alpha framework can add up to, or even exceed, 3% in net
returns for your clients and help you differentiate your skills and practice. Like any approximation, the actual
amount of value added may vary significantly, depending on clients’ circumstances.

• While the data in this paper is directed toward U.S. advisors, we have estimated the benefits of
implementing the framework for non-U.S. investors over multiple time periods with similar results.
Additionally, the global advice markets have converged and the potential value-add of up to, or even beyond,
3% remains whether using U.S. or non-U.S. data. The specific value added by each individual best practice
will vary by local tax laws, regulations, and the average advised experience in each market.

Authors: Francis M. Kinniry Jr., CFA | Colleen M. Jaconetti, CPA, CFP® | Michael A. DiJoseph, CFA | David J.
Walker, CFA | Maria C. Quinn

Acknowledgments: The authors would like to acknowledge Donald G. Bennyhoff, CFA, and Yan Zilbering for their
meaningful contributions to this body of work.
The value proposition for advisors has always been An infinite number of alternate histories might have
easier to describe than to define. Value is a subjective happened if we made different decisions; yet, we
assessment that varies from individual to individual. tend only to measure the outcomes of implemented
The added value of some aspects of investment decisions. For instance, most statements don’t keep
advice can be quantified, but at best this can only be track of the benefits of talking your clients into
estimated, because each is affected by the unique “staying the course” in the midst of a bear market or
client and market environments to which it is applied. convincing them to rebalance when it doesn’t “feel”
like the right thing to do. But their value and impact on
As the industry continues to gravitate toward fee-
clients’ wealth creation is very real.
based advice, there is a great temptation to define
an advisor’s value-add as an annualized number. In The quantifications in this paper compare the
this way, fees deducted annually for the advisory projected results of a portfolio that is managed using
relationship can be justified by the “annual value-add.” well-known and accepted best practices for wealth
However, although some of the strategies we describe management with those that are not. Obviously,
here could be expected to yield an annual benefit—such results will vary significantly.
as reducing expected investment costs or taxes—the
most significant opportunities present themselves not
consistently but intermittently, often during periods of
either market duress or euphoria.

These opportunities can pique investors’ fear or

greed, tempting them to abandon well-thought-
out investment plans. In such circumstances, the
advisor may have the opportunity to add tens of
percentage points of value-add, rather than mere
basis points (bps),1 and may more than offset years of
advisory fees. However, the difference in your clients’
performance if they stay invested according to your
plan, as opposed to abandoning it, does not show up
on any client statement.

Notes on risk and performance data

All investments, including a portfolio’s current and future holdings, are subject to risk, including the possible
loss of the money you invest. Past performance is no guarantee of future returns. The performance of
an index is not an exact representation of any particular investment, as you cannot invest directly in an
index. Diversification does not ensure a profit or protect against a loss in a declining market. There is no
guarantee that any particular asset allocation or mix of funds will meet your investment objectives or
provide you with a given level of income. Be aware that fluctuations in the financial markets and other
factors may cause declines in the value of your account. Bond funds are subject to the risk that an issuer will
fail to make payments on time and that bond prices will decline because of rising interest rates or negative
perceptions of an issuer’s ability to make payments. While U.S. Treasury or government-agency securities
provide substantial protection against credit risk, they do not protect investors against price changes due
to changing interest rates. U.S. government backing of Treasury or agency securities applies only to the
underlying securities and does not prevent share-price fluctuations.

1 One basis point equals 1/100 of a percentage point.

2
Believing is seeing
What makes one car with four doors and wheels worth It is understandable that advisors would want a less
$300,000 and another $30,000? The answer likely abstract or subjective basis for their value proposition.
differs from person to person. Vanguard Advisor’s Investment performance seems the obvious,
Alpha is similarly difficult to define consistently. For quantifiable value-add. For advisors who promise
some investors without the time, willingness, or ability better returns, the question is: Better than what?
to confidently handle their financial matters, working Those of a benchmark or "the market"? Not likely, as
with an advisor may bring peace of mind. They may evidenced by the historical track record of active fund
simply prefer to spend their time doing something— managers, who have regularly failed to consistently
anything—else. Maybe they feel overwhelmed by outperform benchmarks in pursuit of excess returns
product proliferation in the fund industry, given, for (see Rowley and Plagge, 2022). Better returns than
example, that the number of ETFs in the United States those provided by an advisor or investor who doesn't
now exceeds 2,000. use the value-added practices described here?
Probably, as we discuss in the sections following.
The value of an advisor in this context is virtually
impossible to quantify. Nonetheless, the overwhelming Indeed, investors have already hinted at their thoughts
majority of mutual fund assets are advised, on the value of market-beating returns. Over the 15
indicating that investors strongly value professional years ended December 31, 2021, cash flows into mutual
investment advice. We don’t need to see oxygen to feel funds have heavily favored broad-based index funds,
its benefits. ETFs, and lower cost active funds, rather than higher-
cost, actively managed funds. 2 In essence, investors
Investors who prepare their own tax returns probably
have chosen investments that are generally structured
have wondered whether an expert such as a CPA
to match their benchmark’s return, less management
might do a better job. Might a CPA save them from
fees. They seem to feel there is great value in investing
paying more tax than necessary? If you believe an
in funds whose expected returns typically trail rather
expert can add value, you see value, even if the value
than beat their benchmarks’ returns.
can’t be well-quantified in advance.
Why would they do this? Ironically, their approach is
The same reasoning applies to other household
sensible, even if “better performance” is the overall
services that we pay for—such as painting,
goal. Over the long term, index and lower cost active
housecleaning, or landscaping. These can be
funds, such as the ones offered by Vanguard, have
considered “negative carry” services, in that we expect
and can be expected to outperform the return of the
to recoup the fees we pay largely as emotional rather
average mutual funds in their benchmark categories. 3
than financial benefits. You may well be able to wield a
paintbrush, but you might want to spend your limited A similar logic can be applied to the value of advice:
free time doing something else. Or you may suspect Paying a fee to a professional who follows Vanguard’s
that a professional painter will do a better job. Value is Advisor’s Alpha Framework described here can add
in the eye of the beholder. value in comparison to the average investor experience,
currently advised or not. We are in no way suggesting
that every advisor—charging any fee—can add value.
Advisors can add value if they understand how they
can best help investors.

2 Based on calculations from the Vanguard Advisor’s Alpha research team using data from Morningstar.
3 See Rowley and Plagge, 2022.

3
Similarly, we cannot hope to define here every avenue Many advisors are already applying these best
for adding value. For example, charitable-giving practices and adding this value; others have the
strategies, estate planning, tax-loss harvesting, and opportunity to move closer to these outcomes for their
business-continuation planning all can add tremendous clients. As a result, we are presenting the potential
value in the right circumstances, but they are not value add of all seven modules as a range based on
universal advisory alpha levers. The framework for the observed dollars allocated in portfolios. Note that
advice that we describe in this paper can serve as the individual client circumstances can result in outcomes
foundation on which to construct an Advisor’s Alpha. 4 closer to the lower end of the range or even exceed the
upper end of the range.
Figure 1 is a high-level summary—organized into the
seven modules detailed in the “Vanguard Advisor’s Obviously, our suggested strategies are not universally
Alpha Quantification Modules” section (beginning on applicable. Our aim is to motivate advisors to adopt
page 10)—of the value we believe advisors can add by and embrace these best practices and to provide a
incorporating wealth-management best practices. framework for describing and differentiating their
value propositions. This paper focuses on the most
Based on our analysis, advisors can common tools for adding value, encompassing both
potentially add up to, or even exceed, 3% in investment and relationship-oriented strategies
net returns by using the Vanguard Advisor’s and services.
Alpha framework.
Because clients only get to keep, spend, or bequest
net returns, the focus of wealth management should
always be on maximizing net returns. We do not
believe this potential 3% improvement can be expected
annually; rather, it is likely to be very irregular. Further,
the extent of the value will vary based on each
client’s unique circumstances and the way the assets
are managed.

FIGURE 1
The value-add of best practices in wealth management

Benefit of moving from the scenario described to

Vanguard Advisor’s Alpha methodology

T YPI CAL VALU E AD D E D FO R

VAN GUAR D ADVISO R ’S ALPHA S TR ATEGY M O D U LE CLI E NT(BAS IS PO I NTS)

Suitable asset allocation using broadly diversified funds/ETFs ❶ > 0*

Cost-effective implementation (expense ratios) ❷ 30

Rebalancing ❸ 14

Behavioral coaching ❹ 0 to > 200

Asset location ❺ 0 to 60

Spending strategy (withdrawal order) ❻ 0 to 120

Total return versus income investing ❼ > 0*

Range of potential value added (basis points) Up to, or even exceed, 3% in net returns

* Value is deemed significant but too unique to each investor to quantify.

Notes: We believe implementing the Vanguard Advisor’s Alpha framework can add up to, or even exceed, 3% in net returns for your clients
and also allow you to differentiate your skills and practice. The actual amount of value added may vary significantly depending on client
circumstances and time horizon.
Source: Vanguard.

4 As Ritholtz Wealth Management’s Josh Brown has written: “Vanguard’s whitepaper, The Advisor’s Alpha, was the most seminal thing ever written about the
ways in which financial advisors can add value to a client away from the fussing over asset management. I don’t know a single serious person in our industry
that hasn’t read it, shared it and internalized it.”
4
Vanguard Advisor’s Alpha: Good for your clients and your practice
For many clients, entrusting their future to an advisor The research cited not being proactive in contacting
is both a financial and an emotional commitment. clients and not returning phone calls or e-mails in a
As they would when finding a new doctor or other timely fashion as among the top reasons investors
professional service provider, they typically enter the changed financial advisors. In fee-based practices,
relationship based on a referral or other due diligence. advisors are paid the same whether they make a point
They put their trust in someone and assume he or she of calling clients just to ask how they’re doing or call
will keep their best interests in mind. only when suggesting a change in their portfolio. A
client’s perceived value-add from the “hey, how are you
Yet, trust can be fragile. Typically, it is established
doing?” call is likely to be far greater.
when the relationship is new. Once it has been
established and the investment policy has been This is not to say that performance is unimportant.
implemented, we believe the key to asset retention is Although advisors cannot control performance, they
keeping that trust. can choose the strategies on which they build their
practice. For example, they can decide how strategic
First and foremost, clients want to be treated as
or tactical they want to be with their investments
people, not portfolios. This is why beginning the
or how far they are willing to deviate from a broad-
client relationship with a financial plan is so essential.
market portfolio.
Not only does it promote complete disclosure about
investments, but more important, it provides a perfect As part of this decision process, it’s important to
way for clients to share what is of most concern to consider how committed you are to a strategy, why a
them: their goals, feelings about risk, family, and counterparty may be willing to commit to the other
charitable interests. All this information is emotionally side of the strategy, which party has more knowledge
based, and a client’s willingness to share it is crucial in or information, and the holding period necessary to
building trust. see the strategy through. For example, opting for an
investment process that deviates significantly from
Another important aspect is delivering on your
the broad market may work extremely well when you
promises—which begs another question: How
are “right” but could be disastrous if your clients lack
much control do you actually have over the
the patience to stick with it during difficult times.
services promised? At the start of the relationship,
expectations are set regarding services, strategies,
and performance. Some aspects, such as personality
and service levels, are entirely within your control.
Research suggests that clients want more contact
and responsiveness from their advisors (Kinniry et al.,
forthcoming).

5
Many people do not like change. They tend to have an FIGURE 2
affinity for inertia and, absent a compelling reason Hypothetical return distribution for portfolios that
not to, are inclined to stick with the status quo. What significantly deviate from a market cap-weighted
would it take for a long-time client to leave your portfolio
practice? The return distribution in Figure 2 illustrates Portfolios’
where, in our opinion, the risk of losing clients periodic returns Benchmark
return
increases. Although outperformance of the market is
possible, history suggests that underperformance is
more probable.
Risk of losing clients
Significantly tilting your clients’ portfolios away from
a market capitalization weighting or engaging in large
tactical moves can result in meaningful deviations
from the benchmark return. As shown in Figure 2,
the farther a portfolio return moves to the left—that
is, the amount by which the return underperforms 4 3 2 1
the benchmark return—the greater the likelihood Client Client Client Client
pulls pulls pulls asks
that a client will remove assets from the advisory all most some questions
relationship. assets assets assets

Source: Vanguard.

Carl Richards, CFP®, a popular author and media

figure in investor education, is known for creating
illustrations that bring immediate clarity to complex
financial issues. The sketch shown at right
encapsulates not only the basic framework of
Vanguard Advisor’s Alpha but the essence of how
we believe investors and advisors should view the
entire investing process. Understand what’s
important, understand what you can control, and
focus your time and resources accordingly.

Source: Carl Richards, [Link]. Reproduced

by permission.

6
 The markets are uncertain and cyclical—but your We are not suggesting that market deviations are
practice doesn’t have to be. To take one example, an unacceptable, but rather that you should carefully
advisor may believe that a value-tilted stock portfolio consider the size of those deviations, in light of the
will outperform over the long run. However, he or she markets’ cyclicality and investor behavior. As Figure
will need to keep clients invested for this belief to have 3 shows, there is a clear performance differential
the possibility of paying off. Historically, there have between allocating 50% versus 10% of a broad-market
been periods—sometimes protracted—in which value U.S. equity portfolio to value. As expected, the smaller
has trailed the broad market (see Figure 3). the deviation from the broad market, the tighter the
tracking error and performance differential. With this
It’s reasonable to expect this type of cyclicality. But
in mind, consider allocating a significant portion of
remember, your clients’ trust is fragile. Even if you
your clients’ portfolios to the “core,” which we define
have a deep relationship with well-established trust,
as broadly diversified, low-cost, market cap-weighted
periods of large underperformance—such as the 12-
investments (see Figure 4). Limit the deviations to a
and 60-month return differentials shown in Figure
level that aligns with average investor behavior and
3—can undermine this trust. (Appendix 1 highlights
your comfort as an advisory practice.
performance differentials for market areas such as
sectors, countries, size, duration, and credit.)

FIGURE 3
Relative performance of value versus broad U.S. equity
Rolling five-year cumulative total return differentials, in percentage points
Forward annualized return versus starting yield

60%

40

20

0 10% value/90%
broad market
–20
50% value/50%
–40 broad market
–60 100% value

–80
1984 1988 1992 1996 2000 2004 2008 2012 2016 2020

12 months 60 months

L ARG ES T PE R FO R MAN CE
D I FFE R E NTIAL S (CU M U L ATIVE ,
I N PE RCE NTAG E PO I NTS) O UTPE R FO R M E D U N D E R PE R FO R M E D O UTPE R FO R M E D U N D E R PE RFO RM E D

100% value 28.3% –19.1% 44.4% –66.6%

50% value/50% broad market 13.4% –9.9% 22.0% –34.7%

10% value/90% broad market 2.6% –2.0% 4.4% –7.2%

Notes: Broad U.S. equity is represented by the Dow Jones Wilshire 5000 Index through April 22, 2005; the MSCI US Broad Market Index from
April 23, 2005, through June 2, 2013; and the CRSP US Total Market Index thereafter. Value U.S. equity is represented by the S&P 500/Barra
Value Index through May 16, 2003; the MSCI US Prime Market Value Index from May 17, 2003, through April 16, 2013; and the CRSP US Large Cap
Value Index thereafter. The line graph reflects monthly observations of five-year cumulative total return differentials, starting with the period
ended December 31, 1984, and concluding with the period ended December 31, 2021.
Source: Vanguard calculations based on data from FactSet.

7
For advisors in a fee-based practice, substantial “Annuitizing” your practice “to
deviations from a core approach to portfolio
construction can have major implications and result in
infinity and beyond”
an asymmetric payoff. Because investors commonly In a world of fee-based advice, assets reign. Why?
report that they hold the majority of their investable Acquiring clients is expensive, requiring a large
assets with a primary advisor (Cerulli, 2021), the investment of your time, energy, and money.
advisor has less to gain from outperformance than Developing a financial plan can take many hours and
lose if the portfolio underperforms instead. Although require multiple meetings. Figure 5 demonstrates that
the advisor might gain slightly more assets from these costs tend to be concentrated at the beginning of
success, he or she might lose some or even all of the relationship, if not before (in terms of the advisor’s
the client’s assets in the event of a failure. So when overhead and preparation), then moderate over time.
considering deviations from the market, make sure In a transaction-fee world, this is where most revenues
your clients and practice are prepared for all the occur, more or less as a lump sum. However, in a fee-
possible implications. based practice, the same assets would need to remain
with an advisor for several years to generate the same
FIGURE 4
revenue. Hence, assets—and asset retention—are
Hypothetical return distribution for portfolios that paramount.
closely resemble a market cap-weighted portfolio

Periodic returns
FIGURE 5
Less risk of losing clients
Benchmark Advisor’s
Benchmark alpha “J” curve
return return

15% To “infinity
and beyond”
Per-client profitability

10 Trying to
get there

4 3 2 1 0
Client Client Client Client
pulls pulls pulls asks
–5
all most some questions
0 1 2 3 4 5 6 7 8 9 10
assets assets assets
Years
Source: Vanguard. Source: Vanguard.

8
Conclusion
“Putting a value on your value” is as subjective and The Vanguard Advisor’s Alpha framework is not only
unique as each individual investor. For some, the good for your clients but also good for your practice.
value of working with an advisor is peace of mind. For With the compensation structure for advisors evolving
others, we found that working with an advisor can from a commission- and transaction-based system to
add up to, or even exceed, 3% in net returns through a fee-based asset management framework, assets—
following the Vanguard Advisor’s Alpha framework and asset retention—are paramount. Following this
for wealth management, particularly for taxable framework can provide you with additional time
investors. This increase should not be viewed as an to spend communicating with your clients and can
annual value-add but is likely to be intermittent. increase client retention by avoiding large deviations
Some of the best opportunities to add value occur from the broad-market performance—thus taking your
during periods of market duress or euphoria when practice “to infinity and beyond.”
clients are tempted to abandon their well-thought-out
investment plans.

Although the strategies discussed in this paper are

available to every advisor, the applicability—and
resulting value added—will vary by client circumstance
(time horizon, risk tolerance, financial goals, portfolio
composition, and marginal tax bracket, to name a
few) and advisor implementation. Our analysis and
conclusions are meant to motivate you to adopt and
embrace these best practices as a framework for
describing and differentiating your value proposition.

9
Vanguard Advisor’s Alpha Quantification Modules

This section includes our supporting analysis and a chart providing a high-level summary of
wealth-management best-practice tools and their corresponding modules, together with
the range of potential value we believe can be added by following these practices.

Modules

❶ Asset allocation......................................................................................................................... 11

❷ Cost-effective implementation............................................................................................. 13

❸ Rebalancing............................................................................................................................... 14

❹ Behavioral coaching..................................................................................................................17

❺ Asset location............................................................................................................................ 19

❻ Withdrawal order for client spending from portfolios..................................................... 21

❼ Total return versus income investing....................................................................................23

The value-add of best practices in wealth management

Benefit of moving from the scenario described to

Vanguard Advisor’s Alpha methodology

T YPI CAL VALU E AD D E D FO R CLI E NT

VAN GUAR D ADVISO R ’S ALPHA S TR ATEGY M O D U LE (BAS IS PO I NTS)

Suitable asset allocation using broadly diversified funds/ETFs ❶ > 0*

Cost-effective implementation (expense ratios) ❷ 30

Rebalancing ❸ 14

Behavioral coaching ❹ 0 to > 200

Asset location ❺ 0 to 60

Spending strategy (withdrawal order) ❻ 0 to 120

Total return versus income investing ❼ > 0*

Total potential value added Up to, or even exceed, 3% in net returns

Notes: We believe implementing the Vanguard Advisor’s Alpha framework can up to, or even exceed, 3% in net returns for your clients and also
allow you to differentiate your skills and practice. The actual amount of value added may vary significantly, depending on client circumstances
and time horizon.
Source: Vanguard.

* Value is deemed significant but too unique to each investor to quantify.

10
Module ❶

Asset allocation
Potential value-add: Value is significant but too unique to quantify, based on each investor’s
time horizon, risk tolerance, and financial goals.

Asset allocation refers to the percentages of a Asset allocation and diversification are two of the
portfolio invested in various asset classes such as most powerful tools advisors can use to help their
stocks, bonds, and cash investments, according to clients achieve their financial goals and manage
the investor’s financial situation, risk tolerance, and investment risk. Over the last 25 years, many
time horizon. It is the most important determinant of sophisticated investors have embraced portfolios
the return variability and long-term performance of with more asset classes than in the past. This is
a broadly diversified portfolio that engages in limited often attributed to a trio of significant equity bear
market-timing (Davis, Kinniry, and Sheay, 2007). markets as well as very low yields on traditional high-
grade bonds.
We believe a sound investment plan begins with
an individual’s investment policy statement. This One way to demonstrate that a traditional long-only,
outlines financial objectives as well as any other highly liquid, investable portfolio can be competitive
pertinent information such as asset allocation, is to compare traditional stock/bond portfolios to
annual contributions, planned expenditures, and the endowments studied by NACUBO-TIAA (2021)
time horizon. Unfortunately, many ignore this critical as shown in Figure I-1. The institutions studied have
effort, in part because it can be very time-consuming, incredibly talented professional staffs as well as
detail-oriented, and tedious. But the financial plan unique access, so replicating or even coming close
is integral to success; it’s the blueprint for a client’s to their performance would be a tough task. And
entire financial house and, done well, provides a firm yet, a portfolio constructed using traditional asset
foundation on which all else rests. classes—domestic and nondomestic stocks and
bonds—held up quite well, outperforming the majority
Starting with a well-thought-out plan can not only
of these endowments. At the same time, the largest
ensure that clients will be in the best position possible
endowments have combined heavy doses of active
to meet their long-term financial goals but can
and alternative investments, such as private equity,
also form the basis for future behavioral coaching.
with unique access, early adoption, and professional
Whether the markets have been performing well
due diligence in manager selection to improve their
or poorly, you can help your clients cut through the
investment outcomes.
noise they hear suggesting that if they’re not making
changes in their investments, they’re doing something Although the traditional stock/bond portfolios may
wrong. Almost none of what investors hear pertains not hold as many asset classes as the endowments,
to their specific objectives: Market performance and it should not be viewed as unsophisticated. More
headlines change far more often. Thus, not reacting often than not, these asset classes and the investable
to the ever-present noise and sticking to the plan can index funds and ETFs that track them are perfectly
add tremendous value. The process sounds simple suitable. For example, a diversified portfolio using
but has proven to be very difficult for investors and broad-market index funds gives an investor exposure
advisors alike. to more than 9,000 individual stocks and more than
16,000 individual bonds—representing more than
99% and 83% of market cap coverage, respectively.
Better yet, the tools for implementation, such as
mutual funds and ETFs, can be very efficient—broadly
diversified, low-cost, tax-efficient, highly liquid, and
more accessible to the average investor.

11
Taking advantage of these strengths, assets can be Simple is a strength, not a weakness, and can be used
allocated using only a small number of funds. Too to promote better understanding of asset allocation
simple to charge a fee for, some advisors say, but and of how returns are derived. When incorporating
simple isn’t simplistic. A portfolio that provides broad index funds, ETFs, and highly talented lower cost
asset-class diversification, low costs, and return active funds as the portfolio’s core, simplicity and
transparency can enable most investors to adopt transparency are enhanced, as the risk of portfolio
the investment strategy with confidence and better tilts (a source of substantial return uncertainty) is
endure the inevitable ups and downs in the markets. minimized. These features can be used to anchor
expectations and help keep clients invested when
headlines and emotions tempt them to abandon the
investment plan.

FIGURE I-1
Performance comparison of endowments and traditional stock/bond portfolios

L ARG E MEDIUM S MALL

E N DOWM E NTS E N DOWM E NTS E N DOWM E NTS 60% S TOCK / 70% S TOCK /
(19% O F (50% O F (31% O F 4 0% BO N D 30% BO N D
Y E ARS E N DOWM E NTS) E N DOWM E NTS) E N DOWM E NTS) PO R TFO LI O PO R TFO LI O

1 37.3% 30.7% 26.5% 25.0% 29.3%

3 14.2% 11.7% 10.7% 12.2% 13.2%

5 13.0% 11.2% 10.3% 11.1% 12.4%

10 9.5% 8.1% 7.7% 8.9% 9.7%

15 8.1% 6.9% 6.4% 7.7% 8.2%

30 10.4% 8.6% 7.7% 8.5% 8.8%

Notes: Data are as of June 30 for each year through June 30, 2021. For the 60%/40% and 70%/30% stock/bond portfolios, the equity portion
is split 70% U.S. equity and 30% non-U.S. equity. U.S. equity is represented by the Dow Jones Wilshire 5000 Index through April 22, 2005, the
MSCI US Broad Market Index through June 2, 2013, and the CRSP US Total Market Index thereafter. Non-U.S. equity is represented by the MSCI
World ex USA through December 1987 and the MSCI All Country World Index ex USA thereafter. Bonds are represented by the Bloomberg U.S.
Aggregate Bond Index. Past performance is not a guarantee of future results. The performance of an index is not an exact representation of any
particular investment, as you cannot invest directly in an index.
Sources: Vanguard and NACUBO-TIAA Study of Endowments.

12
Module ❷

Cost-effective implementation
Potential value-add: 30 basis points (bps) annually, by moving to low-cost funds. This is the
difference between the average investor experience, measured by the asset-weighted
expense ratio of the entire mutual fund and ETF industry, and the lowest-cost of these
funds. This value would be larger if compared with higher-cost funds.

Cost-effective implementation is a critical component low-cost funds, as shown in Figure II-1. By measuring
of every advisor’s tool kit and is based on simple math: the asset-weighted expense ratio of the entire mutual
Gross return minus costs (expense ratios, trading or fund and ETF industry, we found that, depending on
frictional costs, and taxes) equals net return. As the asset allocation, the average investor pays between
formula states, it is not always about lowest costs, but 34 bps annually for an all-bond portfolio and 38 bps
gross returns less expenses. As such, we do not rule annually for an all-stock portfolio, while the average
out active management. Over the long term, index and investor in the lowest quartile of the lowest-cost
talent-driven active funds with higher gross returns funds can expect annually to pay between 7 bps
at lower costs, such as the ones at Vanguard, have (all-bond portfolio) and 9 bps (all-stock portfolio).
and can be expected to outperform the return of the This includes only the explicit carrying cost (ER) and
average mutual fund in their benchmark category. is extremely conservative when taking into account
total investment costs, which often include sales
If low costs are associated with better investment
commissions and 12b-1 fees.
performance (and research has repeatedly shown this
to be true), then costs should play a role in an advisor's This value-add has nothing to do with market
investment selection process. With the recent performance. When you pay less, you keep more,
expansion of the ETF marketplace, advisors now regardless of whether the markets are up or down.
have many more investments to choose from—and In fact, in a low-return environment, costs are even
ETF costs tend to be among the lowest in the mutual more important because the lower the returns,
fund industry. the higher the proportion that is assumed by fund
expenses. In comparison to higher-cost funds than the
Expanding on Vanguard’s previous research, 5 we
asset-weighted average shown in Figure II-1 (34 to 38
examine net expense ratios and find that an investor
bps), the increase in value would be even higher than
could save from 27 to 30 bps annually by moving to
stated here.

FIGURE II-1.
Asset-weighted expense ratios versus “low-cost” investing

S TOCKS/BO N DS 10 0%/0% 80%/20% 60%/4 0% 50%/50% 4 0%/60% 20%/80% 0%/10 0%

Asset-weighted expense ratio 0.38% 0.37% 0.37% 0.36% 0.36% 0.35% 0.34%

“Lowest of the low” 0.09 0.09 0.08 0.08 0.08 0.08 0.07

Cost-effective implementation (expense ratio bps) 0.30 0.29 0.28 0.28 0.28 0.27 0.27

Note: “Lowest of the low” category includes funds whose expense ratios ranked in approximately the lowest 7% of funds in our universe by
fund count.
Sources: Vanguard calculations based on data from Morningstar, Inc., as of December 31, 2021.

5 See the Vanguard research paper Investors Are “Voting With Their Feet” on Costs (Vanguard Advisor’s Alpha research team, 2019).

13
 Module ❸

Rebalancing
Potential value-add: Up to 14 bps when risk-adjusting a 60% stock/40% bond portfolio that
is rebalanced annually versus the same portfolio that is not rebalanced (and thus drifts).

Given the importance of selecting an asset In a balanced portfolio this equity risk premium tends
allocation, it’s also vital to maintain that allocation. to result in stocks becoming overweighted relative to a
As investments produce different returns over time, lower risk–return asset class such as bonds, as shown
the portfolio likely drifts from its target allocation, in Figure III-1. Although failing to rebalance may help
acquiring new risk-and-return characteristics that may long-term returns as the weighting of equities rises,
be inconsistent with your client’s original preferences. the true benefit of rebalancing is in controlling risk. A
Note that the primary goal of a rebalancing strategy portfolio overweighted to equities is more vulnerable
is to adhere to the investor’s risk tolerance. Investors to equity market corrections, putting it at risk of larger
wishing to maximize returns, with no concern for the losses compared with the 60% stock/40% bond target
inherent risks, should allocate their portfolios to 100% portfolio.
equity to best capitalize on the equity risk premium.
Investments that are not rebalanced but drift with the
markets have experienced higher volatility.

FIGURE III-1
Equity allocation of 60% stock/40% bond portfolio, rebalanced and nonrebalanced, 1960 through 2021

100% 60%/40%
nonrebalanced
80
Equity allocation

60%/40%
60 rebalanced

40

20

0
1960 1970 1980 1990 2000 2010 2020

Notes: Stocks are represented by the Standard & Poor’s 500 Index from 1960 to 1974; the Wilshire 5000 Index from 1975 to April 22, 2005; the
MSCI US Broad Market Index from April 23, 2005, through June 2, 2013; and the CRSP US Total Market Index thereafter. Bonds are represented
by the S&P High Grade Corporate Index from 1960 through 1968; the Citigroup High Grade Index from 1969 through 1972; the Bloomberg U.S.
Long Credit AA Bond Index from 1973 through 1975; the Bloomberg U.S. Aggregate Bond Index from 1976 through 2009; and the Bloomberg U.S.
Aggregate Float Adjusted Index thereafter. Data are through December 31, 2021.
Sources: Vanguard calculations based on data from FactSet.

14
 During this period (1960–2021), a 60% stock/40% To assign a return value for rebalancing we found the
bond portfolio that was rebalanced annually provided portfolio that created a risk parity to compare the
a marginally lower return (9.23% versus 9.88%) rebalancing premium. Specifically, we searched over
with significantly lower risk (11.00% versus 13.81%) the same time period for a rebalanced portfolio that
than a 60% stock/40% bond portfolio that was not exhibited risk similar to that of the nonrebalanced
rebalanced but drifted, as shown in Figure III-2 . portfolio. We found that an 80% stock/20% bond
portfolio provided similar risk as measured by
standard deviation (13.69% versus 13.81%) with a
higher average annualized return (10.02% versus
9.88%), as shown in Figures III-2 and Figure III-3.

FIGURE III-2.
Portfolio returns and risk, rebalanced and nonrebalanced, 1960 through 2021

60% stocks/40% bonds, 60% stocks/40% bonds 80% stocks/20% bonds,

rebalanced (drift) rebalanced

Average annualized return 9.23% 9.88% 10.02%

Average annual standard deviation 11.00% 13.81% 13.69%

Sharpe ratio 0.43 0.39 0.40

Notes: Stocks are represented by the Standard & Poor’s 500 Index from 1960 to 1974; the Wilshire 5000 Index from 1975 to April 22, 2005; the
MSCI US Broad Market Index from April 23, 2005, through June 2, 2013; and the CRSP US Total Market Index thereafter. Bonds are represented
by the S&P High Grade Corporate Index from 1960 through 1968; the Citigroup High Grade Index from 1969 through 1972; the Bloomberg U.S.
Long Credit AA Bond Index from 1973 through 1975; the Bloomberg U.S. Aggregate Bond Index from 1976 through 2009; and the Bloomberg
U.S. Aggregate Float Adjusted Index thereafter. The risk-free rate used in the Sharpe ratio calculation is the U.S. cash reserve return, using the
Ibbotson U.S 30-Day Treasury Bill Index from 1960 to 1977, and the FTSE 3-Month U.S. T-Bill Index thereafter.
Sources: Vanguard calculations based on data from FactSet.

FIGURE III-3
Looking backward, the nonrebalanced (drift) portfolio exhibited risk similar to that of a rebalanced 80%
stock/20% bond portfolio

20%
Ten-year rolling annual

15 60%/40%
portfolio volatility

drift

10 80%/20%
rebalanced

5 60%/40%
rebalanced

0
1969 1982 1995 2008 2021
Notes: Stocks are represented by the Standard & Poor’s 500 Index from 1969 to 1974; the Wilshire 5000 Index from 1975 to April 22, 2005; the
MSCI US Broad Market Index from April 23, 2005, through June 2, 2013; and the CRSP US Total Market Index thereafter. Bonds are represented
by the S&P High Grade Corporate Index from 1960 through 1968; the Citigroup High Grade Index from 1969 through 1972; the Bloomberg U.S.
Long Credit AA Bond Index from 1973 through 1975; the Bloomberg U.S. Aggregate Bond Index from 1976 through 2009; and the Bloomberg U.S.
Aggregate Float Adjusted Index thereafter.
Sources: Vanguard calculations based on data from FactSet.

15
Helping investors stay committed to their asset An advisor can furthermore determine whether
allocation strategy and remain invested increases to rebalance to the target or to an intermediate
the probability of meeting their goals. But the task allocation based on the type of costs. When trading
of rebalancing is often an emotional challenge. costs are mainly fixed and independent of the size of
Historically, rebalancing opportunities have occurred the trade—the cost of time, for example—rebalancing
when there has been a wide dispersion between the to the target allocation is optimal because it reduces
returns of different asset classes (such as stocks and the need for further transactions. When trading costs
bonds). Whether in bull or bear markets, reallocating are mainly proportional to the size of the trade—
assets from the better-performing asset classes to as with commissions or taxes—rebalancing to the
the worse-performing ones feels counterintuitive. An closest boundary is optimal, minimizing the size of the
advisor can provide the discipline to rebalance when it transaction.6
is needed most, which is often when it involves a very
Advisors who can systematically direct investor cash
uncomfortable leap of faith.
flows into the most underweighted asset class or
Keep in mind, too, that rebalancing is not necessarily rebalance to the most appropriate boundary are likely
free. Associated costs can include taxes and to reduce rebalancing costs and thereby increase the
transaction costs, as well as time and labor on the returns their clients keep.
part of advisors. These could all potentially reduce a
client’s return. An advisor can add value by balancing
these trade-offs, thus potentially minimizing costs. For
example, a portfolio can be rebalanced with cash flows
by directing dividends, interest payments, realized
capital gains, and new contributions to the most
underweighted asset class. This can keep the client’s
asset allocation closer to its target and limit costs.

6 Source: Vanguard research paper Best Practices for Portfolio Rebalancing (Jaconetti, Kinniry, and Zilbering, 2010).

16
Module ❹

Behavioral coaching
Potential value-add: Vanguard research and other academic studies have concluded that
behavioral coaching may add 100 to 200 bps in net return. Providing discipline and guidance
could be the largest potential value-add of the tools available to advisors.

Because investing evokes emotion, advisors need to act as emotional circuit breakers by circumventing
help their clients maintain a long-term perspective and clients’ tendencies to chase returns or run for cover
a disciplined approach. This can add a large amount in emotionally charged markets. In the process, they
of potential value. Most investors are aware of these may prevent significant wealth destruction and add
time-tested principles; the hard part is sticking to percentage points—rather than basis points—of value.
them in the best and worst of times. Having emotions A single such intervention could more than offset years
isn’t a “rational or irrational investor” issue; it’s a of advisory fees.
human issue. It’s normal for people to be swayed by
To analyze fund investor behaviors, we compared
the opinions voiced by those considered experts—the
investor returns (internal rates of return, or IRRs) to
talking heads or news headlines that often recommend
fund-reported total returns (time-weighted returns,
change. Abandoning a well-planned investment
or TWRs). A fund’s TWR represents the performance
strategy can be costly, and research has shown that
of its assets under management for a defined period
some of the most significant challenges are behavioral.
and is generally the industry standard for reporting
That is where you, as a behavioral coach, can earn your
returns. The IRR approximates the return earned by
fees and then some. Recognizing that, to some clients,
the average dollar invested in the fund over the same
factors that affect their wealth are almost as serious
period, rather than the result of any specific investor.
as those affecting their health. Providing emotional
The two results tend to differ to various degrees and
detachment is one of the most overlooked benefits you
in various directions. The IRR differs from the TWR
can provide.
because of cash flows in and out of the fund; absent
When clients are tempted to abandon the markets any cash flows, the TWR and IRR should be the same.
because performance has been poor or to chase the All funds should expect return drags versus their
next “hot” investment, you need to remind them of benchmark over longer periods as money continually
the plan you created before emotions were involved. enters a (generally) rising market. However, larger
The trust they have in you is key: Strong relationships differences can be a sign of performance-chasing
need to be established before bull- and bear-market (Kinniry and Zilbering, 2012).
periods challenge their confidence.7 Advisors can

7 Sources: Vanguard research papers The Vanguard Advisor’s Alpha Guide to Proactive Behavioral Coaching (Bennyhoff, 2018) and Reframing Investor Choices:
Right Mindset, Wrong Market (Kinniry et al. 2016).

17
Investors and the funds they invest in commonly core portfolio that is broadly diversified, low-cost, and
receive much different returns (see Figure IV-1). For market cap-weighted, with satellite allocations limited
the 10-year period ending December 31, 2021, investors to levels appropriate for each investor and practice.
received lower returns than the funds they invested in,
It is important to point out that such an evaluation
demonstrating that these funds’ cash flows tended to
is time-period dependent; results can look much
be attracted, rather than followed, by higher returns.
different from one year to the next. For example,
History suggests that, on average, this gap is most
Figure IV-1 shows that the behavior gap during the
evident in fund categories that are more concentrated,
year of a recent equity bear market, 2020, increased
narrow, or different from the overall market. It is less
meaningfully relative to the longer-term average. This
negative in the more broadly diversified categories,
underscores the importance of acting as a behavioral
which typically include a varying mix of equity
coach during episodic market distress.
and fixed income. The Vanguard Advisor’s Alpha
framework was built with a significant allocation to a

FIGURE IV-1
Annualized shortfalls of investor returns (IRR) versus fund or time-weighted returns (TWR)

U.S. large-cap equity U.S. mid-cap equity U.S. small-cap equity

Cautious Moderate
Blend Growth Value Blend Growth Value Blend Growth Value allocation allocation
Investor return less time-weighted return

–0.12%
–0.30%
–0.43%
–0.70% –0.68%
–0.84% –0.81% –0.83% –0.80% –0.78%
–1.02% –1.07% –1.07% –1.05%
–1.18% –1.25% –1.16%

–1.66% –1.67% –1.59%

–1.96%

–2.47%

Ten years One year

ended December 31, 2021 ended December 31, 2020

Notes: The time-weighted returns underlying this figure represent the average fund return in each category. Investor returns assume that the
growth of a fund’s total net assets for a given period is driven by market returns and investor cash flow. An internal rate-of-return function
calculates the constant growth rate that links the beginning total net assets and periodic cash flows to the ending total net assets. Discrepancies
in the return difference are due to rounding. Fund categories include fund-of-fund assets and cash flows to best capture investors’ experience
when that structure is common.
Sources: Vanguard calculations based on data from Morningstar, Inc.

18
Module ❺

Asset location
Potential value-add: On average, the value ranges from 0 to 60 bps; however, for any
individual it could be in excess of this range. The primary drivers are: the investor’s current
holdings, asset allocation, and “bucket” size—the breakdown of assets between taxable and
tax-advantaged accounts. Most of the benefits occur when the accounts are roughly equal
in size, the target allocation is in a balanced portfolio, and the investor is in a high marginal
tax bracket. If all the assets are in one account type (that is, all taxable or all tax-
advantaged), the value of asset location is 0 bps.

The allocation of assets between taxable and tax- Our research has shown that constructing the
advantaged accounts can add value each year that portfolio in this manner can add up to 60 bps of
can compound through time.8 From a tax perspective, additional return in the first year, without increasing
optimal portfolio construction minimizes the impact risk (see Figure V-1).
of taxes by holding tax-efficient broad-market equity
Investors or advisors who want to include active
investments in taxable accounts and taxable bonds
strategies—such as actively managed equity funds (or
in tax-advantaged accounts. This arrangement takes
ETFs), REITs, or commodities—should purchase them
maximum advantage of the yield spread between
in tax-advantaged accounts before taxable bonds
taxable and municipal bonds, which can generate a
because of their tax inefficiency. However, this likely
higher and more certain return premium. And those
means giving up space in tax-advantaged accounts
incremental differences have a powerful compounding
that would otherwise have been devoted to taxable
effect over the long run.
bonds—thereby losing the extra return generated by
the taxable-municipal spread.9

FIGURE V-1
On average, asset location can add up to 60 basis points of value annually to a portfolio

PR E-TA X AF TE R-TA X R E L ATIVE TO

TA X AB LE ACCO U NTS TA X- D E FE R R E D ACCO U NTS R E TU R N R E TU R N O P TI MAL (ROW A )

A. Index equity (50%) Taxable bonds (40%) and equity (10%) 6.7% 6.5% —

B. Taxable bonds (40%) and index

Equity (50%) 6.7% 6.0% –0.5%
equity (10%)

C. Municipal bonds (40%) and index

Equity (50%) 6.4% 6.3% –0.2%
equity (10%)

D. Active equity (50%) Taxable bonds (40%) and equity (10%) 6.7% 5.9% –0.6%

Notes: Pre-tax and after-tax returns are based on the following assumptions: taxable bond return, 4.4%; municipal bond return, 3.5%; index
equity, 8.3% (1.8% for dividends, 0.5% for long-term capital gains, and 6.0% for unrealized gains); and active equity, 8.3% (1.8% for dividends,
1.0% for short-term capital gains, 4.5% for long-term capital gains, and 1.0% for unrealized gains). This analysis uses a marginal U.S. income
tax rate of 37% for income and short-term capital gains and 20% for long-term capital gains and includes the 3.8% Medicare tax on investment
income. These values do not assume liquidation.
Source: Vanguard.

8 Absent liquidity constraints, wealth-management best practices would dictate maximizing tax-advantaged savings opportunities.
9 The taxable-municipal spread is the difference between the yields on taxable bonds and municipal bonds.

19
Purchasing actively managed equities or taxable bonds Advisors may decide to incorporate active equity
in taxable accounts frequently results in higher taxes strategies in tax-advantaged accounts before
because your client will be subject to: fulfilling a client’s strategic allocation to bonds for
several reasons. First, active equity investments can
1. Paying a federal marginal income tax rate on
potentially generate an excess return large enough to
taxable bond income. This could be as high as
offset not only the yield spread but
40.8%. One could, of course, purchase municipal
also the higher costs associated with these
bonds, but the result would be to forgo the taxable–
investments.10 Second, they may bring sufficient
municipal income spread.
benefits in other ways, such as risk reduction as a
2. Paying a long-term capital gains tax rate as high result of additional diversification. Although these
as 23.8%, depending on income, long-term capital outcomes are both possible, they are less probable
gains/distributions, and the client’s marginal than capturing the return premium offered by taxable
income tax rate on short-term gains. To the extent bonds held in tax-advantaged registrations.
the portfolio includes actively managed equity
In addition, estate-planning benefits may result
funds, capital gains distributions are more likely.
from placing broad-market equity index funds or
3. Paying a tax rate on qualified dividend income, ETFs in taxable accounts. Because broad-market
also as much as 23.8%, from equities, depending equity investments usually provide more deferred
on income. capital appreciation than bonds over the long term,
By contrast, purchasing tax-efficient broad-market the taxable assets have the added advantage of a
equity funds or ETFs in taxable accounts will still potentially larger step-up in cost basis for heirs.
be subject to points 2 and 3; however, the amount
of income or capital gains distributions will likely be
significantly lower.

10 See the Vanguard research paper The Case for Low-Cost Index Fund Investing (Rowley and Plagge, 2022).

20
Module ❻

Withdrawal order for client spending from portfolios

Potential value-add: Up to 120 bps, depending on the investor’s bucket size—the breakdown
of assets between taxable and tax-advantaged accounts—and marginal tax bracket. The
greatest benefits occur when the accounts are roughly equal in size and the investor is in a
high marginal tax bracket. If the assets are all in one account type (that is, all taxable or all
tax-advantaged), or the investor is not currently spending from the portfolio, the value of
the withdrawal order is 0 bps.

With the retiree population on the rise, an increasing FIGURE VI-1A.

number of clients are facing important decisions about Average internal rate of return of different
how to spend from their portfolios. Complicating withdrawal-order strategies
matters is the fact that many hold multiple account
1.7%
types, including taxable, tax-deferred (such as a

Internal rate of return

traditional 401(k) or IRA), and tax-free (such as a Roth
401(k) or IRA). Advisors who implement informed
withdrawal-order strategies can minimize the total
taxes investors will pay over the course of retirement,
thereby increasing their wealth and the longevity of 0.5% 0.5%
their portfolios. This process alone could represent the
entire value proposition for the fee-based advisor.
Spend taxable Spend tax- Spend tax-
assets prior deferred assets free assets
The impact of taxes can be minimized by spending to tax-advantaged prior to taxable prior to taxable
from the portfolio in the following order: required
IMPORTANT: The projections and other information
minimum distributions (RMDs), if applicable, followed generated by the Vanguard Capital Markets Model
by cash flows on assets held in taxable accounts, regarding the likelihood of various investment outcomes
taxable assets, and finally tax-advantaged assets are hypothetical in nature, do not reflect actual investment
results, and are not guarantees of future results. Distribution
(see Figure VI-1a and Figure VI-1b).11 Our research of return outcomes from VCMM are derived from 10,000
has shown that this can add up to 120 basis points of simulations for each modeled asset class. Simulations are as
average annualized value without any additional risk.12 of December 31, 2021. Results from the model may vary with
each use and over time. For more information, see Appendix
To calculate this value, we compared the IRR of this 2 on page 31.

spending order to that of two alternatives in which Notes: These hypothetical data do not represent the returns on any
particular investment. Each IRR is calculated by running the same
tax-advantaged assets were tapped first: (1) spending 10,000 VCMM simulations through three separate models, each
from tax-deferred assets before taxable assets and (2) designed to replicate the stated withdrawal-order strategy.
spending from tax-free assets before taxable assets. Source: Vanguard.
Both cases resulted in lower terminal wealth.
Assumptions for our analysis
PO R TFO LI O 50% S TOCKS/50% BO N DS
Equtiy allocaiton 60% domestic/40% international
Fixed income allocaiton 70% domestic/30% international

Time horizon 35 years

Marginal U.S. income tax rate 40.8%

Long-term capital gains tax rate 23.8%

11 Tax-advantaged assets include both tax-deferred and tax-free (Roth) accounts.

12 Clearly, an investor’s specific financial plan may warrant a different spending order, but this framework can serve as a prudent guideline for most investors.
See From Assets to Income: A Goals Based Approach to Retirement Spending (Jaconetti et al., 2020) for a more detailed analysis.
21
FIGURE VI-1B. spent from the tax-deferred accounts first. Over time,
Detailed spending order and explanation the acceleration of income taxes and the resulting
loss of tax-deferred growth can negatively affect the
portfolio, resulting in lower terminal wealth values and
1. RMDs (if applicable)
success rates.

2. Taxable flows Investors should likewise consider spending from

their taxable accounts before their tax-free accounts
3. Taxable portfolio
to maximize the long-term growth of their overall
portfolio. Reducing the amount of assets with tax-free
growth potential can result in lower terminal wealth
A B values and success rates.

1.
Higher expected marginal
1.
Lower expected marginal Once the order of withdrawals has been determined,
tax bracket in the future tax bracket in the future
the next step is to specifically identify which asset or
2. 2.
assets to sell to meet spending needs. Within taxable
Tax-deferred Tax-free
portfolios, investors should first spend portfolio cash
3. Tax-free 3. Tax-deferred flows, because this money is taxed regardless of
whether it’s spent or reinvested. Reinvesting and then
Source: Vanguard. selling the assets later to meet spending needs could
result in short-term capital gains, which are currently
RMDs are the first assets to spend because they
subject to ordinary income tax rates.
are required by law for retired investors more than
70½ years old (or 72 for those born after July 1, 1949) Next, the investor should consider selling the asset or
who own assets in tax-deferred accounts. For those assets that would produce the lowest taxable gain or
who are not subject to RMDs or who need additional realize a loss. This should continue until the spending
money, the next source should be cash flows from need has been met or the taxable portfolio has been
assets held in taxable accounts, including interest, exhausted.
dividends, and capital gains distributions, followed by
assets held in taxable accounts. Once their taxable accounts have been depleted,
investors must decide whether to spend next from
Investors should deplete their taxable assets before tax-deferred or tax-free (Roth) accounts. This decision
spending from their tax-deferred accounts because should be based on future tax-rate expectations. If
swapping the order would accelerate the payment future tax rates are expected to be higher, spending
of income taxes. Taxes on withdrawals from tax- from tax-deferred accounts should take priority. This
deferred accounts will likely be higher than those allows investors to lock in the lower tax rates on the
on withdrawals from taxable accounts, for two tax-deferred withdrawals, rather than allowing tax-
reasons. First, investors will pay ordinary income deferred accounts to continue to grow and be subject
taxes on the entirety of their withdrawals (assuming to higher future tax rates.
the contributions were made with pre-tax dollars),
rather than just paying capital gains taxes on capital Conversely, for investors who anticipate lower future
appreciation. Second, ordinary income tax rates tax rates, spending from tax-free assets should take
are currently higher than capital gains tax rates, so priority. This will result in lower taxes over the entire
investors would have to pay higher tax rates if they investment horizon.

22
Module ❼

Total return versus income investing

Potential value-add: Value is significant but unique and unquantifiable, based on each
investor’s desired level of spending and portfolio composition.

With yields on balanced and fixed income portfolios they can reallocate to higher-yielding investments, or
at historically low levels and expected to remain low they can spend from the total return on their portfolio,
relative to past standards, the value of advice has which includes not only the income or yield but also the
never been more critical for retirees. Historically, capital appreciation.
retirees holding diversified equity and fixed income
As your clients’ advisor, you can help them make
investments could have easily lived off the income
the right choice. For many investors, moving away
generated by their portfolios. Unfortunately, that is no
from broad diversification could put their portfolio’s
longer the case. Investors who wish to spend only the
principal value at higher risk than spending from it.
income generated by their portfolio, referred to here
as the “income-only” approach, have three choices if
Figure VII-1 outlines several common techniques for
increasing a portfolio’s yield, along with their impacts.
their current cash flows fall short. They can spend less,

FIGURE VII-1
Income-only strategies and potential portfolio impact

I M PAC T O N A PO R TFO LI O
(CO M PAR E D WITH A MAR K ET CAP -WE I GHTE D PO R TFO LI O AT
S TR ATEGY TH E SU B -ASS ET- CL ASS LE VE L )

1. Overweighting of longer-term bonds

Increases exposure to changes in interest rates
(extending the duration)

2. Overweighting of high-yield bonds and/or

Increases credit risk and raises overall volatility
underweighting of U.S. Treasury bonds

Decreases diversification of equity portfolio by overweighting certain

3. Increasing exposure to dividend-centric equity sectors and/or increases overall volatility and risk of loss if it reduces the
bond portfolio

Source: Vanguard.

23
1. Overweighting longer-term bonds (extending 3. Increasing exposure to dividend-centric equity
the duration) An often-advocated equity approach to increase
Extending the duration of the bond portfolio will income is to shift some or all of a fixed income
likely increase the current yield but will also increase allocation into higher-yielding dividend-paying
sensitivity to changes in interest rates. Generally stocks. But stocks are not bonds. At the end of
speaking, the longer the bond portfolio’s duration, the day, they will perform like stocks—they have
the greater the decline in prices when interest rates higher volatility and the potential for greater losses.
rise (and the greater the gain when rates fall). Moreover, dividend stocks are correlated with stocks
in general, whereas bonds typically show little
2. Overweighting high-yield bonds to no correlation with either of these. If you view
Another strategy to increase yield is to increase fixed income as providing not just yield but also
the allocation to higher-yielding bonds exposed to diversification, dividend-paying stocks fall well short
marginal or even significant credit risk.13 However, as a substitute.
credit risk tends to be correlated with equity risk, A second approach is to shift from broad-market
which tends to be magnified when investors move equity to dividend- or income-focused equity.
into riskier bonds at the expense of U.S. Treasury However, this may inadvertently change the
bonds. Treasury bonds are a proven diversifier portfolio’s risk profile, because dividend-focused
during periods of equity market duress, when equities tend to display a bias toward value stocks.14
diversification is needed the most. Although value stocks are generally considered to be
Vanguard research has shown that replacing broad- a less risky subset of the broader equity market, the
market, investment-grade fixed income holdings risks nevertheless can be substantial.15 Portfolios
with high-yield bonds historically has increased the focused on dividend-paying stocks tend to be
volatility of a balanced portfolio. This is because overly concentrated in certain individual stocks and
high-yield bonds are more highly correlated with sectors.
the equity markets and are more volatile than In addition, in an income-only approach, asset
investment-grade bonds. Investors who employ such location is typically driven by access to income at
a strategy are sacrificing diversification benefits in the expense of tax efficiency. As a result, investors
hopes of receiving higher current income. and advisors are more likely to purchase taxable
bond funds or income-oriented stock funds in
taxable accounts to gain access to their income
(yield). This approach will most likely increase taxes,
resulting in a direct reduction in spending.

13 The term high-yield bonds refers to fixed income securities rated as below investment grade by the primary ratings agencies (Ba1 or lower by Moody’s
Investors Service; BB+ or lower by Standard & Poor’s).
14 See the Vanguard research paper From Assets to Income: A Goals Based Approach to Retirement Spending (Jaconetti et al., 2020).
15 “Less risky” should not be taken to mean “better.” Going forward, value stocks should have a risk-adjusted return similar to that of the broad equity market,
unless there are risks that are not recognized in traditional volatility metrics.

24
Benefits of a total return approach Modules conclusion
to investing
Where should you begin? We believe you should focus
Some may feel that the income strategies described
on those areas in which you have control, at least to
above will reward them with a more certain return
some extent, such as:
and therefore less risk. But in reality, such strategies
will increase the portfolio’s risk. It will become too • Helping your clients select the asset allocation
concentrated in certain sectors, with less tax efficiency that is most appropriate to meeting their goals
and a higher chance of failing to provide for long-term and objectives, given their time horizon and risk
financial goals. tolerance.
Vanguard believes in a total return approach, which • Implementing the asset allocation using low-cost
considers both income and capital appreciation. investments and, to the extent possible, asset-
This has the following potential advantages over an location guidelines.
income-only method: • Limiting deviations from the market portfolio, and
thus benefiting your clients and your practice.
• Less risk. It allows better diversification, instead
of concentrating on certain securities, market • Concentrating on behavioral coaching and spending
segments, or industry sectors to increase yield. time communicating with your clients.
• Better tax efficiency. It offers more tax-efficient
asset locations (for clients who have both taxable
and tax-advantaged accounts). An income approach
focuses on access to income, resulting in the need to
keep tax-inefficient assets in taxable accounts.
• A potentially longer lifespan for the portfolio.
Designing tax-efficient total return strategies
when investors require specific cash flows to meet
their spending needs involves substantial analysis,
experience, and transactions. To do this well is not easy
and could well represent the entire value proposition of
an advisory relationship.

25
References
Bennyhoff, Donald G., 2018. The Vanguard Advisor’s Alpha Guide to Proactive Behavioral Coaching. Valley Forge,
Pa.: The Vanguard Group.

Bennyhoff, Donald G., and Colleen M. Jaconetti, 2016. Required or Desired Returns? That Is the Question. Valley
Forge, Pa.: The Vanguard Group.

Bennyhoff, Donald G., and Francis M. Kinniry Jr., 2018. Vanguard Advisor’s Alpha. Valley Forge, Pa.: The Vanguard
Group.

Bennyhoff, Donald G., and Yan Zilbering, 2009. Market-Timing: A Two-Sided Coin. Valley Forge, Pa.: The Vanguard
Group.

Davis, Joseph H., Francis M. Kinniry Jr., and Glenn Sheay, 2007. The Asset Allocation Debate: Provocative
Questions, Enduring Realities. Valley Forge, Pa.: The Vanguard Group.

Jaconetti, Colleen M., 2007. Asset Location for Taxable Investors. Valley Forge, Pa.: The Vanguard Group.

Jaconetti, Colleen M., Michael A. DiJoseph, Francis M. Kinniry Jr., David Pakula, and Hank Lobel, 2020. From
Assets to Income: A Goals-Based Approach to Retirement Spending. Valley Forge, Pa.: The Vanguard Group;
available at [Link]/content/dam/corp/research/pdf/from-assets-to-income-a-goals-based-
approach-to-retirement-spending-usa-isgelr_042020_online.pdf.

Jaconetti, Colleen M., Francis M. Kinniry Jr., and Yan Zilbering, 2010. Best Practices for Portfolio Rebalancing.
Valley Forge, Pa.: The Vanguard Group.

Kinniry, Francis M., Jr., Michael A. DiJoseph, Colleen M. Jaconetti, David Walker, and Maria C. Quinn, forthcoming.
The Evolution of Vanguard Advisor’s Alpha: From Portfolios to People. Valley Forge, Pa.: The Vanguard Group.

Kinniry, Francis M., Jr., Colleen M. Jaconetti, Donald G. Bennyhoff, and Michael A. DiJoseph, 2016. Reframing Investor
Choices: Right Mindset, Wrong Market. Valley Forge, Pa.: The Vanguard Group.

Kinniry, Francis M., Jr., and Yan Zilbering, 2012. Evaluating Dollar-Weighted Returns of ETFs Versus Traditional Fund
Returns. Valley Forge, Pa.: The Vanguard Group.

National Association of College and University Business Officers, 2021. 2021 NACUBO-TIAA Study of Endowments.
Washington, D.C.: NACUBO.

Philips, Christopher B., 2012. Worth the Risk? The Appeal and Challenge of High-Yield Bonds. Valley Forge, Pa.: The
Vanguard Group.

Rowley, James J., Jr., and Jan-Carl Plagge, 2022. The Case for Low-Cost Index Fund Investing. Valley Forge, Pa.:
The Vanguard Group; available at [Link]/content/dam/corp/research/pdf/the_case_for_low_
cost_index_fund_investing_052022.pdf.

Smith, Scott, and John McKenna, 2021. The Cerulli Report—U.S. Retail Investor Advice Relationships 2021:
Navigating Perpetual Unease. Boston, Ma.: Cerulli Associates.

Vanguard Advisor’s Alpha Research Team, 2019. Investors Are “Voting With Their Feet” on Costs. Valley Forge, Pa.:
The Vanguard Group.

Vanguard Investment Strategy Group, 2021. Vanguard Economic and Market Outlook for 2022: Striking a Better
Balance. Valley Forge, Pa.: The Vanguard Group; available at [Link]/content/dam/corp/
research/pdf/ISGVEMO2022_122021_online.pdf.

26
 Appendix 1. Relative performance charts
FIGURE A-1
Relative performance of U.S. equity and U.S. bonds
Rolling cumulative total return differentials, in percentage points over various periods
200%
U.S. equity outperforms
Differential (percentage points)

150
60-month
100
return differential
50 36-month
return differential
0
12-month
–50 return differential
U.S. equity underperforms
–100
1980 1985 1990 1995 2000 2005 2010 2015 2020

L ARG ES T PE R FO R MAN CE
D I FFE R E NTIAL S
(CU M U L ATIVE , I N PE RCE NTAG E
PO I NTS) O N E M O NTH 12 M O NTHS 36 M O NTHS 60 M O NTHS

U.S. equity outperforms 12.1% 62.0% 95.4% 186.0%

U.S. equity underperforms –25.1% –45.3% –73.8% –61.7%

Notes: U.S. bonds are represented by the Bloomberg U.S. Aggregate Bond Index. U.S. equity is represented by the Dow Jones Wilshire 5000
Index through April 22, 2005; the MSCI US Broad Market Index from April 23, 2005, through June 2, 2013; and the CRSP US Total Market Index
thereafter. The line graph reflects monthly observations of cumulative total return differentials, starting with the 12 months ended November 30,
1980, and concluding with the 12-, 36-, and 60-month periods ended December 31, 2021.
Sources: Vanguard calculations based on data from FactSet.

27
 FIGURE A-2
Relative performance of U.S. equity and non-U.S. equity
Rolling cumulative total return differentials, in percentage points over various periods

200%
U.S. equity
Differential (percentage points)

outperforms
100 60-month
return differential

0 36-month
return differential

–100 12-month
U.S. equity return differential
underperforms
–200
1980 1985 1990 1995 2000 2005 2010 2015 2020

L ARG ES T PE R FO R MAN CE
D I FFE R E NTIAL S
(CU M U L ATIVE , I N PE RCE NTAG E
PO I NTS) O N E M O NTH 12 M O NTHS 36 M O NTHS 60 M O NTHS

U.S. outperforms 12.6% 31.5% 98.0% 167.1%

U.S. underperforms –15.7% –32.6% –96.6% –136.9%

Notes: U.S. equity is represented by the Dow Jones Wilshire 5000 Index through April 22, 2005; the MSCI US Broad Market Index from April
23, 2005, through June 2, 2013; and the CRSP US Total Market Index thereafter. Non-U.S. equity is represented by the MSCI World Index
through December 31, 1987, and the MSCI AC World ex US Index thereafter. The line graph reflects monthly observations of cumulative total
return differentials, starting with the 12 months ended November 30, 1980, and concluding with the 12-, 36-, and 60-month periods ended
December 31, 2021.
Sources: Vanguard calculations based on data from FactSet.

28
 FIGURE A-3
Relative performance of large-cap U.S. equity and small-cap U.S. equity
Rolling cumulative total return differentials, in percentage points over various periods

200%
Differential (percentage points)

150 Large-cap U.S. equity outperforms

100 60-month
return differential
50
36-month
0 return differential

–50 12-month
Large-cap U.S. equity underperforms
return differential
–100
1980 1985 1990 1995 2000 2005 2010 2015 2020

L ARG ES T PE R FO R MAN CE
D I FFE R E NTIAL S
(CU M U L ATIVE , I N PE RCE NTAG E PO I NTS) O N E M O NTH 12 M O NTHS 36 M O NTHS 60 M O NTHS

Large-cap U.S. equity outperforms 16.4% 34.7% 85.8% 150.5%

Large-cap U.S. equity underperforms –18.4% –37.5% –66.9% –74.0%

Notes: Large-cap U.S. equity is represented by the S&P 500 Index through December 31, 1983; the MSCI US Prime Market 750 Index from
January 1, 1984, through January 31, 2013; and the CRSP US Large Cap Index thereafter. Small-cap U.S. equity is represented by the Russell 2000
Index through May 16, 2003; the MSCI US Small Cap 1750 Index from May 17, 2003, through January 31, 2013; and the CRSP US Small Cap Index
thereafter. The line graph reflects monthly observations of cumulative total return differentials, starting with the 12 months ended November 30,
1980, and concluding with the 12-, 36-, and 60-month periods ended December 31, 2021.
Sources: Vanguard calculations based on data from FactSet.

29
 FIGURE A-4
Relative performance of developed-market equity and emerging-market equity
Rolling cumulative total return differentials, in percentage points over various periods

200%
Developed-market
Differential (percentage points)

equity outperforms
60-month return
differential
0
36-month return
differential
12-month return
–200 differential

Developed-market
equity underperforms
–400
1980 1985 1990 1995 2000 2005 2010 2015 2020

L ARG ES T PE R FO R MAN CE
D I FFE R E NTIAL S
(CU M U L ATIVE , I N PE RCE NTAG E PO I NTS) O N E M O NTH 12 M O NTHS 36 M O NTHS 60 M O NTHS

Developed-market equity outperforms 15.6% 56.5% 101.7% 150.3%

Developed-market equity underperforms –16.7% –64.7% –171.8% –333.4%

Notes: Developed-market equity is represented by the MSCI World Index. Emerging-market equity is represented by the MSCI Emerging Markets
Index. The line graph reflects monthly observations of cumulative total return differentials, starting with the 12 months ended December 31,
1988, and concluding with the 12-, 36-, and 60-month periods ended December 31, 2021.
Sources: Vanguard calculations based on data from FactSet.

FIGURE A-5
Relative performance of value U.S. equity and growth U.S. equity
Rolling cumulative total return differentials, in percentage points over various periods

100%
Value U.S. equity outperforms
60-month
Differential (percentage points)

return differential

0 36-month
return differential

12-month
–100 return differential
Value U.S. equity underperforms

–200
1980 1985 1990 1995 2000 2005 2010 2015 2020

L ARG ES T PE R FO R MAN CE
D I FFE R E NTIAL S
(CU M U L ATIVE , I N PE RCE NTAG E
PO I NTS) O N E M O NTH 12 M O NTHS 36 M O NTHS 60 M O NTHS

Value U.S. equity outperforms 9.7% 40.4% 35.0% 58.7%

Value U.S. equity underperforms –12.0% –43.3% –84.7% –147.3%

Notes: Value U.S. equity is represented by the S&P 500/Barra Value Index through May 16, 2003; the MSCI US Prime Market Value Index from
May 17, 2003, through April 16, 2013; and the CRSP US Large Cap Value Index thereafter. Growth U.S. equity is represented by the S&P 500/
Barra Growth Index through May 16, 2003; the MSCI US Prime Market Growth Index from May 17, 2003, through April 16, 2013; and the CRSP
US Large Cap Growth Index thereafter. The line graph reflects monthly observations of cumulative total return differentials, starting with the 12
months ended November 30, 1980, and concluding with the 12-, 36-, and 60-month periods ended December 31, 2021.
Sources: Vanguard calculations based on data from FactSet.

30
Appendix 2. About the Vanguard Capital Markets Model
The Vanguard Capital Markets Model® (VCMM) is a The VCMM projections are based on a statistical
proprietary financial simulation tool developed and analysis of historical data. Future returns may behave
maintained by Vanguard’s Investment Strategy Group. differently from the historical patterns captured
Part of the tool is a dynamic module that employs in the VCMM. More importantly, the VCMM may
vector autoregressive methods to simulate forward- be underestimating extreme negative scenarios
looking return distributions on a wide array of broad unobserved in the historical period on which the model
asset classes, including stocks, taxable bonds, and estimation is based.
cash. For the VCMM simulations in Figure V-1, we
The VCMM is a proprietary financial simulation tool
used market data available through June 30, 2013, for
developed and maintained by Vanguard’s primary
the U.S. Treasury spot yield curves. The VCMM then
investment research and advice teams. The model
created projections based on historical relationships
forecasts distributions of future returns for a wide
of past realizations among the interactions of several
array of broad asset classes. Those asset classes
macroeconomic and financial variables, including the
include U.S. and international equity markets, several
expectations for future conditions reflected in the U.S.
maturities of the U.S. Treasury and corporate fixed
term structure of interest rates. The projections were
income markets, international fixed income markets,
applied to the following Bloomberg U.S. bond indexes:
U.S. money markets, commodities, and certain
1–5 Year Treasury Index, 1–5 Year Credit Index, 5–10
alternative investment strategies. The theoretical and
Year Treasury Index, and 5–10 Year Credit Index. It is
empirical foundation for the VCMM is that the returns
important to note that taxes are not factored into
of various asset classes reflect the compensation
the analysis.
investors require for bearing different types of
Limitations: The projections are based on a statistical systematic risk (beta). At the core of the model are
analysis of December 31, 2021, yield curves in the estimates of the dynamic statistical relationship
context of relationships observed in historical data for between risk factors and asset returns, obtained
both yields and index returns, among other factors. from statistical analysis based on available monthly
Future returns may behave differently from the financial and economic data from as early as 1960.
historical patterns captured in the distribution of Using a system of estimated equations, the model
returns generated by the VCMM. It is important to then applies a Monte Carlo simulation method to
note that our model may be underestimating extreme project the estimated interrelationships among risk
scenarios that were unobserved in the historical data factors and asset classes as well as uncertainty and
on which the model is based. randomness over time. The model generates a large
set of simulated outcomes for each asset class over
IMPORTANT: The projections and other information
several time horizons. Forecasts are obtained by
generated by the VCMM regarding the likelihood of
computing measures of central tendency in these
various investment outcomes are hypothetical in
simulations.
nature, do not reflect actual investment results, and
are not guarantees of future results. VCMM results
will vary with each use and over time.

31
Connect with Vanguard®
[Link] • 800-997-2798

For more information about Vanguard funds, visit [Link] or call

800-997-2798 to obtain a prospectus. Investment objectives, risks, charges,
expenses, and other important information about a fund are contained in the
prospectus; read and consider it carefully before investing.
Morningstar data: © 2023 Morningstar, Inc. All rights reserved. The information contained
herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or
distributed; (3) does not constitute investment advice offered by Morningstar; and (4) is not
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are responsible for any damages or losses arising from any use of this information.
© 2023 The Vanguard Group, Inc.
Past performance is not a guarantee of future results. All rights reserved.
CFA® is a registered trademark owned by CFA Institute. Vanguard Marketing
Corporation, Distributor.
Vanguard is investor-owned, meaning the fund shareholders own the funds, which in turn
own Vanguard. IARCQAA 042023

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