For many, the title might remind you of the Greek alphabet. For those in the investment industry it denotes factors for returns.

Professionals in my industry are obsessed with measuring everything. In some cases this is very important. In others, unfortunately, it tends to obfuscate the important dynamics of investment management and financial planning.

For those unfamiliar with the terms, alpha generally refers to the outperformance or underperformance of an investment or fund in regards to its underlying benchmark. For example, a positive alpha of 1 means the fund of question has outperformed its relevant benchmark index by 1%. Beta of an investment, on the other hand, is a measure of the risk arising from exposure to general market movements as opposed to idiosyncratic factors. In this case, a fund with a beta of 2 would be twice as volatile as its underlying index. It is a measure of systematic risk. Knowing this, many investors wish to pay very little for beta (market risk) and more for alpha that helps them outperform. But there is another aspect that investors should consider … gamma.

Garnering Gamma

An inordinate time is spent on selecting great funds or mangers to capture alpha and proper asset allocation to encapsulate a client’s correct beta exposure. The benefit and value of making proper financial planning decisions, however, is difficult to measure and often overlooked.

In a paper published in August of 2013, Morningstar titled “Alpha, Beta, and Now … Gamma” (http://corporate.morningstar.com/ib/documents/PublishedResearch/AlphaBetaandNowGamma.pdf), they attempt to quantify the additional value that can be achieved by an individual investor from making “more intelligent financial planning decisions”. They focus on five fundamental financial planning decisions/techniques: a total wealth framework to determine the optimal asset allocation, a dynamic withdrawal strategy, incorporating guaranteed income products (i.e. annuities), tax-efficient decisions, and liability-relative asset allocation optimisation. Their conclusion is significant:

“Each of these five Gamma components creates value for retirees, and when combined, can be expected, given the paper’s assumptions about risk aversion and other variables, to generate 22.6 per cent more certainty-equivalent income when compared to a simplistic static withdrawal strategy according to our analysis. This additional certainty-equivalent income has the same impact on expected utility as an arithmetic “alpha” of 1.59 per cent (i.e., Gamma equivalent alpha) and thereby represents a significant potential increase in portfolio efficiency (and retirement income) for retirees.”

The follow on conclusion for this is also telling. They suggest that if your advisor is paid solely to manage assets and does not assist in providing additional advice regarding anything outside of this mandate, then using alpha and beta as measurements of value should work relatively well. When it comes to providing more complicated financial advice like retirement saving and/or legacy planning, the value of an advisor should not be solely predicated on these two factors.

The successful achievement of the client’s goal is paramount. For example, if the advisor helped the client choose funds which generated significant alpha over his/her retirement but the client ran out of money at age 70 this obviously would not be of any value. To quote Morningstar: “It may be that a financial advisor generates significant negative alpha for a client (i.e., invests the client’s money in very expensive mutual funds that underperform), but still provides other valuable services that enable a client to achieve his or her goals. While this financial advisor may have failed from a pure alpha perspective, the underlying goal was accomplished. This is akin to losing a battle but winning the war.”

In other words, an obsessive focus on relative returns is not constructive when other goals are paramount. There is a great deal of value in getting across the finish line for clients that I’m pretty sure they don’t mind paying for.

Another factor not implicitly stated in Morningstar’s study would be the enormous value a high quality advisor can provide with calm, consistent, empathetic but tough-love counselling. It’s very difficult for investors to avoid the myriad of behavioural traps involved in investing. An advisor can help overcome many through proper planning, perspective and possibly some behavioural modification. Thus it could be said that the highest and most valuable function of an advisor is coaching clients in a way that avoids fatal errors. This coaching alone can be well in excess of what investors pay in fees.

The achievement of one’s financial goals and wealth is not necessarily driven solely by performance but increasingly due to investor behaviour. Examples would include ignoring euphoric bull markets and avoiding panic capitulation at bear market bottoms. There is probably no more stark portrayal of this cost and effect than the results of the Dalbar study. Dalbar’s 21st annual “Quantitative Analysis of Investor Behavior” study continues to suggest investors desperately need more education and guidance from advisers.

In 2014, the 20-year annualised S&P return was 9.85 per cent while the 20-year annualised return for the average equity mutual fund investor was only 5.19 per cent, a gap of 4.66 per cent. In fact they suggest there are three primary causes for chronic shortfalls found among fixed income and equity investors: psychological factors, capital not available to invest and capital needed for other purposes. The biggest factor among these is the psychological aspects. If an advisor can help clients avoid poor timing decisions and adhering to a well-constructed longer-term plan, significant gamma can be achieved.

In an investing world that continues to be obsessed with debate on “smart-beta”, “portable alpha” and passive vs. active, some important factors tend to be lost. Gamma, or the additional value investors can capture from more intelligent financial decisions and behaviour is an important and crucial aspect for investor success. In fact it may be the most valuable letter in the Greek alphabet.

Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd. and can be reached at nkowalski@anchor.bm

Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by the author to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.