How to outperform using boring old index funds

One of the most common knocks against index funds is that they guarantee you average returns minus fees and, by golly, clients need above average returns or else they're going to start looking for a new adviser.

But it's silly to think that the only way an adviser can add alpha to a client's portfolio is by finding the next hot fund manager, sector or stock.

In fact, for advisers, adding alpha is as simple as making savvy tax moves and as stopping clients from making classic investing mistakes like buying high, selling low and thinking short-term instead of long-term. These are all basic things that mom-and-pop investors probably aren't thinking about on their own. And these are things that an adviser can actually control, unlike, say, the market's returns.

So even by using index funds, which are designed to give investors the market's return, minus fees, an adviser can add performance to a client's portfolio that they likely wouldn't get on their own.

“Advisers are the alpha,” said Martha King, managing director of The Vanguard Group Inc.'s financial adviser services division.

“It's not about stock picking anymore,” she said. “Advisers can make a difference through their coaching and their guidance. They add value through building the relationship and helping clients be clear about their life goals.”

The shift is already well under way within the financial advice industry, but becoming comfortable with pitching themselves as the alpha to clients, rather than promising to kick the pants off the market, is one of the biggest challenges advisers face this year, Ms. King said.

“Many advisers are still in the midst of that turn,” she said.

Some major institutions also are in deeply involved in helping advisers make that turn as well. Bank of America Merrill Lynch, for example, is in the middle of a five-year strategic plan to shift its focus to goals-based wealth management.

Of course, this doesn't mean active management has no room in a portfolio. Focusing on long-term planning will also benefit advisers using actively managed funds, since research has shown that finding above-average long-term outperformance from an active manager requires a great deal of patience.

Two-thirds of the 275 actively managed stock funds that outperformed over the 15-year period ended Dec. 31, 2012, suffered at least three consecutive years of underperformance, for example, according to Vanguard.

So really, thinking about yourself as alpha rather than spending time and resources trying to find it in the market, is a win for you and for your clients.