Benjamin Felix August 13, 2018 Starting Out Asset Location: Promising Theories vs. Practical Applications The nonsense of trying to come out ahead by picking stocks or timing the market has long been one of my recurring themes. So, if you’ve stuck with me so far, you probably already know to avoid these sorts of active pursuits. There are other, more sensible ways to seek more from your investments – such as effective tax planning to help you keep more of your returns as your own. Asset location is one form of tax planning. So far, so good. But now, I’m going to shake things up a bit. While asset location sounds great in theory, once we work the actual numbers, we often discover it may not be all it’s cracked up to be. At the very least, you don’t want to get lost in the weeds when trying to locate your assets. What Is Asset Location? First things first: What is asset location? I am not talking about asset allocation, which is deciding how much of each asset class you should hold overall. Asset location is the practice of holding certain asset classes in certain account types. Typically, you follow a set of rules for holding the assets with the highest expected tax costs in your non-taxable accounts. For example, you may deliberately hold less-tax-efficient bonds in your RRSP and more-tax-efficient Canadian stocks in your taxable account. Easy right? Well, it is easy in theory, but there’s a catch. To know where the highest expected tax costs will occur, it helps to know in advance what your future taxes and returns are going to be. Without a crystal ball to help you peer into the future, it can be really, really hard. Can Asset Location Add Value? On the plus side, much has been written about asset location and its potential contribution to after-tax returns. Here are several analyses that compare an asset location strategy versus holding the same asset mix in each of your accounts (such as the same 60/40 stock/bond allocation in every account you own): [Can you hyperlink to these papers?] In a 2013 paper from Morningstar, David Blanchett and Paul Kaplan determined that asset location might add up to 23 basis points (bps) of value per year to after-tax returns. In a 2014 paper, my PWL colleagues Dan Bortolotti and Justin Bender found that optimal asset location would have added 30 bps per year to the after-tax returns in an ETF portfolio held from 2003–2012. In a 2017 paper, I used statistical analysis to test an asset location model and found that optimal asset location could ideally add an average of 23 bps per year to after-tax returns. My ideal situation included an investor taxed at Ontario’s highest marginal rate, with enough room in their RRSP to hold most of their bonds while staying in line with their target asset allocation. But, again, we cannot know in advance what returns a portfolio will actually earn. So, in my own paper, I used Monte Carlo analysis to stress test my optimal asset location strategy across a range of about 1,000 potential outcomes. I found that asset location did in fact add value about 80% of the time. While this was an interesting finding, it was still based on forward-looking assumptions. Any asset location optimization decision is based on the expectation of future returns … which, of course, we cannot know except in hindsight. To test the robustness of my optimal asset location decision against my inability to know the future, I next ran the Monte Carlo model against actual returns instead of the expected returns that had been used to make the optimal asset location decision. Under these circumstances, the average value-added dropped from 23 bps to 7 bps. More importantly, the optimal asset location strategy only outperformed holding an identical asset allocation in all accounts 58% of the time. Should You Pursue Asset Location? When we realize that asset location does not guarantee higher after-tax returns, we should start to wonder about other issues that may arise. I explore these possibilities in more detail in my related video, but to name a few, there are: Regulatory risks – What if tax rates or other tax laws change? Room for error – Given all the future unknowns, even financial professionals and academics often heatedly debate just what qualifies as “optimal” asset location. Added complexities – Obviously, it takes a lot more time and energy to engage in asset location than to simply duplicate the same asset allocation in each account. Is the potential value-added worth it? Debilitating distractions – Asset location may cause more harm than good if it distracts you from other investment best practices, such as remaining fully invested and engaging in periodic rebalancing. In response to a comment on one of his blog posts, my PWL colleague Justin Bender echoed my own thoughts perfectly: “There are many thoughts on the asset location decision and in the end, it probably doesn’t matter much.” Put simply, since we cannot predict the future, I often question the value of trying to optimize for asset location. It may even make an investor worse off if they’re struggling with the complexity or, worse, delaying the implementation of their portfolio due to asset location concerns. Do you have an opinion on the asset location decision? Leave me a comment about it in my asset location video. Share: Facebook Twitter LinkedIn Email CIRO Advisor Report
Advanced Investing Benjamin Felix Optimizing Your After-Tax Asset Allocations: Is It Worth It? Nov 23, 2018 Advanced Investing