In my 2017 paper, Asset Location and Uncertainty, I demonstrated that the failure to accurately predict future returns can quickly make an ex ante optimal asset location strategy ex post sub-optimal. That paper focused on the value-added from optimal asset location through the lens of pre-tax asset allocation. I focused on pre-tax asset allocation because that is how most practitioner literature approaches the topic.

The problem with comparing various asset location strategies through the lens of pre-tax asset allocation is that it provides a poor framework for comparing expected investment outcomes. Two portfolios with the same pre-tax asset allocation can have materially different risk-return characteristics. This is the most important point to be made in this paper.

For example, assuming a 50% tax rate, take a $600,000 taxable account and a $400,000 RRSP with the RRSP full of bonds and the taxable account full of stocks. This portfolio has a pre-tax asset allocation of 60% stocks and 40% bonds, but it has an after-tax asset allocation of 75% stocks and 25% bonds. It is important to recognize that the after-tax asset allocation is measuring the allocation of the capital that you own. The pre-tax asset allocation is skewed by the government’s capital – your future tax bill. While counterintuitive to consider, the after-tax asset allocation is the driver of your expected outcome.

If we optimize asset location for a given pre-tax asset allocation, our optimization will always lead us to hold bonds in the RRSP account, leading to a more aggressive after-tax asset allocation, which drives higher expected returns. The problem with this approach is that we are not comparing apples to apples; a more aggressive portfolio is not necessarily a more tax efficient portfolio. We will examine this issue with examples throughout this paper.

Finally, even comparing two portfolios with the same after-tax asset allocation may not be rational. In a 2004 paper in the Journal of Finance aptly titled Optimal Asset Location and Allocation with Taxable and Tax-Deferred Investing the authors take it one step further: they adjust asset location to maximize the utility of after-tax wealth.

Utility maximization is not as easy to understand as asset allocation; the simplest explanation is that the risk and expected return characteristics are entirely different in a taxable and a tax-free account. Stocks are less risky and have lower expected returns in a taxable account due to taxes. Adjusting the location of assets may also require an asset allocation adjustment to maintain the desired portfolio characteristics. Approaching the problem from the perspective of utility leads to an interesting and easy to apply conclusion on the optimal location of assets.

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