I think that most of the people watching my videos would agree that it is next to
impossible to beat the market consistently through stock picking or market timing. Knowing that,
it is sensible for investors to look for other ways to get more out of their investments.
Tax planning is one way that investors can keep more of their returns. Asset
location is a form of tax planning. I am not talking about asset allocation,
which is deciding how much of each asset class you should hold. Asset location is the practice of
holding certain asset classes in certain account types. For example, holding bonds in the RRSP,
and Canadian stocks in the taxable account to minimize the overall tax drag on returns.
Finding the optimal location for each asset class is accomplished by holding the assets with the
highest tax costs in non-taxable accounts. Easy right? Well, it is easy if you know the magnitude
and characteristics of future returns, and future tax rates, otherwise it’s really, really hard.
I’m Ben Felix, Associate Portfolio Manager at PWL Capital. In this episode of Common
Sense Investing, I’m going to tell you why you shouldn’t get lost trying to locate your assets.
Asset location typically follows a set of rules.
The rules make sense assuming that we know future returns.
Hold Fixed Income in your RRSP because interest income is taxable at your full
marginal tax rate, and the lower expected returns should lead to lower RRIF minimums.
Hold Canadian Equities in your personal taxable account because Canadian dividends
are taxed at a more favourable rate than interest or foreign dividends.
Hold International Equities in your TFSA because International
stocks tend to have higher yields and foreign dividends are fully taxable.
Hold U.S. Equities in your RRSP (but not before Fixed Income) because a U.S. listed ETF of U.S.
stocks will avoid U.S. withholding tax, which would otherwise be unrecoverable in an RRSP.
Much has been written about asset location and the
value that it might be expected to add to after-tax returns.
The value of asset location is measured against holding the same mix of assets
in all accounts. In a 2013 paper from Morningstar, David Blanchett and Paul
Kaplan determined that asset location might add twenty three basis points of value per
year to after-tax returns. In a 2014 paper my PWL colleagues Dan Bortolotti and Justin
Bender determined that optimal asset location would have added thirty basis
points per year to the after-tax returns to an ETF portfolio between 2003 and 2012.
In a 2017 paper I used statistical analysis to test an asset location model and found
that optimal asset location would add twenty three basis points per year on
average to after tax returns in an ideal situation. My ideal situation included
an investor taxed at the highest marginal rate in Ontario with enough RRSP room to
hold most of their bonds while staying in line with their target asset allocation.
Using Monte Carlo analysis I tested this optimal asset location strategy against uncertain returns
by running 1,000 simulations and found that in about eighty percent of outcomes
asset location did in fact added value. While this was an interesting finding,
I was still assuming that we are able to predict future returns. Any asset location optimization
decision is based on the expectation of future returns. Of course, we cannot know future returns.
To test the robustness of my optimal asset location decision against my inability to
know the future, I 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 zero point two three percent to
zero point zero seven percent. More importantly, the optimal asset location
strategy only outperformed holding the same portfolio in all accounts 58% of the time.
When we realize that asset location does not guarantee higher after-tax returns,
we should start to wonder about the other issues that may arise. There is some regulatory risk.
An optimal asset location strategy under the current tax rules could become sub optimal
under new rules. For example, if the tax rate on Canadian dividends increased, or capital
gains inclusion increased, a previously optimal location of assets could become sub optimal.
There is also the added complexity. If you are managing your own portfolio,
complexity makes things like rebalancing or investing new money a challenge. If
your assets are managed by a wealth management firm, optimizing asset location reduces their
ability to scale, inevitably leading to higher fees over the long-term.
I am not alone in my skepticism about optimal asset location. In a 2009 paper, Gerard O’Reilly
of Dimensional Fund Advisors outlined his attempt to model optimal asset location, and concluded
that the model was too sensitive to its inputs to define an optimal asset location strategy.
In a recent blog post John Robertson, author of The Value of Simple,
explained “When the experts can’t even agree on what optimal is, then you know it’s not
worth your time to worry about. If you defer investing your contributions for a year or
two because you have to find a bigger block of time to plan out where everything goes,
or if you ignore rebalancing because it’s too hard with everything in separate accounts, then it’s
not worth the potential savings.” He concludes the post “This is all very confusing and my default
suggestion is that it’s best to just replicate the same allocation in all your accounts.”
In response to a comment on one of his blog posts,
my PWL colleague Justin Bender wrapped my thoughts up perfectly: “There are many
thoughts on the asset location decision and in the end, it probably doesn’t matter much.”
Put simply, if we cannot predict the future, the value of trying to optimize for asset
location can be called into question, and it may even make you worse-off in the end.
I think that this should be considered by anyone struggling with the complexity,
or even worse delaying the implementation of their portfolio due to asset location concerns.
I do not attempt to optimize the location of assets in the portfolios that I oversee,
opting instead to hold the same mix of assets in all accounts.
Do you have an opinion on the asset location decision? Tell me about it on the comments.
Thanks for watching. My name is Ben Felix of PWL Capital and this is Common Sense
Investing. I’ll be talking about a lot more common sense investing topics in this series,
so subscribe, and click the bell for updates.