Search results for: "asset location"

For the past several decades, asset allocation has been the cornerstone of portfolio design, with a focus on diversification and the addition of non-correlated investments to the portfolio to reduce overall volatility and improve risk-adjusted returns. This trend has been accelerated in recent years, as weak returns in both bonds and stocks have helped to fuel a drive towards “alternative” investments that further increase the intended diversification and the number of asset classes in the portfolio.

Yet running in parallel with this trend has been the rise of various types of tax-preferenced accounts, with first the IRA and 401(k) and more recently the Roth IRA and Roth 401(k), in addition to the ongoing presence of tax-deferred annuities and the standard taxable brokerage account. As a result, a new challenge is beginning to emerge: the question becomes not only which asset classes should be owned and in what amounts, but also where should those asset classes be held? In other words, it’s not just about allocation of the assets to build a diversified portfolio now, but also about the locations in which to place those diversified investments.

Given that recent research has shown effective asset location strategies can add 20-50+ basis points of “free” value to annual returns, providing guidance on asset location is becoming increasingly popular. Yet unfortunately, asset location strategies are often dominated by myths and misperceptions! Ultimately, the reality is that good asset location decisions actually should be influenced by both the tax efficiency of investments and also their expected returns, which makes the analysis somewhat more complex… but also reveals why in today’s environment most bonds actually should NOT go into tax-deferred accounts!

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In an environment where generating portfolio alpha is difficult, strategies like managing assets on a household basis to take advantage of asset location opportunities to generate “tax alpha” are becoming more and more popular. The caveat, however, is that making effective asset location decisions is not easy, either.

For instance, while the traditional asset location strategy “rule of thumb” is that tax-inefficient bonds go into an IRA, while equities eligible for preferential tax rates go into a brokerage account, the reality is that for investors with long time horizons the optimal solution may be the opposite. Once stock dividends and portfolio turnover are considered, the ongoing “tax drag” of the portfolio can be so damaging to long-term returns that placing equities into an IRA may be more efficient, even though they are ultimately taxed at higher rates!

In fact, it turns out that almost any level of portfolio turnover will eventually tilt equities towards being held in IRAs given a long enough time horizon (and especially while today’s low interest rates result in almost no benefit for bonds to gain tax-deferred growth inside of retirement accounts). Which means in the end, good asset location decisions depend not only on returns and tax efficiency, but an investor’s time horizon as well!

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