Welcome back to the second installment of our three-part series, in which we’re tackling one of the thorniest questions of all: How does asset location really work?
In Part 1, we covered several key concepts about asset location, and why I recommended most DIY investors simply use a single asset allocation ETF to hold the same asset allocation across all account types.
That’s what Asset Location Light is good for. However, what if “good enough” isn’t enough for you? Today, I’ll show you how to take the expected after-tax return of your portfolio to ludicrously mind-bending levels by implementing a traditional asset location strategy.
First, let’s take a moment to review the three key concepts we covered in Part 1. You’ll need them to make sense of the next steps.
As covered in Part 1, this all speaks to why it’s fine to use Asset Location Light, with one-ticket asset allocation ETFs across all account types. It’s also by far the easiest way to set up your portfolio.
Now that you’ve conquered Asset Location Light, let’s look at a ludicrous level of asset location, so you can consider whether it’s worth your while.
In the following illustrations, we’ll use the single-fund, Asset Location Light approach as our benchmark for all comparisons, with the Vanguard Balanced ETF Portfolio (or VBAL) as our holding. VBAL allocates 60% of its portfolio to stocks, and 40% to bonds.
For our Ludicrous Asset Location strategy, we’ll follow the traditional asset location advice of holding stocks in the following order:
Remember from Part 1, holding stocks in your RRSP last will make your after-tax asset allocation inherently more aggressive, which will in turn increase the expected after-tax return of your portfolio. It’s important to note this is no free lunch. Even though you may not realize it, you are taking more equity risk from an after-tax perspective, so the higher expected after-tax return of this strategy is your compensation for taking on this additional risk.
Enough preamble. Let’s build out both our Light (benchmark) and Ludicrous portfolios.
First, we’ll create a 3-ETF clone of VBAL, by separating its underlying stock and bond components:
By combining these three ETFs in the correct weights, we’ll have identical exposure to VBAL, but more flexibility, so we can locate our individual stock and bond ETFs in different accounts.
For both our Light and Ludicrous asset location strategies, our total before-tax portfolio value will be $1 million, split as follows:
Since our before-tax target asset allocation is 60% stocks and 40% bonds, we’ll want to allocate our $1 million as follows:
For the Light benchmark, we’ll automatically be invested in the same 60% stock, 40% bond mix in each account:
For our Ludicrous asset location strategy, well locate our 60% stock, 40% bond mix as follows:
So far, so good. But, as we learned in Part 1, the taxable portion of your RRSP, and any growth on this amount, is effectively owned by the government. So, if we assume a 50% effective tax rate on RRSP withdrawals, the $400,000 before-tax RRSPs are actually only worth $200,000 after-tax.
What happens if we adjust our asset class figures to account for this? We’ll find our total portfolio value is only worth $800,000 from an after-tax perspective. This doesn’t impact the after-tax asset allocation of our Asset Location Light strategy. It remains at 60% stocks and 40% bonds.
But it makes our Ludicrous strategy more aggressive, with stocks now making up $600,000 of an $800,000 after-tax portfolio. That translates to a 75% stock, 25% bond asset mix after-tax.
As we now know, a higher after-tax allocation to stocks is expected to result in higher after-tax returns, but this is by no means guaranteed. This assumes stocks outperform bonds over your unique investment timeframe. Especially given the higher expected risks, this isn’t a sure bet.
Let’s forget we know anything about after-tax asset allocation for a moment. As far as a naïve investor is concerned, both portfolios are the same, even though their asset location strategies differ. From a before-tax perspective, both portfolios should earn the same rate of return, as their underlying investment strategies are the same.
To put this to the test, let’s assume stocks return 6% and bonds return 2% over the next year, with no rebalancing in either portfolio. At the end of the year, our stocks have increased from $600,000 to $636,000, and our bonds have increased from $400,000 to $408,000. From a total portfolio perspective, both strategies would have yielded the same before-tax portfolio value of $1,044,000 and before-tax annual return of 4.4%. Investors in either strategy would be indifferent between the two strategies.
But, again, that’s before we consider taxes.
Now let’s pay all taxes owing to the government, including the taxes we’ll eventually owe on the RRSP. We’ll assume a 50% effective tax rate on all taxable income. We’ll also assume stocks have a fully taxable dividend yield of 2%, and the remaining 4% of the stock return will be taxed as a capital gain with a 50% inclusion rate. The 2% bond return will also be fully taxable as income, along with the entire market value of the RRSP on deregistration.
After paying all taxes owed at the end of our one-year period, we find Ludicrous outperformed Light by 0.35% after-tax. But as we already know from Part 1, this outperformance is explained by the portfolio’s riskier after-tax asset allocation, not by its asset location. That is, the before-tax 60% stock, 40% bond asset mix was actually a riskier after-tax asset allocation of 75% stocks, 25% bonds.
So, you now know how to implement a traditional asset location strategy to increase the future expected after-tax return of your portfolio.
From a behavioral standpoint, this more complicated, Ludicrous strategy has its benefits. If you don’t overthink it, the portfolio remains a 60% stock, 40% bond portfolio on paper. Your account statements and performance reports would reflect the same, as they are all reported before-tax.
Now that you’ve read this post, you know you’re actually tricking your brain into thinking you’re increasing your expected return with what seems like no added risk. Even though the added risk remains (if well-hidden), you may still want to take this approach. There are so few times when irrational behaviour can benefit an investor; this seems like it could be one of those times.
That said, there are also disadvantages to ditching your single asset allocation ETF.
If the disadvantages of a Ludicrous location strategy don’t intimidate you, it could make sense for your portfolio. Or, in a final, Part 3 of our asset location series, we’ll look at one more take on asset location. Sure, you can expect to earn higher returns by tricking yourself into taking on higher, after-tax market risks. But what if you want to pursue higher returns specifically from your asset location actions? For that, we’ll need to move past Ludicrous, into a Plaid asset location strategy. Look for that post soon.
