Most investors have heard of the term “asset allocation” when it comes to investments and know it’s one important factor when building a portfolio. Investors should always aim to diversify their holdings to both match their personal tolerance for risk and to seek to help them meet financial goals. However, many investors may not have considered the additional importance of asset location—that is, in what types of accounts each of their investments should be held. We believe that it’s one of the keys to any well-managed investment strategy.
Clearly, saving for retirement is an arduous task for any individual or couple and typically involves decades of saving and investing. Along the way, an investor may obtain and fund many different types of investments: Brokerage accounts, trust accounts, 401(k)s, traditional IRAs, and Roth IRAs. It’s quite common for average investors to determine their overall asset allocation and then implement that same strategy in each of their accounts.
Unfortunately,this philosophy fails to account for a key fact: Different types of accounts are taxed differently. At RegentAtlantic, we believe it’s inefficient to implement a portfolio this way for two reasons:
1.) Duplicating the same investment strategy in multiple accounts causes excessive trading costs because you are purchasing and selling the same securities multiple times.
2.) There is an opportunity cost to not allocating your investments in a way that skews tax-efficient securities to a taxable account and tax-inefficient securities to a tax-deferred account.
Matching Expected Returns to the Right Accounts
Investments produce their returns in a two ways. The first is capital appreciation, which may only be taxable when a profitable holding is sold. The second is income, which may be taxable in the year in which it is earned. For best results, high-return investments that produce the majority of their returns through capital appreciation should be primarily held in taxable accounts. High-return assets that produce a substantial amount of their return through taxable income, on the other hand, should be primarily held in tax-deferred accounts such as IRAs and 401(k)s.
Investments that are expected to provide lower returns through either appreciation or income can be used to fill in the gaps, since the amount of funds each investor has in taxable versus tax-deferred accounts will vary. Finally, there is one more wrinkle to consider: Accounts such as Roth IRAs are potentially tax-free. These accounts should hold the very highest-return potential assets since their returns will not be taxed at all based on current tax law.
The Benefits of a Tax-Location Portfolio
Let’s review a hypothetical portfolio to illustrate the benefits of savvy asset location. The portfolio starts with $1 million spread across three types of accounts: An individual account, a traditional IRA account, and a Roth IRA account.
|Portfolio Accounts||Value||Tax Characteristics of Account|
|Individual Account||$700K||Income and realized capital gains taxed each year|
|IRA||$150K||Tax-deferred until distributions are made|
We assume in this simplified example that we will invest in three unique assets at the following percentages:
|Asset Class||% of Portfolio||Representative Index for each Asset Class|
|Large-Cap Stocks||70%||S&P 500 Index|
|REITs||15%||FTSE NAREIT Index|
|Emerging Markets||15%||MSCI Emerging Markets Index|
Portfolio 1–which we’ll call the “tax-location portfolio”–places all of the large-cap stocks in the individual account, all of the REITs in the IRA, and all of the emerging market assets in the Roth IRA.
By contrast, Portfolio 2—which we’ll call the “equal-weighted portfolio”—invests all three accounts with the same mixture of large-cap stocks, REITs, and emerging markets funds (70% large caps, 15% REITs, 15% emerging markets).
The tax-location portfolio attempts to capitalize on the fact that large-cap stocks generate a substantial part of their return from capital appreciation in the taxable account. This portfolio also defers taxes by placing into the IRA the REITs that are paying out significant dividends, and places the highest-return potential investment—emerging market stocks—in the tax-free Roth account.
The result: The tax-location portfolio allocates assets to the type of account that gives the client the opportunity to earn the most after-tax wealth.
Using the above-mentioned indices to calculate the after-tax value of the original $1 million investment over the last 10 calendar years (1/1/2003 to 12/31/2012),the tax-location portfolio grew to $2,201,372. In comparison, the equal-weighted portfolio grew to an after-tax value of $2,131,012. The increase in wealth over 10 years by utilizing asset location tenets was $70,360 (see disclosure for details on tax calculations).
To read more about the benefits of tax location, click here.
Important Disclosure Information
Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable. Please remember to contact RegentAtlantic if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add, or modify any reasonable restrictions to our investment management services. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request. This article is not a substitute for personalized advice from RegentAtlantic. This information is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic. Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.
The portfolio illustrations included in this article are intended to show the return differences between a tax location based portfolio and an equal weighted portfolio. They are NOT intended to illustrate investment results that were actually achieved or could have been achieved by any of our clients. The reported return of each of the sample portfolios was derived using what we, as of the date hereof, deemed to be the most appropriate available benchmark indices for the asset classes making up that portfolio. In addition, the returns used for each asset class do not reflect any costs of investing such as commissions, and other expenses that investors would incur. The portfolios were not rebalanced each year. The tax location portfolio invested the entire taxable account in large-cap stocks and earned the return of the S&P 500. It paid a 23.8% tax rate on dividends earned in any given year. At the end of 2012 it realized all capital gains and paid a 23.8% tax rate on those gains. It invested the entire IRA into REITs and earned the total return of the FTSE NAREIT index. At the end of 2012, it withdrew the entire value of its IRA account and paid a 39.6% tax rate upon withdrawal. It invested the entire Roth IRA into emerging markets stocks, and earned the total return of the MSCI Emerging Markets index. The Roth IRA, being a tax exempt account, owed no income taxes at the end of 2012. The equal weighted portfolio invested 70% of each account into the S&P 500, 15% of each account into FTSE NAREIT and 15% of each account into MSCI Emerging Markets. In its taxable account it paid a 23.8% tax rate on dividends earned by the S&P 500 or by MSCI Emerging Markets in any given year. For dividends earned by FTSE NAREIT, it paid a 43.4% tax rate in any given year. At the end of 2012 it realized all capital gains in the taxable accounts and paid a 23.8% tax rate on those gains. At the end of 2012, it withdrew the entire value of its IRA account and paid a 39.6% tax rate upon withdrawal. The Roth IRA, being a tax exempt account, owed no income taxes at the end of 2012.
Past performance is not indicative of future returns. Many factors affect performance including changes in market conditions and interest rates and in response to other economic, political, or financial developments.
A comparison to indices may not be a meaningful comparison. Comparisons to benchmarks have limitations because benchmarks have volatility and other material characteristics that may differ from the performance of a client’s portfolio. The investments in a client’s portfolio may differ substantially from the securities that comprise each index and are not intended to track the returns of any index. One cannot invest directly in an index, nor is any index representative of the a client’s portfolio. Actual client accounts will hold different securities than the ones included in each index. The index returns are gross of applicable account transaction, custodial, and investment management fees. The actual investment results would be reduced by such fees and any other expenses incurred as an investor.
S&P 500 – The S&P 500 is an index consisting of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large-cap universe. Each constituent in an index is weighted by its market-capitalization, as determined by multiplying its price by the number of shares outstanding after float adjustment
MSCI EAFE – The MSCI Europe, Australia and Far East (EAFE) Index is a free float-adjusted market capitalization weighted that is designed to measure equity market performance of large capitalization companies in foreign developed markets.
Russell 2000 – The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.
MSCI Emerging Markets – The MSCI Emerging Markets Index is a free float-adjusted market capitalization weighted index that is designed to measure equity market performance in the global emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
MSCI Frontier Markets – The MSCI Frontier Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of frontier markets. The MSCI Frontier Markets Index consists of the following 25 frontier market country indices: Argentina, Bahrain, Bangladesh, Bulgaria, Croatia, Estonia, Jordan, Kenya, Kuwait, Lebanon, Lithuania, Kazakhstan, Mauritius, Nigeria, Oman, Pakistan, Qatar, Romania, Serbia, Slovenia, Sri Lanka, Tunisia, Ukraine, United Arab Emirates, and Vietnam
Barclays High Yield US Corp – The Barclays Capital High Yield Very Liquid Index includes publicly issued U.S. dollar denominated, non-investment grade, fixed-rate, taxable corporate bonds that have a remaining maturity of at least one year, regardless of optionality, are rated high-yield (Ba1/BB+/BB+ or below) using the middle rating of Moody’s, S&P, and Fitch, respectively (before July 1, 2005, the lower of Moody’s and S&P was used), and have $600 million or more of outstanding face value. Only the largest issue of each issuer with a maximum age of three years can be included in the Index. Original issue zero coupon bonds, step-up coupons, and coupons that change according to a predetermined schedule are also included. The High Yield Index includes only corporate sectors. The corporate sectors are Industrial, Utility, and Financial Institutions. Excluded from the High Yield Index are non-corporate bonds, structured notes with embedded swaps or other special features, private placements, bonds with equity-type features (e.g., warrants, convertibility), floating-rate issues, Eurobonds, defaulted bonds, payment in kind (PIK) securities and emerging market bonds. The High Yield Index is issuer capped and the securities in the Index are updated on the last business day of each month.
FTSE NAREIT – FTSE NAREIT All REITs Index represents the full universe of publically traded REITs, including those companies that do not meet minimum size rule, liquidity criteria or free float adjustments. Stocks are free-float weighted to ensure that only the investable opportunity set is included within the index.
DJUBS Commodity – The Dow Jones-UBS Commodity IndexSM (DJ-UBSCISM) is a broadly diversified index that allows investors to track commodity futures through a single, simple measure. The DJ-UBSCISM is composed of futures contracts on physical commodities. The index is designed to minimize concentration in any one commodity or sector. It currently includes 19 commodity futures in five groups. No one commodity can comprise less than 2% or more than 15% of the index, and no group can represent more than 33% of the index (as of the annual reweightings of the components).
Alerian MLP Index – The Alerian MLP Index (“Index”) is a market-cap weighted, float-adjusted index created to provide a comprehensive benchmark for investors to track the performance of the energy MLP sector. It is a composite of the 50 most prominent energy master limited partnerships calculated by Standard & Poor’s using a float-adjusted market capitalization methodology. The Index components are selected by Alerian Capital Management, LLC. Alerian is a registered investment advisor that exclusively manages portfolios focused on midstream energy MLPs. The index is disseminated by the New York Stock Exchange real-time on a price return basis (NYSE: AMZ).
Lipper Long/Short – The index consists of the 30 largest mutual funds in the long/short equity category and is based on their average performance. Long/Short Equity funds invest on both long and short sides of equity markets, generally focusing on diversifying or hedging across particular sectors, regions or market capitalizations. Managers have the flexibility to shift from value to growth; small to medium to large capitalization stocks; and net long to net short. Managers may also trade equity futures and options as well.
Important disclosure information
Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.
Please remember to contact RegentAtlantic if there are any changes in your personal or financial situation or investment objectives for the purpose of reviewing our previous recommendations and services, or if you wish to impose, add, or modify any reasonable restrictions to our investment management services. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.
This article is not a substitute for personalized advice from RegentAtlantic. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic. Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.
RegentAtlantic does not provide legal or tax advice. Please consult with a legal and or tax professional of your choosing prior to implementing any of the strategies discussed in this article.