Asset Location - YouTube

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,  

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