While most advisors understand the importance of asset allocation, many are less aware of the importance of asset location -- the positioning of assets between taxable and tax-advantaged accounts to maximize a portfolio's after-tax returns.
Yet financial advisors can earn extra returns for their clients without adding risk by purchasing tax-efficient investments in taxable accounts and tax-inefficient investments in tax-advantaged accounts.
Our research shows that constructing a portfolio in such a tax-efficient manner can add up to 0.75% of additional return in the first year. This is part of a potential
Source: Vanguard. Pre-tax and after-tax returns are based on the following assumptions: Taxable bond return, 3.00%; municipal bond return, 2.40%; index equity, 9.00% (1.80% for dividends, 0.45% for long-term capital gains, and 6.75% for unrealized gains); active equity, 9.00% (1.80% for dividends, 1.80% for short-term capital gains, 4.50% for long-term capital gains, and 0.90% for unrealized gains). This analysis uses a marginal U.S. income tax rate of 39.6% for income and short-term capital gains and 20% for long-term capital gains. These values do not assume liquidation. See Jaconetti (2007) for more details.
COMPLICATING ISSUES
Keep in mind, earning this extra return can be more challenging when you throw active management into the mix.
Advisors who want to include active strategies -- such as actively managed equity funds, REITs or commodities -- or taxable bonds should purchase these investments within tax-advantaged accounts because of the two asset types' tax inefficiency.
Purchasing either actively managed equities or taxable bonds in taxable accounts frequently results in higher taxes, for a variety of reasons:
- Clients could wind up paying a federal marginal income tax rate -- as high as 39.6% -- on taxable bond income. One could, of course, purchase municipal bonds, but the result would be to forgo the taxable-municipal income spread.
- To the extent the portfolio includes actively managed equity funds, capital gains distributions are more likely. So clients could wind up paying a long-term capital gains tax rate as high as 15% or 20%, depending on income, on long-term capital gains or distributions, and the clients marginal income tax rate on short-term gains.
- Additionally, clients could pay a tax rate on qualified dividend income also as high as 15% or 20% from equities, depending on income.
However, including active strategies in tax-advantaged accounts likely means giving up space that would otherwise have been devoted to taxable bonds -- thereby giving up the extra return generated by the taxable-municipal spread.
The same considerations dont apply to broad-market equity index funds or similar ETFs. Even though these investments are subject to the same taxes as active equity strategies, they will generate significantly lower income or capital gains distributions, so can generally be held in taxable accounts.
Advisors may also find estate-planning benefits from placing broad-market equity index funds or ETFs in taxable accounts: Because broad-market equity investments usually provide more deferred capital appreciation than bonds over the long term, the taxable assets have the added advantage of a potentially larger step-up in cost basis for heirs.
ACTIVE STRATEGIES
Of course, some advisors may still want to include active strategies in client portfolios.
They may believe that the alternative investment can potentially generate an excess return large enough to offset both the yield spread and the higher costs associated with these investments.
Or they may decide that the active strategies bring other benefits -- such as risk reduction as a result of additional portfolio diversification.
Both these outcomes are both possible. (In fact, Vanguard itself offers low-cost, high-quality actively managed funds.) Yet they are not highly probable -- and are certainly less probable than capturing the return premium offered by taxable bonds when held in tax-advantaged accounts.
The bottom line: To maximize the returns attributable to asset location, advisors should either forgo active management, or include it only after fulfilling a clients strategic allocation to bonds.
Fran Kinniry is principal of Vanguard Investment Strategy Group.
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