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Summary­­

• In a world of anemic asset returns, tax management may help significantly contribute to improving portfolio returns.
• Ideally, asset location decisions would be made with full investor information, including goals, risk tolerances, tax rates, and distribution of wealth among account types.
• Without perfect information, we believe it is helpful to have both tax-deferred and tax-managed model portfolios available.
• We explore how tax-adjusted expected returns can be created, and how adjusting for taxes affects an optimized portfolio given today’s market outlook.

Before we begin, please note that we are not Certified Public Accountants, Tax Attorneys, nor do we specialize in tax management.  Tax law is complicated and this commentary will employ sweeping generalizations and assumptions that will certainly not apply to every individual’s specific situation.  This commentary is not meant as advice, simply research.  Before making any tax-related changes to your investment process, please consult an expert.

Tax-Managed Thinking

We’ve been writing a lot, recently, about the difficulties investors face going forward.[1][2][3]  It is our perspective that the combination of higher-than-average valuations in U.S. stocks and low interest rates in core U.S. bonds indicates a muted return environment for traditionally allocated investors going forward.

There is no silver bullet to this problem.  Our perspective is that investors will likely have to work hard to make many marginal, but compounding, improvements.  Improvements may include reducing fees, thinking outside of traditional asset classes, saving more, and, for investors in retirement, enacting a dynamic withdrawal plan.

Another potential opportunity is in tax management.

I once heard Dan Egan, Director of Behavioral Finance at Betterment, explain tax management as an orthogonal improvement: i.e. one which could seek to add value regardless of how the underlying portfolio performed.  I like this description for two reasons.

First, it fits nicely into our framework of compounding marginal improvements that do not necessarily require just “investing better.”  Second, Dan is the only person, besides me, to use the word “orthogonal” outside of a math class.

Two popular tax management techniques are tax-loss harvesting and asset location.  While we expect that tax-loss harvesting is well known to most (selling investments at a loss to offset gains taken), asset location may be less familiar.  Simply put, asset location is how investments are divided among different accounts (taxable, tax-deferred, and tax-exempt) in an effort to maximize post-tax returns.

Asset Location in a Perfect World

Taxes are a highly personal subject.  In a perfect world, asset location optimization would be applied to each investor individually, taking into account:

• State tax rates
• Federal tax rates
• Percentage of total assets invested in each account type

Such information would allow us to run a very simple portfolio optimization that could take into account asset location.

Simply, for each asset, we would have three sets of expected returns: an after-tax expected return, a tax-deferred expected return, and a tax-exempt expected return.  For all intents and purposes, the optimizer would treat these three sets of returns as completely different asset classes.

So, as a simple example, let’s assume we only want to build a portfolio of U.S. stocks and bonds.  For each, we would create three “versions”: Taxable, Tax-Deferred, and Tax-Exempt.  We would calculate expected returns for U.S. Stocks – Taxable, U.S. Stocks – Tax-Deferred, and U.S. Stocks – Tax-Exempt.  We would do the same for bonds.

We would then run a portfolio optimization.  To the optimizer, it would look like six asset classes instead of two (since there are three versions of stocks and bonds).  We would add the constraint that the sum of the weights to Taxable, Tax-Deferred, and Tax-Exempt groups could not exceed the percentage of our wealth in each respective account type.  For example, if we only have 10% of our wealth in Tax-Exempt accounts, then U.S. Stocks – Tax Exempt + U.S. Bonds – Tax Exempt must be equal to 10%.

Such an approach allows for the explicit consideration of an individual’s tax rates (which are taken into account in the adjustment of expected returns) as well as the distribution of their wealth among different account types.

Case closed.[4]

Asset Location in a Less Than Perfect World

Unfortunately, the technology – and expertise – required to enable such an optimization is not readily available for many investors.

As an industry, the division of labor can significantly limit the availability of important information.  While financial advisors may have access to an investor’s goals, risk tolerances, specific tax situation, and asset location break-down, asset managers do not.  Therefore, asset managers are often left to make sweeping assumptions, like infinite investment horizons, defined and constant risk tolerances, and tax indifference.

Indeed, we currently make these very assumptions within our QuBe model portfolios. Yet, we think we can do better.

For example, consider investors at either end of the spectrum of asset location.  On the one end, we have investors with the vast majority of their assets in tax-deferred accounts.  On the other, investors with the vast majority of their wealth in taxable accounts.  Even if two investors at opposite ends of the spectrum have an identical risk tolerance, their optimal portfolios are likely different.  Painting with broad strokes, the tax-deferred investor can afford to have a larger percentage of their assets in tax-inefficient asset classes, like fixed income and futures-based alternative strategies.  The taxable investor will likely have to rely more heavily on tax-efficient investments, like indexed equities (or active equities, if they are in an ETF wrapper).

Things get much messier in the middle of the spectrum.  We believe investors have two primary options:

1. Create an optimal tax-deferred portfolio and try to shift tax-inefficient assets into the tax-deferred accounts and tax-efficient assets into taxable accounts. Investor liquidity needs need to be carefully considered here, as this often means that taxable accounts will be more heavily tilted towards more volatile equities while bonds will fall into tax-deferred accounts.
2. Create an optimal tax-deferred portfolio and an optimal taxable portfolio, and invest in each account accordingly. This is, decidedly, sub-optimal to asset location in a perfect world, and should even under most scenarios be sub-optimal to Option #1, but it should be preferable to simply ignoring taxes.  Furthermore, it may be easier from an implementation perspective, depending on the rebalancing technology available to you.

With all this in mind, we have begun to develop tax-managed versions of our QuBe model portfolios, and expect them to be available at the beginning of Q4.

Adjusting Expected Returns for Taxes

To keep this commentary to a reasonable length (as if that has ever stopped us before…), we’re going to use a fairly simple model of tax impact.

At the highest level, we need to break down our annual expected return into three categories: unrealized, externally realized, and internally realized.

• Unrealized: The percentage of the total return that remains un-taxed. For example, the expected return of a stock that is bought and never sold would be 100% unrealized (ignoring, for a moment, dividends and end-of-period liquidation).
• Externally Realized: The percentage of total return that is taxed due to asset allocation turnover. For example, if we re-optimize our portfolio annually and incur 20% turnover, causing us to sell positions, we would say that 20% of expected return is externally realized.
• Internally Realized: The percentage of total return that comes from internal turnover, or income generated, within our investment. For example, the expected return from a bond may be 100% internally realized.  Similarly, a very active hedge fund strategy may have a significant amount of internal turnover that realizes gains.

Using this information, we can fill out a table, breaking down for each asset class where we expect returns to come from as well as within that category, what type of tax-rate we can expect.  For example:

For example, in the table above we are saying we expect 70% of our annual U.S. equity returns to be unrealized while 30% of them will be realized at a long-term capital gains rate.  Note that we also explicitly estimate what we will be receiving in qualified dividends.

On the other hand, we only expect that 35% of our hedge fund returns to be unrealized, while 15% will be realized from turnover (all at a long-term capital gains rate) and the remaining 50% will be internally realized by trading within the fund, split 40% short-term capital gains and 60% long-term capital gains.For example, in the table above we are saying we expect 70% of our annual U.S. equity returns to be unrealized while 30% of them will be realized at a long-term capital gains rate.  Note that we also explicitly estimate what we will be receiving in qualified dividends.

Obviously, there is a bit of art in these assumptions.  How much the portfolio turns over within a year must be estimated.  What types of investments you are making will also have an impact.  For example, if you are investing in ETFs, even very active equity strategies can be highly tax efficient.  Mutual funds on the other hand, potentially less so.  Whether a holding like Gold gets taxed at a Collectible rate or a split between short- and long-term capital gains will depend on the fund structure.

Using this table, we can then adjust the expected return for each asset class using the following equations:

Where,

In English,

• Take the pre-tax return and subtract out the amount we expect to come from qualified dividend yield.
• Take the remainder and multiply it by the total blended tax rate we expect from externally and internally realized gains.
• Add back in the qualified dividend yield, after adjusting for returns.

As a simple example, let’s assume U.S. equities have a 6% expected return.  We’ll assume a 15% qualified dividend rate and a 15% long-term capital gains rate.  We’ll ignore state taxes for simplicity.

Our post-tax expected return is, therefore 6% – (6%-2%)*(30%*15%) – 2%*15% = 5.52%.

We can follow the same broad steps for all asset classes, making some assumptions about tax rates and expected sources of realized returns.

(For those looking to take a deeper dive, we recommend Betterment’s Tax-Coordinated Portfolio whitepaper[5], Ashraf Al Zaman’s Tax Adjusted Portfolio Optimization and Asset Location presentation[6], and Geddes, Goldberg, and Bianchi’s What Would Yale Do If It Were Taxable? paper[7].)

How Big of a Difference Does Tax Management Make?

So how much of a difference does taking taxes into account really make in the final recommended portfolio?

We explore this question by – as we have so many times in the past – relying on J.P. Morgan’s capital market assumptions.  The first portfolio is constructed using the same method we have used in the past: a simulation-based mean-variance optimization that targets the same risk level as a 60% stock / 40% bond portfolio mix.

For the second portfolio, we run the same optimization, but adjust the expected return[8] for each asset class.

We make the following assumptions about the source of realized returns and tax rates for each asset class (note that we have compressed the above table by combining rates together after multiplying for the amount realized by that category; e.g. realized short below represents externally and internally realized short-term capital gains).

Again, the construction of the below table is as much art as it is science, with many assumptions embedded about the type of turnover the portfolio will have and the strategies that will be used to implement it.

We also make the following tax rate assumptions:

• Ordinary Income: 28%
• Short-Term Capital Gains: 28%
• Long-Term Capital Gains: 28%
• Qualified Dividend: 15%
• Collectibles: 28%
• Ignore state-level taxes.

The results of both optimizations can be seen in the table below.

Broadly speaking, we see a shift away from credit-based asset classes (though, they still command a significant 27% of the portfolio) and towards equity and alternatives.

We would expect that if the outlook for equities improved, or we reduced the expected turnover within the portfolio, this shift would be even more material.

It is important to note that at least some of this difference can be attributed to the simulation-based optimization engine.  Percentages can be misleading in their precision: the basis point differences between assets within the bond category, for example, are not statistically significant changes.

And how much difference does all this work make?  Using our tax-adjusted expected returns, we estimate a 0.20% increase in expected return between tax-managed and tax-deferred versions right now.  As we said: no silver bullets, just marginal improvements.

What About Municipal Bonds?

You may have noticed municipal bonds are missing from the above example.  What gives?

Part of the answer is theoretical.  Consider the following situation.  You have two portfolios that are identical in every which way (e.g. duration, credit risk, liquidity risk, et cetera), except one is comprised of municipal bonds and one of corporate bonds.  Which one do you choose?

The one with the higher post-tax yield, right?

This hypothetical highlights two important considerations.  First, the idea that municipal bonds are for taxable accounts and corporate bonds are for tax-deferred accounts overlooks the fact that investors should be looking to maximize post-tax return regardless of asset location.  If municipal bonds offer a better return, then put them in both accounts!  Similarly, if corporate bonds offer a more attractive return after taxes, then they should be held in taxable accounts.

For example, right now the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) has a 30-day SEC yield of 3.16%.  The VanEck Vectors ATM-Free Intermediate Municipal Index ETF (ITM) has a 30-day SEC yield of just 1.9%.  However, this is the taxable equivalent to an investor earning a 3.15% yield at a 39.6% tax rate.

In other words, LQD and ITM offer a nearly identical return within in a taxable account for an investor in the highest tax bracket.  Lower tax brackets imply lower taxable equivalent return, meaning that LQD may be a superior investment for these investors.  (Of course, we should note that municipal bonds are not corporate bonds.  They often are often less liquid, but of higher credit quality.)

Which brings up our second point: taxes are highly personal.  For a wealthy investor, an ordinary income tax of 35% could make municipal bonds far more attractive than they are for an investor only paying a 15% ordinary income tax rate.

Simply put: solving the when and where of municipal bonds is not always straight forward.  We believe the best approach is account for them as a standalone asset class within the optimization, letting the optimizer figure out how to maximize post-tax returns.

Conclusion

We believe that a low-return world means that many investors will have a tough road ahead when it comes to achieving their financial goals.  We see no silver bullet to this problem.  We do see, however, many small steps that can be taken that can compound upon each other to have a significant impact.  We believe that asset location provides one such opportunity and is therefore a topic that deserves far more attention in a low-return environment.

[1] See The Impact of High Equity Valuations on Safe Withdrawal Rates –   https://blog.thinknewfound.com/2017/08/impact-high-equity-valuations-safe-retirement-withdrawal-rates/

[2] See Portfolios in Wonderland & The Weird Portfolio – https://blog.thinknewfound.com/2017/08/portfolios-wonderland-weird-portfolio/

[3] See The Butterfly Effect in Retirement Planning – https://blog.thinknewfound.com/2017/09/butterfly-effect-retirement-planning/

[4] Clearly this glosses over some very important details.  For example, an investor that has significant withdrawal needs in the near future, but has the majority of their assets tied up in tax-deferred accounts, would significantly complicate this optimization.  The optimizer will likely put tax-efficient assets (e.g. equity ETFs) in taxable accounts, while less tax-efficient assets (e.g. corporate bonds) would end up in tax-deferred accounts.  Unfortunately, this would put the investor’s liquidity needs at significant risk.  This could be potentially addressed by adding expected drawdown constraints on the taxable account.

[5] https://www.betterment.com/resources/research/tax-coordinated-portfolio-white-paper/

[6] http://www.northinfo.com/documents/337.pdf

[7] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2447403

[8] We adjust volatility as well.

Corey Hoffstein

Corey is co-founder and Chief Investment Officer of Newfound Research. Corey holds a Master of Science in Computational Finance from Carnegie Mellon University and a Bachelor of Science in Computer Science, cum laude, from Cornell University. You can connect with Corey on LinkedIn or Twitter.