Morningstar Advisor - Fall 2008 - 40

Spotlight Location, Location, Location By David Harrell How advisors can add value by putting their clients’ assets in their proper place. The nomenclature is unfortunate: When we surveyed some advisors via e-mail about the role of asset location in their practices, we received a number of responses along the lines of “asset allocation is very important to us and we spend a lot of time setting and maintaining asset allocations of each client portfolio.” While it’s doubtful that many advisors aren’t aware of asset location as a concept, in retrospect we probably shouldn’t have been surprised by the confusion caused by the deletion of just two letters. Asset allocation, to be fair, is a topic that is more on the minds of advisors than is asset location. Asset location is, of course, the practice of maximizing the aftertax return of a portfolio via the optimal location of securities within the different account types available to an investor—taxable accounts, IRAs, 401(k) plans, etc. And the old bromide here is that investors should keep tax-efficient assets such as low-turnover stock funds in taxable accounts and—when possible—hold tax-inefficient securities (income-generating securities) in tax-deferred accounts. But beyond that rule of thumb, how should advisors locate client assets to minimize the impact of taxes on the returns of their portfolios? Further, how important is location of assets, relative to asset allocation and security selection decisions? We spoke to two experts to get more details about assetlocation theory, some practical techniques, and the difference between theory and the real-world situations that all investors face. We also asked some practicing advisors to discuss how they implement their assetlocation strategies. Bill Reichenstein, Ph.D, CFA, a professor of finance at Baylor University, is a leading authority on the impact of taxes on investing and asset location. His latest book, In the Presence of Taxes: Application of After-Tax Asset Valuation, was published in September by FPA Press. Peng Chen, CFA, is the president of Ibbotson Associates, which offers assetlocation advice to institutions and advisors. Jerry Plant, CFA, and Nick Harroz, CFA, of Mark I Asset Management are advisors who pay careful attention to how asset location affects taxation. (There’s a direct connection here from theory to practice: Harroz was a graduate assistant to Reichenstein.) Allocation Trumps Location, Yet Location Affects Allocation In any portfolio that includes taxable and tax-deferred accounts, unless the asset allocation is the same across all accounts, there’s likely a difference between the nominal asset allocation and the “real” allocation on an aftertax basis. Reichenstein offers the following example: Consider an investor with $10,000 invested in bonds within a 401(k) account and $7,500 of aftertax dollars held in a Roth IRA. Her nominal asset allocation is a 43/57 stock/fixed-income mixture. But assuming a 25% tax rate, her actual aftertax allocation is 50/50 stocks and fixed income. While he acknowledges that any such “aftertax” allocation calculation requires you to make an assumption about tax rates at the time of withdrawal, Reichenstein points out that ignoring taxes when considering allocation is essentially the same as assuming a tax rate of 0%, a far less realistic assumption that any estimate of future tax rates. As he puts it, “I’d rather be close to right than precisely wrong.” Reichenstein estimates that the typical investor probably has 70% of his or her assets invested with a tax-deferred retirement account, with the balance in taxable accounts. Across the board, his guess is that most investors are— on an aftertax basis—actually 5 percentage points or so away from their nominal asset allocations. Given the amount of effort that Reichenstein and Chen were quick to acknowledge that asset allocation matters more than location. But both pointed out that location decisions can ultimately affect allocation. 40 Morningstar Advisor Fall 2008

Morningstar Advisor - Fall 2008

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