In my 2017 paper, Asset Location and Uncertainty, I demonstrated that the failure to accurately predict future returns can quickly make an ex ante optimal asset location strategy ex post sub-optimal. That paper focused on the value-added from optimal asset location through the lens of pre-tax asset allocation. I focused on pre-tax asset allocation because that is how most practitioner literature approaches the topic.
The problem with comparing various asset location strategies through the lens of pre-tax asset allocation is that it provides a poor framework for comparing expected investment outcomes. Two portfolios with the same pre-tax asset allocation can have materially different risk-return characteristics. This is the most important point to be made in this paper.
For example, assuming a 50% tax rate, take a $600,000 taxable account and a $400,000 RRSP with the RRSP full of bonds and the taxable account full of stocks. This portfolio has a pre-tax asset allocation of 60% stocks and 40% bonds, but it has an after-tax asset allocation of 75% stocks and 25% bonds. It is important to recognize that the after-tax asset allocation is measuring the allocation of the capital that you own. The pre-tax asset allocation is skewed by the government’s capital – your future tax bill. While counterintuitive to consider, the after-tax asset allocation is the driver of your expected outcome.
If we optimize asset location for a given pre-tax asset allocation, our optimization will always lead us to hold bonds in the RRSP account, leading to a more aggressive after-tax asset allocation, which drives higher expected returns. The problem with this approach is that we are not comparing apples to apples; a more aggressive portfolio is not necessarily a more tax efficient portfolio. We will examine this issue with examples throughout this paper.
