As you delve into the world of Risk Parity, you’ll find the topic of asset allocation come up again and again, and with good reason. But what of “asset LOcation” - figuring out in which accounts one should keep various assets, so as to manage the taxation of those assets? Here is a quick guide...
Asset location came up on a recent episode of Risk Parity Radio (see below), and I thought it worth exploring a bit more and putting it “on paper” for posterity. I’ve transcribed Vasquez’s thoughts, added my own, and tried to come up with a handy way to think of this investment issue. A couple of primers to start, though:
- Honestly, there isn’t too much to this topic that is unique to Risk Parity practitioners, and if you find authoritative voices in the individual investing space addressing this issue, then by all means, learn from them since the best practices for this topic apply to Risk Parity and traditional investment approaches alike.
- There are a few possible exceptions, though: 1) since RP portfolios typically feature gold and sometimes commodities, and traditional allocations skip those, I’ll try to cover those here; 2) traditional portfolios tend to just lump bonds together, but RP approaches tend to be more specific, so I’ll address that; 3) a lot of RP portfolios have target allocations for different assets and will buy and sell from one asset class to another. Those transactions can generate a lot of taxable events, so that is something to be aware of.
- Whereas moving within your tax-advantaged accounts is friction-less, selling assets in a normal, taxable brokerage account will generate tax payments. If you are planning on selling from a taxable account to transform your portfolio, I would recommend you consult a tax professional before moving ahead. Move slowly when it comes to changing a portfolio.
- Everyone’s situation is different, and there is a lot of gray area in terms of what is “best,” since your current income, your future income, what other assets you have, what deductions/filing status you have, etc. all impact what goes where. In summarizing my thoughts, I’ll stick to broad principles only to be used for general investing education.
- Asset location is hard to get right, since the optimal place for each asset depends on its future returns, which aren’t knowable. Given that uncertainty, it is not worth stressing over! The Rational Reminder podcast explains that asset location is nearly impossible to get right and can eat up a lot of your brain space in the struggle. In the end, they say, most DIY investors are probably better off holding the same basic mix in all of their account types. So, cut yourself some slack on this issue, since it's not optimizable anyway.
That being said...
there are some general principles to be aware of. First, I’d recommend listening to the caller’s question and Vasquez’s response from Risk Parity Radio. To summarize, Vasquez makes these eight points:
- Look at all assets together, and indeed, where you can, do try to put certain assets in certain accounts.
- Your choices for what goes where is largely driven by tax treatment. REITs and Commodities work well in a traditional IRA or 401k since they generate a lot of ordinary income.
- High growth assets go best in Roth accounts, since you can best maximize growth there.
- Assets that pay qualified dividends or are tax-advantaged (like municipal bonds) are best in a taxable account, since you’ll get the favorable tax treatment there.
- Assets that have a negative expected return - like a volatility fund - put in a taxable account since you can tax loss harvest.
- “Don’t let the tax tail wag the investment dog”, meaning don’t prioritize thinking about tax issues over the bigger issue of what you want to be invested in.
- In general, asset location is ”more art than science” since a lot depends on your particular situation.
To which I'll add...
- If you invest in gold, regular taxable accounts are probably best, since gold funds pay out no dividends and don’t have the likely long-term capital appreciation that make it worth keeping them in a tax-advantaged account.
- As Vasquez says, many commodities funds pay out high amounts of dividends, meaning they are very tax inefficient. But, there are some commodity ETFs such as GSG and DJP which seem to pay out less to shareholders and instead focus on boosting their share price (see my write-up of PDBC for more information). In this case, a taxable account for these commodity funds wouldn’t be as bad since they are more tax efficient. PDBC, meanwhile, would be terrible in a taxable account – its dividend last year was north of 40% and led to a big tax bill inside regular accounts.
- If you are using embedded leverage equity ETFs like UPRO or TNA, or even embedded leverage bonds funds like TMF, then a Roth account really is ideal, if you can. For one, these likely have the highest ceiling for expected outcome of any individual asset in your portfolio, so if they do hit big, then you’ll probably be happiest if those were the gains that were tax-free. Second, since these assets are so volatile, rebalancing them can be beneficial, and you’d want to be able to do that with less tax friction. A traditional IRA or 401k (though I don’t imagine too many employer sponsored plans would have these on the menu anyway) is fine, too, but would help you only with the second issue, not the first.
- If you hold Extended Duration bonds (like EDV), then these are best in a tax-advantaged account. They have fairly high distributions, plus these are a good choice as the “dry powder” that you can keep to sell off when equity funds crash. Those types of exchanges are normally taxable, so if you have EDV in the same fund as VOO, then rebalancing between them will be more efficient in a tax-advantaged account. To me, a traditional Roth/IRA is fine and putting them in a Roth might not be as good as an idea, as they don’t have the expected long-term return that stocks do. I’d rather save Roth room for those. This same logic applies to Long-term Treasuries, as well, though to a lesser degree.
- Individual stocks can kind of go anywhere, though just speaking personally, I tend to only have them in a regular, taxable account. Lots of my individual stock choices have failed (perhaps that’s why I’m an index investor!), so I'm glad they didn’t eat up precious Roth IRA room. Also, if they do fail, you can strategically tax-loss harvest if they are in a regular account.
- Cash, money market funds, municipal bonds, short-term Treasury funds and other super safe assets are great for a taxable account. Putting any of them in a tax-advantaged account would be a lost opportunity. You’d be getting favorable tax treatment for an asset that probably won’t make very much anyway.
- Roth accounts are the crème de la crème of investment accounts, and every asset is best in one of them. But, they are limited: Roth IRAs by the dollar amount you can put in them (and by who is eligible to use them) and Roth 401ks by the fact that your employer determines what can be invested in, and those tend to be things on the safe side. So, treat your Roth space with great care. The fact that dividends, transactions, and capital gains are all tax-free is precious, and must be appreciated (I get shivers down my spine when I see that my work’s Roth 401k offers not one, not two, but three different money market accounts).
Putting it all together, here is a handy chart: