All too often, financial advisors, investors and 401(k) managers fixate on asset allocation — the proverbial pie chart depicting the percentage of stocks, bonds, cash and even alternative investments. This focus on mitigating investor vulnerability to volatility via diversification tends to dominate any conversations about portfolio construction.
We’ve all been indoctrinated in the traditional asset allocation based on Harry Markowitz’s Nobel Prize-winning Modern Portfolio Theory, which mathematically concluded that a portfolio of non-correlated assets would yield better long-term returns because of the volatility smoothing it offered versus an individual asset. Based on this premise, most human and robo-advisors utilize a risk profile to determine whether an investor is conservative, moderate or aggressive, then select the appropriate mathematical allocation in stocks, bonds, cash, alternatives, etc.
But in working with high-net-worth clients, my firm recognized long ago that the often-overlooked aspect of “location” can play a vital role in the actual wealth-building (and protection) outcomes, based on three complementary considerations.
Location, Part 1: Whose Balance Sheet Owns the Investment?
The first consideration is the legal ownership of an asset, which typically dictates not only who can make decisions about it, but also tax implications and beneficiaries in scenarios such as death or dissolution. Is it owned by one party of a household, by the children or perhaps through a trust or in a 529? This is an important concept, because locating assets inside ownership structures that create protections against creditors and predators can provide significant advantages when trying to build and preserve long-term wealth.
Investors tend to focus on the fees they pay to an advisor, fund or management company. However, the vehicle being utilized, such as real estate, an IRA, annuity, brokerage account or mutual fund, often influences the overall cost of its success, also known as tax burden. Sometimes, taxes wind up being the greatest cost associated with an investment, amounting to 20-50% of the total appreciation.
Owning an asset personally, versus doing so jointly or in a trust, can greatly impact tax liability. Such distinctions equate to benefits and value propositions that have little to do with the overall asset allocation of a portfolio, but we find that most investors are unfamiliar with this type of thinking and miss the opportunity to protect their hard-earned investments from unnecessary fees and exposures.
Location, Part 2: What Is the Vehicle Holding the Investment?
The second aspect is the type of vehicle that an asset is invested in. Is it taxable, tax-deferred or tax-free? For example, an IRA is often tax-deductible for contributions, but tax-deferred for growth and taxable on exit. An investment with this type of structure can potentially be impacted by many different decisions affecting taxes one way or another. As a result, some investments are better structured for such a vehicle than others.
Traditional asset allocation can be more effective if certain components are located in different vehicles. For instance, it might make sense to put taxable bonds in a tax-deferred account, or to locate equities in taxable accounts because the capital gains treatment is better. So instead of trying to diversify every investment account, a better option could be to overweight based on the tax implications of each vehicle.
Location, Part 3: Where Is an Asset Managed?
The third investment location consideration is where it’s being managed. Is it held by a brokerage firm, a bank, mutual fund, turnkey asset management platform, direct investment or completely unmanaged?
This is illuminating because it reveals whether concentrated bets are being made on a specific management style. For example, if several instruments are with a single investment advisor, it stands to reason that the investor feels very confident in that manager’s insight. But is the concentration intentional or simply random? Is the overall household portfolio allocation taking into consideration what the right and left hand are both doing? When two or more investment managers are working for a client independently, their allocation decisions may be working against each other unintentionally.
Your clients may have been haphazard about this aspect, as well as the other two locational considerations, because they just don’t know any better. Unfortunately, such lack of awareness often represents a significant missed opportunity, because of the value inherent in matching financial resource locations to the unique circumstances of any given household.
Circumstances Influencing Selections
For instance, if a medical practitioner is concerned about liability related to potential malpractice litigation, they might choose to own assets inside of retirement plans or insurance policies because these vehicles can provide an extra layer of protection against predators. Alternatively, they could decide to transfer ownership of assets to a spouse who doesn’t share the same liability. What’s the value of this decision? Well in a litigation it could mean the difference between a zero or 100% loss, regardless of the asset allocation.
Furthermore, a household in a high tax bracket might focus on investments that provide not only tax deferral, but also tax management as part of the overall strategy. Someone who wants to ensure that their money goes to the next generation without taxes, anxiety or family disputes might select a structure like a trust, or take advantage of the ability to skip a generation when designating beneficiaries within their IRAs and 401(k) plans. These are asset location decisions based on the distinctive features offered by different investment tools.
Are you taking the location of your clients’ assets into account? The considerations and possible incentives go far beyond simply diversifying via stocks, bonds, cash or alternative investments. Although everyone might talk about allocation, location is the missing element that deserves just as much attention. What are you doing to educate and inspect whether location needs to be added to your traditional asset allocation discussion?
H. Adam Holt, CFP, ChFC, is the CEO and founder of Asset-Map, headquartered in Philadelphia.