Five techniques that lift returns 26%; an extra 2.32% makes a big difference (Part III of a Series)

In Part I, we laid out our approach to quantifying five investment techniques, and discussed the first technique, Optimal Asset Location.  In Part II we discussed Overweighting towards small/value equities and Whole portfolio, tax-sensitive rebalancing.  Here in Part III, we continue by evaluating the final two techniques, and draw our conclusions.

Technique #4: Tax loss harvesting

Value: up to .46% per year

Tax loss harvesting means selling assets that have incurred a capital loss.  The investor can either use this loss to offset current capital gains, or, if there currently are insufficient gains, ‘carry forward’ (indefinitely) the losses, using them to offset future gains. If there is not an offsetting capital gain, $3,000 can be deducted every year from ordinary income.

After selling an asset, investors will frequently purchase a ‘proxy’ asset that is expected to behave in an analogous manner, but is not similar enough to the original asset to trigger the “wash sale” rule, which would nullify the tax loss. Under current tax law, buying the same or similar asset 31 days before or after the sale, in any of your accounts, triggers the wash sale rule. After 31 days, if desired, the proxy asset can be sold and the original asset can be repurchased.

Let’s say your S&P-500 fund is down $20,000. You sell it, capturing the loss, and immediately buy a ‘proxy’ asset, for example an ETF (or mutual fund) based on the Russell-1000. After 31 days, you sell the Russell-1000 and buy back the S&P-500. Alternatively, you might stick with the new asset, in this case the Russell-1000.

Harvesting Capital Gains and Losses (Smith and Smith, Financial Services Review, 2008) compared the effect of various tax loss harvesting approaches on a hypothetical portfolio with the following assumptions:

• 20 asset classes
• Long term capital gain rate 15%, short term capital gain rate 36%
• 6% gross return

Examining a large number of possible outcomes with a Monte-Carlo simulation, it found that tax loss harvesting increased the portfolio by 11% over 20 years, which, annualized, equates to 0.52% growth.  Thus for the study’s 6% gross return, tax loss harvesting added 8.72%

(0.52%/6%).  To be conservative, we assumed tax loss harvesting opportunities only occurred on the equity portion (60%) of our model 60/40 portfolio.  After normalizing for our theoretical maximum return of 8.76% of our period 1990-2009, an improvement of 0.46% is calculated (0.46% = 8.72% x 8.76% x 60%).

Technique #5: Enhanced index funds

Value: up to .48% per year

Enhanced index funds use a variety of techniques, including customized indexes (instead of relying on commercial indexes), trading strategies, exclusion rules, and timing strategies to achieve better returns than traditional index funds. The pioneer of enhanced indexing is Dimensional Fund Advisors (DFA), but other firms now offer them, including researchaffiliates.com, wisdomtree.com, and revenuesharesetfs.com.

While DFA funds have real and quantifiable benefits, many advisors overstate them.  A Duke University study concluded that a portfolio composed of DFA funds significantly outperformed similarly weighted Vanguard portfolios, but we felt the study overstated DFA’s advantage.  Our analysis concluded that DFA can add up to 0.48% over the long haul, for our balanced 60/40 portfolio during the study period. 

Individual investors must sign up with a DFA-approved advisor in order to invest in DFA funds, Individual investors should be able to invest in one or more of the alternatives listed above, but we feel they do not have enough of a track record yet.

Conclusion

As always, past performance doesn’t predict future performance.  In which case, was this whole exercise a waste of time?  It’s a fair question, but we think the analysis has some merit.  First, most investors don’t implement all five techniques; for them, this analysis provides a rough idea of what they are missing.  Second, while your mileage will vary, the analysis provides at least a stake in the ground regarding their relative value.  

Five techniques that lift returns 26%; an extra 2.32% makes a big difference (Part II of a Series)

In Part I, we laid out our approach to quantifying five investment techniques, and discussed the first technique, Optimal Asset Location.  Here, in Part II, we continue by evaluating two more techniques.

Technique #2: Overweighting toward small and value

Value: up to .50% per year

Many academic studies indicate that small capitalization stocks and value stocks produce greater returns over the long term, albeit at higher risk.  For a long term investor, this can be a boon – assuming the effect persists. 

In their pioneering studies, Fama and French found that overweighting portfolios with small and value stocks over long periods of time adds significantly to returns (Common Risk Factors in the Returns on Stocks and Bonds, Fama and French, Journal of Financial Economics, 1993; and The Cross-Section of Expected Stock Returns, Fama and French, Journal of Finance, 1992).  To quantify this effect for our purpose, we compared the return of an overweighted (‘tilted’) portfolio with excess small and value asset classes to a non overweighted portfolio with exactly the same proportions (the ‘un-tilted’ portfolio).  The ‘tilted’ portfolio returned 9.08% versus 8.22% for the ‘un-tilted’ one, a difference of 0.86%.  Thus, during the study period we see an improvement of 10.46% from the small/value effect. Since the small/value effect is only for equities, we scale the result by 60% (the portion of equities). Finally, we normalize for our study period and get an improvement of 0.50%.

Since the effect is difficult to see at low levels of diversification, most small/value aficionados invest in mutual funds or exchange-traded funds.

   

Technique #3: Whole portfolio, tax-sensitive rebalancing

Value: up to .55% per year

Rebalancing a portfolio means maintaining a specified asset allocation over time in order to maintain a consistent level of risk.  For instance, you might have 40% of your assets in domestic stocks, 20% in foreign stocks, and 40% in bonds.  If stocks went up more than bonds, you would need to sell some stocks and buy some bonds in order to maintain your desired level of risk.  Some experts also argue that rebalancing encourages you to sell asset classes that are at higher prices and buy those that are at lower prices.  Experts debate how frequently you should rebalance, with some arguing for every three months, and others recommending every 12-18 months.

Most investors have multiple accounts, both taxable and non-taxable (e.g. IRA, 401(k), etc.). Many investors – and even some advisors – rebalance account by account.  This achieves the desired level of risk, but leads to higher taxes.  Whole portfolio rebalancing considers the tax consequence of the trades — buys and sells — required to get a portfolio back in balance so maximum tax advantage is achieved.  The total of each asset class from all accounts is considered.  If there is an excess of an asset (i.e. it is above its desired threshold), tax-sensitive rebalancing will first look for that asset in taxable accounts where there is a capital loss, with short term losses preferred over long term ones.  Next to be considered are sales of that asset in non-taxable accounts (the proceeds from the sale will remain in the non-taxable account, of course, unless a distribution is desired).  Last to be considered are sales from taxable accounts where there is a capital gain, with long term gains preferred over short term gains.

The study Opportunistic Rebalancing: A new Paradigm for Wealth Managers (Daryanani, Journal of Financial Planning, 12/2008) found, over the period from 1992-2004 where the market returned 8%, that an annualized improvement of 0.50% could be achieved with rebalancing. The study attributed this improvement to two effects:

1. Rebalancing as much as possible in non taxable accounts (to avoid taxable gains), the investor improved returns 0.22%;
2. Using the “opportunistic rebalancing” techniques described in the above study, the investor achieved another 0.28% improvement.

Normalizing for our period, we get a 0.55% improvement (0.55% = 0.50%/5.84% x 8.76%).

But there’s a caution.  Properly doing whole portfolio rebalancing, even with the help of a spreadsheet, can be a nightmare.  Some advisors pay thousands of dollars per year for rebalancing software; we sensed an opportunity to do a better job, so we wrote our own, an effort few investors can justify.

In Part III of the series, we’ll consider the final two techniques, and draw our conclusions.

Five techniques that lift returns 26%; an extra 2.32% makes a big difference (Part I of a Series)

Here’s a quick test.  You have to choose between two investments.  One grows at 8.76% annually.  The other grows 26% faster, or 11.08%, but otherwise they are identical.  Which do you pick?

Thanks to the magic of compounding, that extra 2.32% would make a big difference after a few years ($281K more after 20 years on a $100K investment, before taxes, according to our spreadsheet).   And remember, we said the investments are identical.  Amazingly enough, many investors faced with this choice choose the lower return.

Everyone’s constantly looking out for outstanding investment ideas.  But for many investors, some of the best ideas are hiding right in front of them.  We’re talking about what might be called the nuts and bolts of investing, specifically five techniques:

1 – Optimal asset location

2 – Overweighting toward small and value stocks

3 – Whole portfolio, tax-sensitive rebalancing

4 – Tax loss harvesting

5 – Enhanced index funds

These are techniques that sophisticated investors employ, and you can employ them too.  They’ve been discussed in other articles.  They’re good techniques, but how much are they worth? 

At synthiumcapital.com, we sought to quantify them, well aware of the enigmatic nature of our quest.  Google autocomplete wasn’t going to be of much help, to put it mildly.  Our expedition through academic research felt at times like spelunking.  The obscure footnotes we followed had plenty of dead ends.  Illumination was a scarce commodity. 

We were in constant peril of incompatible assumptions.  Each study we found based its conclusions on a different time period with different market characteristics. For example, one article might claim a 0.50% improvement from tax loss harvesting when the market grew at 6%, while another study found rebalancing added 0.60% during a period of 8% returns.  How do these two effects, harvesting and rebalancing, compare?  Which one adds more to returns?  To get a handle on their relative value, we needed to account for each study’s underlying market conditions.  Our solution was to simply scale each study’s findings to a “standard” period and portfolio — the return of a hypothetical globally diversified allocation, 60% equities / 40% bonds (60/40), from 1990-2009, which had an observed return of 8.76%.  Here is an example: say a study found that technique A added 0.50% during a period of 10% returns. We scale the study’s results to our standard period as follows:

Study found a 0.50% improvement from technique A, when the market did 10%

5% = 0.50% / 10% - Therefore the study implies a 5% improvement during its period.

0.44% = 5% x 8.76% - Next, scale the study’s 5% improvement to our “standard” period with its 8.76% return.

But say the study was done for an 80% equity portfolio, not our 60% one, and Technique A only applies to equities.  We just need to scale this result as well:

0.33% = 0.44% x 60%/80% - Scale from 80% to 60% equity portfolio.

With this methodology, we can get the relative effect from each technique.

Now that we have resurfaced, this three-part series summarizes our discoveries.  For each of the five investment techniques, we describe them, quantify their potential impact on investment returns, and conclude with an assessment of whether individual investors can implement the technique on their own.  We’ll conclude Part I with the first technique.  Parts II and III will each cover two techniques to complete the series.

Technique #1: Optimal asset location

Value: up to .33% per year

    

Investments increase in value due to price appreciation (capital gains) and accumulation of interest and dividends.  Taxes can be reduced by placing high yield bonds, which produce a lot of income taxed at higher rates, into nontaxable accounts (IRAs, 401(k)s, etc), and placing lower yielding equity investments in taxable accounts.  This is sometimes referred to as ‘location-aware allocation’; we prefer the term ‘optimal asset location.’

The study Asset Location: A generic Framework for Maximizing After-Tax Wealth (Daryanani and Cordaro, Journal of Financial Planning, January 2005), investigated the effect of initially placing various asset classes in taxable versus non-taxable accounts. The study made the following assumptions:

• 60/40 portfolio (60% equities, 40% bonds)
• Ordinary tax rate = 30 percent; capital gains rate = 15 percent
• Stocks pre-tax return = 8 percent; bonds pre-tax return = 5 percent

It found that over a long (30-year) horizon, the after tax return was 5.84% and that 0.22% of that was due to the optimal placement of securities.  Normalizing for our period, we get a 0.33% improvement (0.33% = 0.22%/5.84% x 8.76%).

Considering the effects of compounding over many years, increasing your effective after tax returns by 33 basis points can have a really big impact.  To the extent you’re able to place assets in nontaxable accounts, the assets you should place there are the less tax efficient ones.  The rest of your assets, which would presumably include the most tax efficient ones, should go in your taxable account. Your overall asset allocation will be the same, but your after-tax returns will be higher.

In Part II of the series, we’ll consider the next two techniques.