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.