If the average investor has little interest in formal asset location help, it’s largely up to the advisor to decide whether to pursue tax optimization. How far down the rabbit hole will they likely want to go?
Hultstrom argues that these tax optimization strategies are still worthwhile for advisors to brush up on anyway—to a point. Getting into the weeds may not be worth it. It depends on the clients and the account details, he says. “Getting it roughly right is worthwhile, but there are diminishing returns at some point.”
In part, doing it efficiently means managing the number of clients. He caps the number of client households at his firm at 100 (currently there are 65 at Financial Architects) and requires a $2 million minimum. “We don’t want a million clients,” he says, in part because the way he does it makes tax location analytics easier: He runs his clients’ tax analysis in a spreadsheet he’s built. “Most people have rebalancing software, but I do it by hand.”
Morningstar’s Rowling agrees that as portfolio assets rise and the broad sweep of accounts expands, the analytics can get thorny and burdensome. That’s when software can help.
She says that tasking computers with the heavy lifting for asset location and other tax-related decisions has several benefits. For instance, it helps advisors identify opportunities that might otherwise go unnoticed. Some steps are obvious—for instance, high-income-producing investments should be put in tax-deferred accounts, such as IRAs, while stocks should be held in taxable accounts.
As the size and diversity of a portfolio increase, however, the analytics become more byzantine and there are more decisions to make, strategies to explore. Market volatility will complicate things, as will a client’s demand to make periodic withdrawals—variables that can turn yesterday’s optimal mix into something substantially less optimal today.
With all these twists and turns, we must bear in mind that optimal asset location is a constantly moving target. As a result, advisors can risk missing big opportunities without the help of software.
To minimize the risk that opportunities will be overlooked, TRX software automates the process, looking as often as once a day for possibilities to boost tax efficiency and offering a comprehensive view of the best choices at a given point in time. By running the numbers on a computer, advisors can free up time to focus on more productive efforts.
Using the software, advisors can mix asset-location analysis with rebalancing optimization, which allows them to pinpoint the ideal timing for trades. An advisor’s traditional strategy is to schedule rebalancing by the calendar (once a quarter, for instance), which gives less optimal results.
This is not to say that turning over all the decisions to a computer is the only choice. Rowling notes that TRX allows advisors to customize the process by inputting their preferences—by running the analysis only when the asset allocation is out of balance by a certain percentage, for instance. But the core analytics should be generated regularly by software, she explains. It’s up to the advisor to decide how and when to use the advice.
What’s It Worth?
The most ideal way for an advisor to use asset location strategies is to have access to all of a client’s accounts and assets (or at least the relevant data). That’s a high bar in some cases, particularly if the clients are high-net-worth investors, who often have multiple advisors and accounts. “The more assets we see, the better we do,” says Jack Sharry, chief growth officer at LifeYield.
In the best-case scenarios, efficient asset location can moderately boost returns each year, although estimates vary. Rowling says some studies show an increase by as much as 100 to 200 basis points a year, though the devil’s in the assumptions.
Wealthfront, a robo-advisor, several years ago estimated there would be a relatively modest bump of 10 to 50 basis points from informed asset allocation choices. “An increase of 0.10%-0.50% in your annual returns may not sound like much, but it can be meaningful when you compound it over many years,” the firm advised in a blog post.
Hultstrom says the process “adds value, probably 50 to 100 basis points” a year through time, assuming it’s executed skillfully.
Nonetheless, there’s a gray area for guesstimating the worth of asset location, he adds. Much depends on the size of the client account and how complicated the portfolio mix. For some clients, the opportunity to add value may be thin. The larger the taxable portion, the more complicated the portfolio, he says. But that also means there’s more opportunity.