Welcome back to the second installment of our three-part series, in which we’re tackling one of the thorniest questions of all: How does asset location really work?

In Part 1, we covered several key concepts about asset location, and why I recommended most DIY investors simply use a single asset allocation ETF to hold the same asset allocation across all account types.

That’s what Asset Location Light is good for. However, what if “good enough” isn’t enough for you? Today, I’ll show you how to take the expected after-tax return of your portfolio to ludicrously mind-bending levels by implementing a traditional asset location strategy.



Asset Location Light, Revisited

First, let’s take a moment to review the three key concepts we covered in Part 1. You’ll need them to make sense of the next steps.

  1. Your RRSP is a lot like a TFSA: The taxable, government portion of your RRSP never really accrues to you, the investor. Nor does any growth on this amount. It’s all simply along for the investment ride. Accordingly, the after-tax portion of your RRSP acts more like a TFSA.
  2. Your RRSP allocations aren’t what you think they are: If you prioritize stocks in your RRSP, this will make your portfolio’s after-tax asset allocation more conservative. Because, after-tax, you end up with less invested in stocks than you might think. If you prioritize bonds in your RRSP, this will make your portfolio’s after-tax asset allocation more aggressive. Because, after-tax, you end up with less invested in bonds than you might think.
  3. What looks like asset location is often asset allocation in disguise: It’s your portfolio’s after-tax asset allocation (not your before-tax asset mix) that drives your future after-tax portfolio returns.

As covered in Part 1, this all speaks to why it’s fine to use Asset Location Light, with one-ticket asset allocation ETFs across all account types. It’s also by far the easiest way to set up your portfolio.

Setting the Ludicrous Stage

Now that you’ve conquered Asset Location Light, let’s look at a ludicrous level of asset location, so you can consider whether it’s worth your while.

In the following illustrations, we’ll use the single-fund, Asset Location Light approach as our benchmark for all comparisons, with the Vanguard Balanced ETF Portfolio (or VBAL) as our holding. VBAL allocates 60% of its portfolio to stocks, and 40% to bonds.

For our Ludicrous Asset Location strategy, we’ll follow the traditional asset location advice of holding stocks in the following order:

  1. TFSA first
  2. Non-registered accounts next
  3. Corporate non-registered accounts (if you have any)
  4. RRSP last

Remember from Part 1, holding stocks in your RRSP last will make your after-tax asset allocation inherently more aggressive, which will in turn increase the expected after-tax return of your portfolio. It’s important to note this is no free lunch. Even though you may not realize it, you are taking more equity risk from an after-tax perspective, so the higher expected after-tax return of this strategy is your compensation for taking on this additional risk.

A Ludicrous Asset Location in Action

Enough preamble. Let’s build out both our Light (benchmark) and Ludicrous portfolios.

First, we’ll create a 3-ETF clone of VBAL, by separating its underlying stock and bond components:

By combining these three ETFs in the correct weights, we’ll have identical exposure to VBAL, but more flexibility, so we can locate our individual stock and bond ETFs in different accounts.

For both our Light and Ludicrous asset location strategies, our total before-tax portfolio value will be $1 million, split as follows:

  • TFSA: $100,000
  • Non-Registered Account: $500,000
  • RRSP: $400,000

Since our before-tax target asset allocation is 60% stocks and 40% bonds, we’ll want to allocate our $1 million as follows:

  • Stocks: $600,000
  • Bonds: $400,000

For the Light benchmark, we’ll automatically be invested in the same 60% stock, 40% bond mix in each account:

  1. TFSA: $60,000 stocks, $40,000 bonds
  2. Non-registered accounts: $300,000 stocks, $200,000 bonds
  3. RRSP: $240,000 stocks, $160,000 bonds

For our Ludicrous asset location strategy, well locate our 60% stock, 40% bond mix as follows:

  1. TFSA: $100,000 stocks
  2. Non-registered accounts: $500,000 stocks
  3. RRSP: $400,000 bonds



Ludicrous Asset Location: Adjusting for the Government’s Take

So far, so good. But, as we learned in Part 1, the taxable portion of your RRSP, and any growth on this amount, is effectively owned by the government. So, if we assume a 50% effective tax rate on RRSP withdrawals, the $400,000 before-tax RRSPs are actually only worth $200,000 after-tax.

What happens if we adjust our asset class figures to account for this? We’ll find our total portfolio value is only worth $800,000 from an after-tax perspective. This doesn’t impact the after-tax asset allocation of our Asset Location Light strategy. It remains at 60% stocks and 40% bonds.

But it makes our Ludicrous strategy more aggressive, with stocks now making up $600,000 of an $800,000 after-tax portfolio. That translates to a 75% stock, 25% bond asset mix after-tax.

As we now know, a higher after-tax allocation to stocks is expected to result in higher after-tax returns, but this is by no means guaranteed. This assumes stocks outperform bonds over your unique investment timeframe. Especially given the higher expected risks, this isn’t a sure bet.



Light vs. Ludicrous Before-Tax Outcomes

Let’s forget we know anything about after-tax asset allocation for a moment. As far as a naïve investor is concerned, both portfolios are the same, even though their asset location strategies differ. From a before-tax perspective, both portfolios should earn the same rate of return, as their underlying investment strategies are the same.

To put this to the test, let’s assume stocks return 6% and bonds return 2% over the next year, with no rebalancing in either portfolio. At the end of the year, our stocks have increased from $600,000 to $636,000, and our bonds have increased from $400,000 to $408,000. From a total portfolio perspective, both strategies would have yielded the same before-tax portfolio value of $1,044,000 and before-tax annual return of 4.4%. Investors in either strategy would be indifferent between the two strategies.

But, again, that’s before we consider taxes.

One year later … before-tax



Light vs. Ludicrous After-Tax Outcomes

Now let’s pay all taxes owing to the government, including the taxes we’ll eventually owe on the RRSP. We’ll assume a 50% effective tax rate on all taxable income. We’ll also assume stocks have a fully taxable dividend yield of 2%, and the remaining 4% of the stock return will be taxed as a capital gain with a 50% inclusion rate. The 2% bond return will also be fully taxable as income, along with the entire market value of the RRSP on deregistration.

After paying all taxes owed at the end of our one-year period, we find Ludicrous outperformed Light by 0.35% after-tax. But as we already know from Part 1, this outperformance is explained by the portfolio’s riskier after-tax asset allocation, not by its asset location. That is, the before-tax 60% stock, 40% bond asset mix was actually a riskier after-tax asset allocation of 75% stocks, 25% bonds.

One year later … after-tax



Ludicrous Asset Location: An Advantageous Sleight of Hand?

So, you now know how to implement a traditional asset location strategy to increase the future expected after-tax return of your portfolio.

From a behavioral standpoint, this more complicated, Ludicrous strategy has its benefits. If you don’t overthink it, the portfolio remains a 60% stock, 40% bond portfolio on paper. Your account statements and performance reports would reflect the same, as they are all reported before-tax.

Now that you’ve read this post, you know you’re actually tricking your brain into thinking you’re increasing your expected return with what seems like no added risk. Even though the added risk remains (if well-hidden), you may still want to take this approach. There are so few times when irrational behaviour can benefit an investor; this seems like it could be one of those times.

That said, there are also disadvantages to ditching your single asset allocation ETF.

Disadvantages of a Ludicrous Asset Location Strategy

  1. It’s more complicated. Even though a three-ETF portfolio may seem simple, nothing beats a single asset allocation ETF in terms of DIY simplicity.
  2. You will be taking more after-tax equity risk. It may not feel like it, but you’re sharing less of the portfolio risk load with the government, relative to holding the same asset mix across all accounts.
  3. You’ll need to rebalance your portfolio. Any time you add to or withdraw from the portfolio, you will need to review all the accounts in your spreadsheet and determine which trades to place (on a consolidated-portfolio rather than an account-by-account basis). Vanguard rebalances their asset allocation ETFs whenever an underlying asset class becomes 2% over or under its target. This means you’ll need to be extremely diligent with your rebalancing thresholds if you want to closely track the returns of a comparable, single asset allocation ETF before-taxes. For example, VBAL returned 10.20% during the 2020 calendar year. If you failed to rebalance your multi-ETF portfolio during 2020, you would have realized only 9.65%.
  4. Your accounts will perform differently from one another. During bull markets, you might wonder why your bond-heavy RRSP is doing so poorly. During bear markets, you might wonder why your TFSA and taxable accounts are underperforming your RRSP. In other words, if tracking-error regret might throw you off-course, you may want to stick with the more benchmark-hugging Light strategy.
  5. You might incur more taxable capital gains. If you can’t keep your portfolio in balance by injecting new cash into it when needed, you may need to instead rebalance periodically by selling equities in your taxable account, realizing capital gains in the process.

Putting Asset Location to Work for You by Going Plaid

If the disadvantages of a Ludicrous location strategy don’t intimidate you, it could make sense for your portfolio. Or, in a final, Part 3 of our asset location series, we’ll look at one more take on asset location. Sure, you can expect to earn higher returns by tricking yourself into taking on higher, after-tax market risks. But what if you want to pursue higher returns specifically from your asset location actions? For that, we’ll need to move past Ludicrous, into a Plaid asset location strategy. Look for that post soon.