Welcome back! We’ve now pressed our Spaceballs-inspired accelerator past Light and Ridiculous, and have reached a Ludicrous level of model portfolio complexity (check out our Vanguard and iShares Ludicrous Model ETF Portfolio Examples here).

Our Ludicrous portfolios include the same ETFs with the same allocations as our Ridiculous portfolios. But they also build in traditional asset location strategies, aimed at increasing your expected after-tax return. In other words, they make sure each ETF is located in its proper account, with “proper” dictated by the asset class each holding represents. By locating relatively tax-inefficient assets in tax-preferred accounts and tax-efficient assets in taxable accounts, the goal is to achieve warp-speed tax-efficiency across your entire portfolio.

That is, if you’re not “chicken”. (If this reference flew past you, please revisit this clip.)


How To Locate Your Assets in Five “Easy” Steps

Since our Ludicrous portfolios’ make-up is identical to their Ridiculous portfolio counterparts, it’s not technically a separate model. It’s really more a different process for managing your holdings across your accounts. The basic process goes something like this:

  1. Plan out your asset allocations. First, determine the dollar amounts to purchase in each asset class. For example, if you have a $1 million portfolio with an 18% target Canadian equity allocation, you would want to purchase $180,000 of Canadian equities.
  2. Fill your TFSA with equities. Next, locate as many of your equity ETFs as you can in your TFSA … with two variations on that theme. I prefer to hold a mix of Canadian, U.S. international and emerging markets ETFs in the TFSA. But some investors prefer to prioritize holding their Canadian equity ETFs in their TFSA, to reduce the portfolio’s overall unrecoverable foreign withholding taxes. I personally don’t have an issue with this approach either, and have implemented both with my clients.
  3. Try to locate the rest of your equities in a taxable account. If you can, locate the rest of your equity ETFs in your taxable account, based on which are expected to have the lowest – or at least lower – taxable distributions. So you would purchase relatively tax-efficient U.S. or Canadian equity ETFs first (with the order depending on your taxable income and where you live in Canada). Next up are emerging markets equity ETFs. Relatively tax-inefficient international equity ETFs come last.
  4. Make your RRSP your last stop for locating any left-over equities. If you still need to purchase more equities after your TFSA and taxable accounts have been filled up, make your RRSP your last stop; locate these equity ETFs in the opposite order of how you did it in your taxable account. So, you’d purchase international equities first, then emerging markets equities, and then either Canadian or U.S. equities. If you’re comfortable with Norbert’s gambit, you could purchase U.S.-based foreign equity ETFs in your RRSP to reduce your overall product costs and foreign withholding taxes.
  5. Round out your taxable account (and RRSP) with bonds. If your equities have now all been purchased and you still have dollars left to invest in your taxable account, you could purchase a tax-efficient bond ETF with your remaining cash, like the BMO Discount Bond Index ETF (ZDB). You could then purchase a traditional (less tax-efficient) bond ETF in your RRSP to round off your fixed income allocation.


Trading Places: Is Ludicrous Asset Location Worth It?

Now for the million-dollar question: Does this old-school asset location strategy actually work?

As we now have a full year of actual (not back-tested) performance and tax data for our Light balanced portfolios, we can compare their 2019 after-tax returns to those of our Ridiculous and Ludicrous balanced portfolios.

For our example, we’ll assume an Ontario top-rate taxpayer and multimillionaire “Pat” invests $1 million in each of our Vanguard Light, Ridiculous and Ludicrous 40% bond / 60% stock model portfolios at year-end 2018. Being the adventurous type, Pat invests $100,000 in each TFSA, $500,000 in each RRSP, and $400,000 in each taxable account. Pat continues to hold these investments until year-end 2019, and then sells everything and deregisters the RRSP assets. (Obviously, Pat’s behavior is more than a little ludicrous, but for the sake of our experiment, we’ll cut our friend some slack.)

2019 is a decent period to analyze, as all asset classes had positive performance, but stocks still handily beat bonds. This is what most investors would expect from these asset classes over the long-term, so it makes for a good microcosm, if you will.

I’ve included examples below showing how Pat located each ETF in each account type at the beginning of the experiment. Keep in mind, since Vanguard’s foreign equity allocations are market-cap weighted, the percentage values in our examples will be slightly different than those seen in our current model portfolios.


Light Model ETF Portfolio

Sources: Vanguard Investment Canada Inc., As of December 31, 2018

Ridiculous Model ETF Portfolio

Sources: Vanguard Investment Canada Inc., CRSP, FTSE Russell Indices, as of December 31, 2018

Ludicrous Model ETF Portfolio

Sources: Vanguard Investment Canada Inc., CRSP, FTSE Russell Indices, as of December 31, 2018


The Light and Ridiculous portfolio arrangements should look familiar from our past discussions. However, the Ludicrous portfolio is set up very differently.

First, you can see that the TFSA is now 100% equities, with 30% in a Canadian equity ETF (VCN), and 70% in three market-cap weighted foreign equity ETFs (VUN, VIU and VEE) (Quick tip: As the Vanguard All-Equity ETF Portfolio (VEQT) is now available to investors, you could also consider simplifying your TFSA investment by replacing VCN/VUN/VIU/VEE with VEQT).

In the taxable account, there is almost enough room for the remaining equities, except for the most tax-inefficient international equity ETF, VIU, with its highest taxable distribution). Only $18,010 will fit into the taxable account, so the remaining $100,000 allocation has spilt over into the RRSP account.

Finally, VAB rounds out the entire bond allocation with the remaining RRSP balance.


The Right Place at the Right Time

So how did Pat do? At the end of 2019, after all securities have been sold and RRSPs deregistered, we find that the Ridiculous portfolio had a slightly higher after-tax portfolio value and after-tax return than the Light portfolio. The numbers were $824,152 vs. $822,456, and 12.54% vs. 12.30%, respectively.

This makes sense, since we already knew that the Ridiculous portfolios are cheaper and more tax-efficient than the Light portfolios. Unsurprisingly, the Ridiculous portfolio offered lower product costs and foreign withholding taxes from its U.S.-based ETF holdings, and higher tax-efficiency from the taxable account ZDB holding.

The more interesting result is the relatively high after-tax performance found in the Ludicrous portfolio. It has a much larger after-tax portfolio value and after-tax return of $833,932 and 13.87%, respectively. So, what’s causing the Ludicrous portfolio’s huge performance advantage?


After-Tax Portfolio Values and Returns: Light, Ridiculous and Ludicrous Model ETF Portfolios

Sources: taxtips.ca (2019), cds.ca (2019), Bank of Canada (2019), Vanguard Investment Canada Inc. (2018-2019), CRSP, FTSE Russell Indices, as of December 31, 2018


Comparing Apples-to-Apples, ATAAs-to-ATAAs

The Ludicrous edge all comes down to differences between the portfolios’ after-tax asset allocations (ATAAs). In all portfolios, the RRSP is worth $500,000 before the government gets its cut. But once we factor in future taxes at the top Ontario tax rate, the RRSP is really only worth $232,350 [$500,000 × (1 – 53.53%)]. As the Light and Ridiculous portfolios hold the same asset mix across all accounts (including the RRSP), their initial after-tax asset allocation is still 40% bonds and 60% stocks. Sure, each security held in the RRSP is worth less from an after-tax perspective, but the overall portfolio’s asset mix stays the same, before- and after-tax.

On the other hand, the Ludicrous portfolio has a significantly more aggressive after-tax asset allocation of around 25% bonds and 75% stocks. This is because the portfolio holds its entire $400,000 bond allocation in the RRSP. From an after-tax perspective, this $400,000 bond allocation is only worth $185,880 [$400,000 × (1 – 53.53%)]. If we divide this after-tax fixed income value by the after-tax value of the entire portfolio – voila – we end up with only a 25.38% after-tax bond allocation.


Light Model ETF Portfolio (After-Tax)

Sources: taxtips.ca, Vanguard Investment Canada Inc., as of December 31, 2018

Ridiculous Model ETF Portfolio (After-Tax)

Sources: taxtips.ca, Vanguard Investment Canada Inc., CRSP, FTSE Russell Indices, as of December 31, 2018

Ludicrous Model ETF Portfolio (After-Tax)

Sources: taxtips.ca, Vanguard Investment Canada Inc., CRSP, FTSE Russell Indices, as of December 31, 2018


Are the Ludicrous Portfolios Really More Tax-Efficient?

To determine whether the Ludicrous portfolios are actually more tax-efficient than the Light or Ridiculous portfolios, we have to make sure we’re comparing portfolios with the same after-tax asset allocations. If we adjust the before-tax asset allocation of the Ludicrous portfolio in our prior example so its after-tax asset allocation matches the Light and Ridiculous portfolios (i.e. 40% bonds, 60% stocks), we would need to start with approximately 56% in bonds and 44% in stocks.


Ludicrous Model ETF Portfolio (Before-Tax Asset Allocation): 56.06% bonds / 43.94% stocks

Sources: taxtips.ca, Vanguard Investment Canada Inc., CRSP, FTSE Russell Indices, as of December 31, 2018

Ludicrous Model ETF Portfolio (After-Tax Asset Allocation): 40% bonds / 60% stocks

Sources: taxtips.ca, Vanguard Investment Canada Inc., CRSP, FTSE Russell Indices, as of December 31, 2018


If we run the same after-tax return analysis using this new portfolio, we find that the adjusted Ludicrous portfolio actually ends up with a lower after-tax portfolio value and return than any of our other portfolios – $819,840 and 11.95%, respectively.  This would indicate that it’s not the tax-efficiency of the original Ludicrous portfolio that made it superior. It was because Pat was perhaps unwittingly taking on more after-tax equity investment risk.

As I’ll cover next in more detail, if you can live with this technically tax-inefficient portfolio to increase your expected after-tax portfolio value, Ludicrous investing can still be a viable strategy. But it’s best if you go in knowing the facts.


After-Tax Portfolio Values and Returns: Light, Ridiculous, Ludicrous and Ludicrous (ATAA) Model ETF Portfolios

Sources: taxtips.ca (2019), cds.ca (2019), Bank of Canada (2019), Vanguard Investment Canada Inc. (2018-2019), CRSP, FTSE Russell Indices, as of December 31, 2018


Advantages of the Ludicrous Portfolios

Okay, so maybe we haven’t found the holy grail of tax-efficient investing with our Ludicrous portfolios. But there are still several great reasons to consider using them for your own investments.

  1. Higher expected after-tax returns. Even though the after-tax benefits of your before-tax asset allocation may be a bit of a mirage, the higher expected portfolio value is very real. Your product fees and unrecoverable withholding taxes will also be lower than with the Light portfolios.
  2. Behavioural benefits. As far as Pat was concerned, the portfolio was a 60/40 stock/bond portfolio. All of Pat’s statements and performance reports would indicate the same, as they are all reported on a before-tax basis. The Ludicrous portfolios can be a great way to trick your brain into thinking you’re taking the same amount of risk as the other portfolios, while increasing your expected return. There are so few opportunities in investing where irrational behaviour can work to your benefit, why not take advantage of this one?
  3. Forecasting future tax rates is not required. At no point will you need to predict future tax rates in order to successfully manage your Ludicrous portfolio.
  4. Lower expected minimum RRIF withdrawals. The Ludicrous portfolios invest more of your lower-yielding bonds in the RRSP, so this account isn’t expected to grow as quickly as your TFSA or taxable account. This can reduce the amount of mandatory minimum RRIF withdrawals at age 72, which could also lead to fewer Old Age Security (OAS) clawbacks in retirement.
  5. Norbert’s gambit may not be required. Depending on your asset mix and account values, you may not need to hold U.S.-based ETFs in your RRSP to reduce the withholding tax drag. If you can hold your entire equity allocation in your TFSA and taxable account, you’ll only need to purchase bond ETFs in your RRSP with your Canadian dollars.
  6. Fewer holdings than the Ridiculous portfolios. The Ludicrous portfolios tend to have fewer holdings to manage than the Ridiculous portfolios. This is especially true if you decide to simply hold a 100% equity ETF, like VEQT or XEQT, in your TFSA and taxable accounts.
  7. More opportunities for tax-loss selling. Investors with larger taxable accounts could hold most of their equities there, which could present more tax-loss selling opportunities over time.

Now, to the potential disadvantages to managing a Ludicrous portfolio.


Disadvantages of the Ludicrous Portfolio

  1. It’s more complicated. Nothing beats the Light portfolios in terms of DIY simplicity. I list this as the primary disadvantage for good reason. Time = money!
  2. You will be taking more after-tax equity risk. Even though it may not feel like it, know that you’re sharing less of the portfolio risk load with the government, relative to holding the same asset mix across all accounts.
  3. Your rebalancing spreadsheet will get a workout. Any time you add new money to the portfolio, or withdraw funds from it, you will need to review all accounts in your spreadsheet, and determine which trades need to be placed. You’ll do so on a consolidated-portfolio rather than an account-by-account basis.
  4. You’ll need to track more ACBs. At least relative to the Light portfolios, you’ll need to track the adjusted cost bases on multiple ETFs held in your taxable accounts.
  5. Your accounts will perform differently from one another. During bull markets, you might be asking yourself why your bond-heavy RRSP is doing so poorly. During bear markets, you’ll be wondering why your TFSA and taxable accounts are underperforming your RRSP. Calculating your portfolio’s performance on a consolidated basis can help with this issue.
  6. Unexpected capital gains. If you require a large, lump-sum amount from your taxable account (such as for a down-payment on a home), you may find yourself realizing more capital gains than the other portfolios. This is because your taxable account will have a higher allocation to equities, which could be trading at a significant gain.
  7. More unexpected capital gains. Also, 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. In contrast, the Ridiculous portfolios hold substantial equities in the RRSP account, which you can sell to rebalance the portfolio with no tax consequences.


Next Up – CPM Goes Plaid

We’re nearing the end of our model portfolio adventures. But before we leave you to chart a Light, Ridiculous or Ludicrous course, we have one last model to show you. The Plaid!

What if you wanted your portfolio to incorporate the after-tax asset location concepts just discussed? For example, what if you wanted to start out with appropriate before-tax allocations to shoot for a truly tax-efficient, after-tax 60/40 portfolio? Good news – our Plaid model portfolios will take you there.