Wealth Manager

Horan is no casual observer of such matters. Taxes and investing
are his specialty, as his published paper trail reveals. Among
his latest: “Applying After-Tax Asset Allocation,” forthcoming in
The Journal of Wealth Management.

Adding taxes to the asset allocation process gets you “closer
to a better after-tax result,” he told Wealth Manager in a recent
interview. No one ever said better was easier, of course. Indeed,
after-tax asset allocation is a relatively embryonic field. Even if
you’re inspired to craft asset allocation strategies with taxes in
mind, there are no turnkey software programs to lean on. This is
still a do-it-yourself niche.

Nonetheless, interest in after-tax asset allocation is rising, says
Horan, who’s worked in the finance industry and was a finance
professor at St. Bonaventure University just before he became
head of CFA’s private wealth division in January.

The proof that taxes matter to the bottom line comes with the
recognition that they ultimately change portfolio allocations,
Horan advises. One simple example can be seen in the table on
page 66, which is based on Horan’s calculations for comparing
how asset allocation shifts in pre- and after-tax analyses.

Factoring in taxes is vital for every individual’s investment
strategy, but it’s particularly crucial for wealthy investors, who
endure higher marginal tax rates. “The wealthier you are,” Horan
reminds, “the higher the dollar stakes.”

Just how big are the stakes? Our conversation with Horan takes
a stab at an answer.

Q: What’s the rationale for building an asset allocation plan on an
after-tax basis?

A: Asset allocation is typically about thinking of how to divide assets
between stocks and bonds. When it comes to figuring out
how much spendable wealth is invested in stocks and bonds,
you have to factor in taxes. And that means factoring in the types
of accounts in which the securities are held.
For example, if I have $1 million in a 401(k) plan, I won’t have
$1 million to spend after I take the money out and pay the taxes.
The anticipated tax liability affects the spendable wealth, and
hence the effective asset allocation.

Q: Is after-tax asset allocation (ATAA) widely used in the investment
advisory profession?

A: No, but its use is growing. It’s still not the usual case for an advisor
to understand and appreciate that those assets in tax-sheltered
accounts ought to be viewed differently than the assets in
taxable accounts.

Prof. William Reichenstein of Baylor University has been developing
models on asset allocation, and he’s been involved in
general after-tax issues for a long time. He and I have been sort
of working in the same field. Another guy in this area is Jarrod
Wilcox in Boston, president of Wilcox Investment Inc. He wrote a
monograph recently that was published by the Research Foundation
of CFA Institute’s private wealth management series. He’s
been focusing on mean variance optimization, which is how to
put together different assets in the most efficient way to minimize
risk for a given level of expected return. What Bill and Jarrod
have done is come up with a way of putting taxes into the asset
allocation framework because taxes affect the efficient assembly
of stocks and bonds.

Q: Is ATAA a formalized strategy, or is it practiced on an ad hoc basis?

A: I’d say that it’s ad hoc. It’s not yet mainstream finance, which
focuses more on institutional issues, and so much of asset allocation
is focused on the pre-tax basis. Introducing taxes into the
[asset allocation] optimization framework creates a fair amount
of complexity. You don’t start with that, but now that all the
pre-tax stuff is more or less figured out, we can address after-tax
asset allocation.

In fact, there’s been a growing demand for after-tax asset allocation
models. Part of the demand is coming from the financial
planning profession. The wealth management business recognizes
that the pre-tax framework doesn’t apply to their clients,
who are heavily taxed—and taxed in different and complex ways
[compared to institutional investors].

One example is the time-horizon difference between a pension
fund, which can have an infinite time horizon, and a private client.
The individual’s finite time horizon changes the focus and
the analysis. For individuals, you’re concerned about end wealth
because you have an end period by which you want to achieve
a certain result. Monte Carlo simulations [for crafting asset allocation
strategies] are prevalent in the private-client framework
because of the finite time horizon.

Q: Modern portfolio theory focuses on maximizing return and
minimizing risk. How do taxes fit into that paradigm?

A: It’s still a two-dimensional framework of risk and return. The
basic modification is changing the standard inputs. Your expected
returns are different because taxes affect returns. Taxes also
affect volatility. By sharing your returns with the government
through taxes, the government actually reduces your risk. If the
tax rate is 50 percent, your range of outcomes has shrunk by that
proportion. Through taxation, the government shares in some of
the investor’s risk.

Take the extreme scenario: the government taxes 100 percent
of all your investment returns. That would stink, but we know the
end result: You’ll make zero, meaning that there’s no variance of
outcome. There’s no risk. Of course, there’s no return either.

Q: The basic inputs for mean variance optimization are returns,
volatility and correlation. So, you’re saying that all three are
affected by taxes, but otherwise they remain intact for building
optimized portfolios.

A: Yes, but rather than correlation I’d say co-variance. Correlations
are probably not affected [by taxes], but the co-variances are. Correlations
measure how likely investments move together or apart
from each other. Co-variance captures that along with the magnitude
of the co-movement. Correlation, in other words, is part of
what comprises co-variance.

But it’s not just a matter of [taxes] changing the inputs. A bond,
for instance, is a different after-tax asset depending on the type
of account it’s held in. If I’m holding a Treasury security in a Roth
IRA and a Treasury security in a taxable account, those are two
different after-tax assets.

Q: Why?

A: Because the returns are taxed differently, and so their risk profiles
are different. Factoring in the after-tax optimization process exponentially
multiplies the number of investment opportunities.
As such, the optimization process will analyze if the bond should
go into the Roth IRA or the taxable account. That’s what we call
asset location.

Q: ATAA, as a result, introduces greater complexity into the task
of building and analyzing portfolios. Is there a risk that the additional
complexity hurts rather than helps when it comes to the
end result?

A: You always run the risk of getting very precise results that are
no more valid than the assumptions on which they’re predicated.
The same certainly is true for the traditional Markowitz
optimization model. Many people eschew it on the basis that
if we can’t trust the inputs, we can’t trust the outputs. The
after-tax asset allocation framework is subject to the same
criticism. However, the tax issues are no less certain than what
we think an asset’s expected return is, or what the expected
volatility or co-variance will be.

For example, my tax rate may be 28 percent. Do I know that for
certain? No. Maybe it will end up being 33 percent; maybe it will
end up being 25 percent. But I’m pretty certain that there will be
taxes, and so there’s more certainty about the tax issue than what
the returns are going to be.

Q: True, but doesn’t introducing additional variables raise the
risk that the model becomes unwieldy and therefore more
unreliable?

A: What I’m saying is that the additional variables that you’re adding
are more predictable than the ones that were there in the first
place. You’re not resolving any of the existing ambiguity [by introducing
taxes into asset allocation], but you’re not introducing
that much more ambiguity, either.

The second thing to keep in mind is that it’s a rare breed that
takes the output from these models as gospel and implements
them in a rigid, prescriptive way. Rather, this type of analysis
provides strong guidance about optimal asset location. If you’re
going to hold bonds, for instance, hold them in your tax-sheltered
accounts because they’re tax inefficient. That may seem like
an intuitive, obvious result, but not everyone agrees with it.

Q: Are there studies showing that, all things equal, investors obtain
superior results with ATAA versus the traditional pre-tax
asset allocation process?

A: There are certainly hard studies on this. It’s clear that when I run Markowitz
optimization in both pre-tax and after-tax environments I get
two different results. To the extent that adding the additional tax
variables gets you closer to reality, closer to what produces the best
result, you’re getting an improvement—a better after-tax result.

Q: Do portfolios informed by pre-tax asset allocation look radically
different from those designed on an after-tax basis?

A: No, but it’s substantial enough to take notice. [The difference]
means that you’ve mis-estimated the risk exposure.

Q: Are there software products that integrate the after-tax issues
into asset allocation modeling?

A: That’s a good question, and I get it all the time. As far as I know,
it’s all pre-tax. Part of the problem is that there’s a fair amount of
inputs that have to go into the model. And every investor’s tax
situation is different. That’s part of what makes after-tax asset
allocation so challenging.