Personal Finance

Improving returns via asset location

B. VENKATESH | Updated on February 19, 2011 Published on February 19, 2011

Individuals' desire to save taxes has led to proliferation of tax-savings products such as Equity-Linked Savings Schemes (ELSS). But changing tax laws prompts investors to choose newer products, which may not always lead to an optimal portfolio. How then should investors construct tax-efficient portfolio?

This article explains the concept of tax-aware investment. It shows why asset allocation is the important driver for tax-efficient portfolio.

A tax-aware portfolio is one that carries tax-efficient investments to fulfil the asset allocation decision. The process of choosing between taxable and tax-exempt (or tax-deferred) products is called asset location.

Most mass-affluent investors typically invest to save taxes. Such investment does not by itself create tax-aware portfolios. The asset location decision is based on the asset allocation policy. This means tax-aware investment is a two-step process. One, individuals have to analyze whether a product such as ELSS is an optimal tax-savings investment. And, two, analyze whether such exposure is within the overall asset allocation framework.

This is based on the logic that investors should look at improving after-tax portfolio returns, given the investment objectives. In other words, investments in ELSS or small-savings products such as PPF may be sub-optimal if it is not aligned with the asset allocation policy.

We, hence, start with the asset allocation decision to create tax-aware portfolio.

An individual's asset allocation decision is a function of his or her risk tolerance level, investment horizon, return objectives and investment capital. It is generally true that asset allocation policy for high net-worth individuals will be different from that of mass-affluent investors. Nevertheless, both classes of investors should have exposure to equity and bonds.

Equity exposure is essential because it provides higher expected return and helps individuals beat inflation. Bond exposure is useful because bonds have finite life, which helps in mapping investments with liability. Besides, bonds have lower volatility. In this backdrop, how should individuals plan their asset location policy?

Equity investments carry higher expected return than bonds. It would appear that the asset location policy depends on the tax treatment for equity. If long-term capital gain on equity is tax-exempt (as it has been for a while), it logically follows that tax-exempt investment should be in bonds to improve after-tax portfolio returns.

But what if long-term capital gain on equity is taxable at marginal rate? Individuals may then be indifferent on their choice of tax-savings investment. Why?

We suggest individuals look at tax exemption as cash flow from the government before investing. And this cash flow is the same whether individuals invest in tax-exempt equity or bonds (this tax exemption cash flow can be assumed to be invested in taxable equity or bonds as part of the overall asset allocation decision).

Suppose an individual has to invest Rs 10 lakh. Assume that the tax exemption is Rs one lakh and the marginal tax rate is 30 per cent. The tax exemption cash flow from the government is Rs 30,000. What drives the after-tax portfolio returns is whether the individual allocates, say, 50 per cent or 60 per cent of Rs 10 lakh to equity, not whether Rs one lakh is invested in tax-exempt equity or bonds.

Given that equity has higher expected return, a portfolio with higher equity allocation would have higher after-tax expected return. But what if the individual experiences losses on her equity exposure? As part of the tax-aware investment, individuals can then explore setting off losses against gains (tax-loss harvesting), depending on the tax laws.

Conclusion

Constructing tax-efficient portfolio is tedious. We suggest that individuals map their asset allocation policy to their investment objectives. The asset location decision follows the asset allocation policy.

When equity is not taxable, it is optimal to take bond exposure through tax-exempt investments. But when equity is taxable at the same rate as bonds, individuals may be largely indifferent to their asset location policy, given the cap on individual tax exemption.

(The author is the founder of Navera Consulting. He can be reached at >enhancek@gmail.com)

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