Asset location: Constructing tax-efficient portfolios

Investors are nervous when it comes to paying taxes. Small wonder then that tax-advantaged investments are in high demand during March every year. A question that an investor has to consider for constructing a tax-efficient portfolio is whether stocks should form part of the tax-advantaged sleeve.

This article discusses this issue in the context of tax-efficient portfolios. It then shows why bonds (fixed-income investments) are optimal for the tax-advantaged sleeve and equity for the taxable sleeve. It also explains how the New Pension System (NPS) could offer an additional tax-efficient avenue for investors.

Asset location


Traditionally, portfolio construction has consisted of allocating assets among various asset classes.

Asset location refers to locating these assets inside the tax-advantaged sleeve and taxable sleeve, while retaining the target asset allocation.

To understand the relevance of tax-efficient investments, consider an investor who invests Rs 2 lakhs, 50 per cent each in stocks and bonds. Assume that equity returns 12 per cent per annum and bonds, 8 per cent per annum.

The investor can choose from three portfolio sets. Portfolio A has Rs 50,000 each in stocks and bonds in the tax-advantaged sleeve and the same exposure in the taxable sleeve.

Portfolio B has Rs 1 lakh in equity in the tax-advantaged sleeve and Rs 1 lakh in bonds in the taxable sleeve.

Portfolio C flips the asset location - it has Rs 1 lakh in bonds inside the tax-advantaged sleeve and Rs 1 lakh in equity in the taxable sleeve.

The tax-efficiency of these portfolios would depend on the tax treatment of income generated by the assets in the taxable sleeve.

That is, the asset location decision would be driven by the difference between tax on fixed-income returns and tax on equity returns. Which then is the tax-efficient portfolio?

Taxable-equity advantage


Consider the current tax structure. The interest on fixed-income securities is taxed at the marginal rate. The long-term capital gains are taxed at 10 per cent on a non-index basis, if equity investment is held for more than 12 months.

Simple calculation shows that Portfolio C is tax-efficient, as it generates the highest after-tax cash flows.

This factor is relevant, as it is only after-tax cash flows that buy goods and services for the investor at the horizon.

The asset-location decision to have equity in the taxable sleeve will be optimal as long as the tax on interest income is significantly higher than that on capital gains.

That is why the asset location makes economic sense within the core-satellite portfolio framework, where the core has low-cost market exposure (beta exposure) and the satellite, above-market-returns strategies (alpha exposure).

A typical core-satellite portfolio would have equity index funds as the passive core.

And the long-term capital-gains on such funds are tax-exempt.

This means that the tax-spread between taxable fixed-income returns and equity returns is higher, making it optimal to locate fixed-income within the tax-advantaged sleeve.

Besides, there is an advantage for self-directed equity investments.

It is obvious that equity is more risky than debt. Locating equity in the taxable sleeve, hence, leads to the government sharing a proportion of the risk.

This is because capital losses can be offset with capital gains, thus, lowering the effective tax rate for the investor.

Conclusion
The New Pension System (NPS) enables investors to take low-cost beta exposure with a longer lock-in period. Investors can take a maximum of 50 per cent exposure to index funds through select asset management firms. The problem is that the gains from the investment will be taxed at the time of withdrawal.

But the withdrawal could well be tax-exempt if the Pension Fund Regulatory and Development Authority has its way.

And that could make NPS an important investment avenue for constructing tax-efficient portfolios. Investors wanting to necessarily locate equity inside the tax-advantaged sleeve within the core-satellite framework would be benefited