I’m having difficulty in understand this passage from CFAI text Vol 4 2013, pg11: “If a taxable investor can hold the bond portfolio within a taxable or a tax-deferred account, the investor can effectively view the benchmark index as having one set of return-risk characteristics in a taxable account and another set in a tax-deferred account. This perspective can be helpful in joint optimization of the asset allocation and location decisions.”
Can you please explain this. Thanks.
taxable account: Risk and return would be viewed on a annual-after tax basis.
For a tax deferred account - the risk and return would consider the fact that tax would be paid at the end of the “investment” horizon (1+r)^N*(1-Tcg) – would be the effective return on the tax deferred account.
So essentially when making the “risk return” analysis - essentially there would be both the Location of asset (whether taxable, or tax deferred) effect as well as the risk-return effect.
so essentially while constructing the efficient frontier (which is the usual tool used for the purpose) - these parameters define the asset class. So you could have the same asset showing up at different points on the efficient frontier - because of the risk/return characteristics of the asset - due to combination of asset location and asset allocation.
Bond Class, Taxable, 30%
Bond Class, Tax Deferred, 20%
Bond Class, Tax-Exempt, 50%
e.g.
The same asset-class offers two (or more internationally) different risk-return characteristics. A taxable account may generate lower returns annually than a tax-deferred account, but also bears lower risk than the tax-deferred one. A risk optimizer might look at the two streams of returns as if they were two different asset classes, and the constrained optimization has a larger variety to choose from. This might be more satisfactory to some investors who seek diversity and better risk-reward characteristics.