Historical Performance of Asset Location Strategies and Its Implications for Investors’ Retirement Portfolios

Abstract

This study investigates how two portfolios, both holding Treasury bonds and the passively managed U.S. stock market index but utilizing opposite location strategies, would have performed historically over the 1928–2009 period and finds that the relative performance of the two portfolios differs substantially during the two halves of the period. The return to full taxation of dividends at marginal income tax rates created a significant advantage for the stock-sheltered portfolio as the combination of the changes in tax legislation and high dividend payouts contributed to the consistent outperformance of the stock-sheltered portfolio until mid-1980s. During the second half of the period, which was characterized by elevated inflation, substantially higher bond returns, and shrinking dividend yields, the advantage of the stock-sheltered portfolio was gradually eliminated due to the diminished level of tax inefficiency of equities. The relative attractiveness of the stock-sheltered portfolio declines with higher risk aversion but increases with a higher share of payout distributions. The expected tax environment of 2011 combined with a modest size of the realized stock market risk premium would marginally favor the stock-sheltered portfolio.

TOPICS: Portfolio construction, security analysis and valuation, fixed income and structured finance, performance measurement