14Apr21: I edited my approach to where to put bonds, based on my post on Required Minimum Distributions.
In Part 1, we discussed the first three of my six steps for asset allocation:
- Why are you investing? What are the goals?
- What broad asset categories do you want to invest in? Stocks vs bonds, US, UK, International, etc.
- What are your percentage targets for each of those asset categories?
- Which account types will you use for each asset categories, considering tax treatments?
- Which funds will you use in those accounts to achieve the overall asset allocation?
- How and when will you rebalance to maintain your target asset allocation?
This post will wrap up with the second half of the list.
Asset Categories & Account Types
Bogleheads has a good primer on tax-efficient fund placement – it’s specific to US investors, but the general concepts apply for Americans investing in both the US and UK, even if some of the numbers will vary (the US and UK systems for taxing capital gains and dividends are very roughly similar).
For more details on any of the account types mentioned below, I’ve put together summaries linked here.
By the nature of the investments I choose, I avoid really tax inefficient options – REITs, high-turnover active funds, and high-yield corporate bonds. The fact that these are tax inefficient just adds to my reasons for not investing in these.
That means the most tax inefficient investments I have are bonds. I keep all my bond funds in a tax-advantaged account that are recognized in both the US and UK: my TSP (similar to a 401(k)). It would also be fine to have a bond fund in a UK pension (including SIPP, as long as you agree it’s a pension) or in a Roth IRA, but there are other advantages to putting bonds in a Traditional IRA or 401(k) account (see my post on Required Minimum Distributions). I also have a number of individual US savings bonds – there’s no choice to hold these anywhere except a taxable account, so there they are.
Individual stocks only live in my S&S ISA (because I don’t want PFICs there), and some RSUs from an old employer that stay where they are because they’re already there. That company won’t be paying dividends anytime soon, so unless I sell, there’s no taxable events there. An IRA is also a perfectly good place for individual stocks, if you particularly want to invest in them.
That just leaves stock index funds. It probably doesn’t really matter where you put these – there are some arguments for where to put US vs non-US and so on, but these are tweaking around the edges. My approach is a combination of simplicity plus taking advantage of accounts where I can get particularly low-cost funds.
- I keep my taxable account simple, to try to keep my taxes simple: this is all US total stock, in a single index ETF which is HMRC reporting
- I take advantage of low fees where they’re only available in specific places.
- After that, it’s just splitting across the account types (TSP, Roth IRA, and UK pension) to achieve the target asset allocation
Fund Selection for Asset Allocation
I’ll quickly run through the funds I use in each of my account types. These are not specific recommendations for these funds – I’m not trying to sell you anything! Just what works for me, do your own research 🙂 There’s nothing extra special about any of these funds, they’re mostly pretty typical index funds.
My key rules, in rough priority order:
- No PFICs outside pensions
- No funds that aren’t HMRC reporting outside pensions
- Minimize costs
- Follow tax-efficient asset allocation, as described above
- Keep it as simple as possible
- US Taxable Brokerage Account
- 100% Vanguard Total Stock Market Index Fund ETF (VTI) – very low expense, covers the whole US market
- US Treasury Bonds
- A chunk of Series EE bonds – my parents bought these for me when I was much younger; they’re now at very competitive interest rates, so I hold on to them to maturity. If you have a 20 year time horizon, these are still an attractive investment for new money, since they’re guaranteed to double in value in 20 years, about a 3.5% interest rate. But if you sell at 19 years and 11 months, you get the pitiful rates of today (0.1% as I write this).
- US Roth IRAs
- Vanguard Extended Market Index Fund ETF (VXF) – low expenses, need a bit more small/mid cap to get to my target allocation
- Vanguard Emerging Markets Index Fund ETF (VWO) – low expenses for the category, this is essentially all of my emerging markets allocation
- Some more VTI, to get to the target asset allocation.
- Vanguard Total International Index Fund (VEU) – I don’t have any here at the moment, but its on my list if I ever need it to get to my target international allocation.
- Thrift Savings Plan
- I know most of you won’t have access to the TSP, unless you’re a current or former US government employee. It works very much like a 401(k), but has a very short but good list of investment options (all low-cost index funds). If you don’t have a TSP account, you could do something very similar in a good 401(k), or in an IRA you’ve rolled your 401(k) into.
- International (I Fund): The lowest expense international fund I can find, it’s the core of my international holdings.
- Large Cap (C Fund): Basic S&P 500 tracker. Combined with VTI, it makes up my US large cap exposure.
- Small Cap (S Fund): Slightly misnamed, this is really mid and small cap – very similar to VXF. A chunk of my US mid/small cap allocation
- Fixed Income (F Fund): Mix of about 70% US government bonds, 30% US corporate bonds. The remainder of my bond allocation, after the savings bonds.
- Government Bond Fund (G Fund): this is a TSP-unique offering, US government bonds issued just to this fund and not traded on the open market. I’m not currently using it, but when I increase my bond allocation in retirement, I likely will.
- Fixed Income Fund (F Fund): a basic, broadly diversified US bond index fund. I don’t currently use it (BND in my IRA plus savings bonds are enough for my US bond allocation), but certainly would if I needed to.
- UK Pension
- Your options will vary tremendously based on the exact plan your employer has selected and who is administering it, so I won’t give specifics on the funds I use. Depending how good or bad your options are, you may even need to readjust the rest of your allocations – I remember having a 401(k) in a previous employer that was so bad I just had to pick the worst of a lot of bad options, and make up for it elsewhere. Even if you only have bad options, it’s worth at least getting the employer match – that’s free money and an instant return!
- UK Equity Index: you’ll find it challenging to buy a UK index fund outside of a UK pension/SIPP. It’s a PFIC in a S&S ISA, and I haven’t found a UK-only index fund that I’d want to own in a US account. So if you want UK-specific exposure beyond what is already in an a total international fund, this is a good place for it.
- Ex-UK Equity Index: This goes into a bit of a mix of different asset categories, but works fine to accept my pension contributions. I can tweak other investments to maintain the overall allocation. In my pension, this is a very low cost option, too.
- UK Stocks & Shares ISA
- I’ve covered my S&S ISA experiment elsewhere – for asset allocation purposes, this is 100% UK large cap.
Rebalancing for Asset Allocation
Rebalancing is simply tweaking the proportion of investments in individual funds in order to maintain the overall target asset allocation. It’s a necessary process – otherwise your allocation will drift as some categories perform better than others, and you wind up over-concentrated in recent winners (which might be primed to underperform), and under-concentrated in recent losers (which might have more room to grow next).
I use two ways of rebalancing:
- Preferred: adjust where new money goes.
- I put my annual Roth IRA contributions in the right place to bring up any categories that are low, and occasionally tweak my monthly UK pension contributions to adjust the mix.
- This has the advantage of not triggering any capital gains, no hassle with selling and buying – it’s easy and free.
- I am missing out on the possibility of tax loss harvesting in my taxable account, but the simplicity is worth it to me. Plus, my taxable account is a pretty small amount of my overall investment – if it was bigger, this calculus might change.
- As necessary: sell overweight categories and buy underweight ones.
- I don’t do this in my taxable account – that’s why it’s all in one investment, it can just stay there and do it’s thing, and I avoid taxable capital gains.
- Occasionally I need to do this in my TSP or Roth IRAs. TSP is easy (I just type in the new percentages I want and they adjust it overnight), but in an IRA you need to sell one ETF and then use the cash to buy another.
- This isn’t taxable within the IRA wrapper, but it’s a bit of a hassle, and there’s a risk of the market moving while you’re in cash, missing out on gains (or losses!). So I limit this to roughly annually, usually about the same time I do my Roth IRA contributions.
That’s really all there is to asset allocation! There are a few tweaks to account for US/UK taxes and available accounts, but the overall concept is the same for any investor. I hope this was a useful description, and appreciate any comments or questions (or telling me I’m doing something stupid!).