If you've been following the news this week, you're no doubt aware of the problems at hedge fund manager Amaranth Advisors LLC. It's hard not to hear about a company that loses nearly one-half of its assets under management in the blink of an eye.
This whole mess reminds me of the First Law of Investing: For every energy trader, there's an equal and opposite trader -- so, for every bullish trader, there's a bearish one. The Second Law of Investing: They're both likely to be wrong. And, oh yes, the Third Law of Investing: Asset "location" matters almost as much as asset "allocation."
Asset location
So much is made of asset allocation decisions. You know, the decision about how much to invest in equities versus fixed income versus cash. But few people talk about asset "location." That is, where are you going to hold specific investments you own: Inside your registered plan? Outside your registered plan? Inside a holding company? In a trust? In your spouse's name? In your name? In the name of a child? Asset location decisions are driven largely by tax and estate planning.
The Amaranth debacle should remind us that there's a best place to hold risky investments -- and that is outside your registered retirement savings plan or registered retirement income fund. The reason is simple. If you hold an investment inside your RRSP or RRIF and it drops in value, you'll get no tax relief from the loss.
Tax benefits
By holding risky investments outside your registered plan, any capital loss you realize can be applied against capital gains on other securities. In fact, if you can't use the loss in the current year, you can carry it back up to three years to recover taxes on capital gains in a prior year, or carry it forward indefinitely until it's used up. And if you don't use it during your lifetime, your executor is likely going to use it in the year of your death since unused capital losses can generally be applied against any type of income, not just capital gains, in the year of death (with some exceptions).
If you're concerned about holding those risky investments outside your registered plan for fear of a tax hit should you, heaven forbid, actually make profit, don't sweat it. There are strategies to reduce the taxes on capital gains, such as: holding the security longer to defer the tax hit; offsetting capital losses against the gains; selling the security over time to spread the capital gain over a number of years; paying tax on the capital gain over five years rather than in the year of sale by structuring a sale to take advantage of the capital gains reserve; splitting ownership (an asset location decision again) to spread the capital gain among family members; and deferring tax on a gain by reinvesting and replacing the asset sold (this can work for certain sales of real estate and eligible small business corporation shares, but not publicly traded securities), among other ideas.
Defining risk
The key is to decide which of your investments is risky enough to hold outside of your registered plan. The less you understand an investment you've made, the riskier you should consider it. Leverage also adds risk. Where a fund uses leverage to supercharge returns, recognize that losses can be magnified as well -- just ask investors in Amaranth.
By the way, if your asset location is all wrong, it's possible to swap assets with your RRSP or RRIF to fix the problem on a tax-free basis. Speak to your investment dealer about it.
Tim Cestnick is a principal with WaterStreet Group Inc. and author of Winning the Tax Game, among other titles.
