Tax efficiency: A decisive advantage for index funds

Vanguard writes: Key highlights

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"Tax cost" —the difference between the before-tax return of a fund and its preliquidation after-tax return—is a way to gauge a fund's tax efficiency.

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Vanguard analysis found that, for the 15 years ended October 31, 2013, the median tax cost of domestic actively managed stock funds was 27 basis points higher than that of domestic index stock funds.

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Some index funds can be tax-inefficient as well, especially those that seek to track more narrowly focused benchmarks such as those in the mid- and small-cap markets.

 

With upper-income Americans facing tax increases as a result of legislation enacted at the beginning of 2013, it's no surprise that there's heightened interest in tax-efficient investing.

Broad-market index funds and their exchange-traded counterparts (ETFs) may be more tax-efficient than actively managed funds. Just as some ways of managing investments are more tax-efficient than others, certain types of investments are, by their nature, more tax efficient as well.

What makes one mutual fund more tax-efficient than another? Some relevant factors include a portfolio's management strategy, the turnover or trading strategy, the accounting methodology used, and the activity of the funds' investors.

"One way that a fund's tax efficiency can be measured is with its 'tax cost,'" said Scott Donaldson of  Vanguard Investment Strategy Group. "Tax cost refers to the before-tax return of a fund minus its preliquidation after-tax return. It represents a very high hurdle for active fund managers to overcome, in addition to their ongoing fund management expenses."

The illustration below shows a decisive tax advantage for index funds: The median tax cost for index funds (left side, green) was 73 basis points, whereas the median tax cost for actively managed funds (right side, green) was 100 basis points. Thus, for the funds in the data set, the median tax cost of domestic actively managed funds was 27 basis points higher than that of domestic index funds. The gap can be even larger: Note the 277-basis-point difference between the worst tax costs (shown in blue) of domestic actively managed and index funds. Moreover, the chart shows a much narrower range in tax cost within the index category and that 75% of all index funds had a lower tax cost than that of the median actively managed fund.

Why index funds may have the upper hand

Because an active manager makes decisions based on a security's potential to outperform, he or she is more inclined to make specific concentrated purchases in fewer stocks and to liquidate entire holdings more often than a manager of a broad-market index fund would. In making wholesale liquidations, active managers are much more likely to realize capital gains, since an entire position's gain could be realized at once. The tax efficiency of actively managed funds could therefore be much less stable, and the lack of depth and breadth of share lots within an actively managed fund could bode poorly for its future tax efficiency. An actively managed fund also has the potential for a manager change, resulting in a new manager completely restructuring the portfolio, which would cause realization of gains generated from past investment success.

Granted, some index funds can be tax-inefficient as well (see chart above). For example, funds that seek to track more narrowly focused benchmarks such as those in the mid- and small-cap markets fall into the bottom quartile in Vanguard's tax cost analysis.

"Much more broadly based index funds will typically be more tax-efficient because they change their holdings less often," said Sarah Hammer of Vanguard Investment Strategy Group. "Moreover, not all ETFs or conventional index funds are the same. Even funds that seek to track the same index can have different performance. The bottom line is, while Vanguard believes it's much more important to manage the overall allocation of assets in your portfolio than it is to manage exclusively for taxes, your portfolio's tax efficiency is important to take into account."

Aside from choosing funds that are more tax-efficient, investors can also engage in other best practices to minimize their taxes:

• Use tax-advantaged accounts. Maximize the use of tax-advantaged accounts such as traditional and Roth 401(k)s, IRAs, and 529 college savings plans.
• Be a tax-efficient investor. Use tax-advantaged accounts to rebalance an asset allocation or to sell appreciated positions that may provide better after-tax returns than completing similar transactions in a taxable account.
• Pay attention to asset location. Purchase tax-efficient investments in taxable accounts and tax-inefficient investments in tax-advantaged accounts, which can help earn extra returns without added risk. Those incremental differences have a powerful compounding effect over the long run.

Notes:

• All investing is subject to risk, including the possible loss of the money you invest.
• Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
• We recommend you consult an independent tax advisor for specific advice about your individual situation.