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A Superior Tax-Conscious Balanced Fund From Vanguard

A prudent process, experienced team, and rock-bottom fees earn Vanguard Tax-Managed Balanced a Morningstar Analyst Rating of Gold.

Gretchen Rupp, 08/27/2016

The following is our latest Fund Analyst Report for Vanguard Tax-Managed BalancedVTMFX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Vanguard Tax-Managed Balanced fund follows a straightforward approach for taxable accounts. The prudent process, experienced team, and rock-bottom fees support the fund's Morningstar Analyst Rating of Gold.

On the surface, this fund may not appear unusual, but the tax-managed approach creates a distinct portfolio. It splits exposure evenly between an equity stake that closely tracks the Russell 1000 Index and a fixed-income sleeve made up of tax-efficient municipal bonds. Lead manager Bill Coleman runs the stock portion, tweaking position sizes to improve post-tax returns by mitigating dividend payments. The fund’s dividend yield is about 20 basis points less than its benchmark as of July 2016, reflecting the typical result of the adjustments. Jim D’Arcy has managed the fixed income portion since June 2013 with a higher-quality stance than its peers in the allocation--30% to 50% equity Morningstar Category. The fund held about 70%-75% of the bond portfolio in bonds rated AAA or AA compared with the roughly 50% category average as of July 2016. D’Arcy’s preference for higher-quality bonds, along with minor duration adjustments, has helped the fixed-income portion stay slightly ahead of its index over his tenure through July 2016.

The fund’s structural bias to municipal bonds, instead of taxable bonds, has provided an advantage in recent years, as the underlying municipal bond index topped the Barclays U.S. Aggregate Bond Index by 50 basis points annually over the five years through July 2016. But this is likely not a permanent trend, and category peers that follow a core index would benefit should the direction reverse.

In addition to the fund’s tax-efficient holdings, Coleman engages in tax-loss harvesting, locking in either equity or bond losses to offset gains. This process helps keep the annual tax bill low. Indeed, the fund has not made a capital gains distribution since its 1994 inception, the only allocation fund with at least a three-year history that can make that claim. The fund’s 0.11% expense ratio is among the lowest of its allocation peer group, providing another advantage for investors.

Process Pillar: Positive | Gretchen Rupp 08/19/2016
This fund follows a sensible approach to keep taxes low. The fund splits its assets evenly between U.S. equities and high-quality municipal bonds. Managers use trading techniques, such as locking in losses to offset gains, to minimize capital gains. Although tax-loss harvesting can prove difficult after extended market rallies, lead manager Bill Coleman takes advantage whenever possible. For example, he harvested losses in June 2016 when the market declined following Great Britain’s vote to leave the EU. Still, the fund’s turnover remains lower than the typical peer. The fund’s 9% turnover ratio in 2015 came in lower than average peer’s 34%. This helps keep a lid on trading costs and taxes. Further, managers recognize that outflows could potentially harm the fund’s tax efficiency and attempt to screen out large, short-term fundholders. The prudent process receives a Positive Process rating.

The managers tailor their index- based approach to account for taxes, adding to the fund’s appeal. The fund’s stock portion generally aims to match the key characteristics of the Russell 1000 Index, but Coleman can adjust stock positions based on their dividend payments to reduce investors’ taxable distributions. The fund's slight bias against high dividend-payers produces a small growth bias at times. The bond portion consists of only municipal issues, which are exempt from federal income tax.

This fund’s equity exposure attempts to replicate the Russell 1000 Index, but management’s sampling technique and tax-managed approach causes the portfolios to differ. The sampling technique results in fewer holdings than the benchmark, though the number has increased from approximately 600 holdings in 2011 to over 800 as of July 2016. As fund assets have grown, management has steadily increased the number of holdings to reduce tracking error, but has kept turnover and transaction costs in check. The sample emphasizes stocks with lower dividend yields to minimize taxes. For example, the fund had overweight positions in Berkshire Hathaway BRK.B and Continental Resources CLR, which do not pay a dividend, as of July 2016.

Gretchen Rupp is an analyst covering fund-of-funds strategies on Morningstar’s manager research team. 

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