Use this screen to uncover tax-efficient options for your clients.
While tax time may seem like a distant memory now, it should always be front and center for investors who are building portfolios in their taxable accounts. There are ways, however, to keep the tax man at bay. In the hunt for funds capable of producing strong returns on a tax-adjusted basis, Morningstar Principia and Advisor Workstation can serve as helpful tools for sifting through thousands of options. There are quite a few criteria to include here, so let's start by zeroing in on a fairly specific group: diversified domestic large-cap funds.
Special Criteria = Distinct Portfolios Only
And ( Morningstar Category = Large Growth
Or Morningstar Category = Large Blend
Or Morningstar Category = Large Value )
Next, we turn to the tax-cost ratio. This measure, which Morningstar calculates on a monthly basis using load- and tax-adjusted returns, reflects Uncle Sam's take as a percentage-point reduction in an annualized return. Essentially, this ratio treats the negative effect of taxes on performance in a similar way to other cost measures, in basis points. The tax-cost ratio typically lands between 0% and 5%, where a measure of 0% means that a fund had no taxable distributions and a higher number indicates that a fund has been less tax-efficient. Here, we screened for funds with a 10-year tax-cost ratio of 1.00% or less, which means that on average each year, investors lost up to 1.00% of their total return to taxes.
And Tax Cost Ratio 10 Yr < = 1.00
There is a second major component to the tax-efficiency test, and this one is more forward-looking. Funds generate capital gains distributions when they sell holdings at a gain, and the tax consequences are the greatest for stocks held less than a year, so we wanted to find offerings that don't trade excessively. The fund's turnover ratio indicates how often the manager trades, so a high ratio indicates that there may be more gains from trades that are subject to taxes in any given year. The typical large-growth fund has 97% annual turnover, so the typical manager in that category trades through nearly the entire portfolio each year. Large-blend and -value fund managers tend to trade a bit less--around 60% to 70% annually. Given this, we set this screen for funds with less than 50% annual turnover, which is consistent with an average two-year holding period.
And Turnover Ratio < = 50
And because strong tax efficiency might be the result of tax-loss carryforwards, where the fund can use past losses to offset future gains, we also required that these funds post top-third 10-year category rankings.
And % Rank Category 10 Yr < = 33