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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.

Performance Pillar: Positive | Gretchen Rupp 08/19/2016
This fund’s underlying sleeves hew tightly to their respective equity and municipal bond indexes, keeping the fund’s performance close to its blended bogy. Still, the managers’ minor tweaks and the fund’s low fees have kept this fund slightly ahead of its benchmark while its tax efficiency surpasses tax-managed peers. The fund earns a Positive Performance rating.

Since management extended the maturity of its underlying municipal bond sleeve in early 2002 through July 2016, the fund has kept pace with its 50% Russell 1000/50% Barclays Municipal 1-15 Year blended benchmark. Low fees keep the fund within reach of its bogy and past downside protection has provided a slight edge. For example, an underweighting in financial stocks during the 2008 financial crisis helped keep this fund’s loss about 110 basis points ahead of its benchmark. Then in 2011, when concerns over the U.S. debt ceiling weighed on markets, the fund’s higher-quality municipal bond sleeve helped buffer results. Despite its above-average equity allocation, the fund still beat more than two thirds of peers that year.

The fund's pretax returns have been solid, but its post-tax gains show its tax-aware strategy has worked as well. The fund’s 5.8% annualized return outpaced 85% of its allocation--30% to 50% equity peers during the 15-year period through July 2016. Even better, its post-tax returns beat 90% of peers over the same period.

People Pillar: Positive | Gretchen Rupp 08/19/2016
Investors shouldn’t be concerned with recent manager turnover. The firm has a history of rotating equity index managers to broadly apply best practices and strengthen the teams’ skills. Bill Coleman only became lead manager in April 2016, but he joined Vanguard in 2006 and brings proven experience running Vanguard equity index funds. He also comanages the Gold-rated Vanguard Target Retirement funds. Plus, he relies on a support team of about 25 long-tenured professionals, including his comanager Donald Butler. This seasoned team has a record of tracking indexes efficiently while remaining cognizant of taxes, supporting the fund’s Positive People rating.

Lead fixed-income manager Jim D’Arcy has run the municipal bond sleeve since 2013. He also manages other municipal-bond offerings, including Silver-rated Vanguard Intermediate-Term Tax-Exempt VWIUX. D’Arcy has ample support from a capable team of more than 20 municipal credit analysts and traders. That team receives support from Vanguard's senior fixed-income leaders who set overarching yield-curve and sector guidelines.

According to regulatory filings, Coleman, Butler, and D’Arcy do not have personal investments in the fund. However, Vanguard’s compensation is well aligned with shareholders' interests, as a manager's bonus is linked to factors like creating operating efficiencies, which help drive down a fund's costs.

Parent Pillar: Positive | 06/26/2015
Vanguard has one of the mutual fund industry’s strongest corporate cultures. Its consistent messages to investors to keep costs low, diversify, and stay the course are illustrated by the firm’s own behavior. Vanguard’s fundholders own the firm through small investments by each mutual fund, eliminating potential conflicts of interest that can exist at other firms that are serving two masters. Fund performance is strong overall: Over the past three-, five-, and 10-year periods, its Morningstar Success Ratios and Morningstar Risk-Adjusted Success Ratios, which measure what percentage of a firm’s funds have both survived and outperformed a given time period, check in at greater than 70%--high among large, diversified fund families.

Over the past year, the firm has collected more than $200 billion in net inflows, thanks in large part to investors’ interest in passive investing. The firm's indexing and ETF prowess, low costs, and success in penetrating the financial-advisor sales channel all have fueled growth. These fund flows, as well as market appreciation, have brought total assets under management to more than $3 trillion. In this number is a nearly 20% market share of U.S. mutual funds, roughly double its next-closest competitor’s.

Fees are very often the industry’s lowest, but manager investment, particularly by index and in-house fixed-income managers, could be better. Vanguard earns a Positive Parent rating.

Price Pillar: Positive | Gretchen Rupp 08/19/2016
This fund’s low cost gives it an advantage over peers, earning the fund a Positive Price rating. The fund's one share class--the Admiral shares--charged an 0.11% expense ratio in 2015, remarkably lower than the 0.84% median expense ratio for peers with a similar equity allocation.

In addition to low fees, the fund's unique tax-aware approach helps fundholders keep more dollars in their pocket by attempting to limit taxable distributions. During its 20-plus year history, the fund has not paid a capital gains distribution. As a result, the fund's 10-year tax-cost ratio--a measure taxes’ bite out of the fund's dividend and capital gains distributions--is lower than 95% of all allocation funds through July 2016.

 

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

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