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3 Fund Ideas for a Tax-Efficient Portfolio

Thu, 31 Jul 2014

Index funds aren't the only vehicles suitable for taxable accounts, and Morningstar's Russ Kinnel offers three names that can help minimize the tax hit.


Video Transcript

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Savvy investors focus on what they can control, and one of those factors is putting tax-efficient investments in their taxable accounts. Joining me to share some ideas is Russ Kinnel. He's director of manager research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, the no-brainer holdings if you have taxable accounts are broad-market index funds. Let's talk about why index funds can be such a good choice for the equity holdings within your taxable account.

Kinnel: You're right. They're the first place to start when you're thinking taxable account. They're very low-turnover, at least a broad market index fund is. They're low-cost, and there are not a lot of changes going on. So, because there is no manager deciding, "I like these stocks today, and I don't like these," with a market-cap-weighted index in particular, there's very little change going on. So, you have low turnover, and that leads to low capital gains. Many of the better index-fund managers, such as Vanguard, can also manage capital gains in a way that reduces that hit, as well. For instance, they can choose to sell the highest-cost lots and do some tax harvesting, even while staying consistent with the index.

Benz: And broad equity market exchange-traded funds would also have those same benefits?

Kinnel: Exactly. It doesn't really matter too much whether it's an open-end fund or an ETF, just as long as it's a well-run broad fund.

Benz: Stepping away from index funds, which you say are a really solid choice for taxable accounts, you brought a couple of other ideas that you think would also work well within investors' taxable accounts. One is a fund, Vanguard Tax-Managed Balanced. It's explicitly managed to keep taxes down. Let's talk about what that fund is and how it works and how it does reduce tax efficiency.

Kinnel: Right. It's an interesting mix. It's kind of unusual. You don't have a lot of balanced funds that include munis, but this fund is half an index fund and half a municipal-bond portfolio. And, of course, for a taxable account that's ideal because munis have tax-sheltered characteristics. The combination is this really nice one. The managers have to keep the muni stake at just over 50% for tax reasons, but it's a really good dependable fund. I think, if you're in a taxable account, why not look at a balanced fund that's got munis in it?

Benz: Another fund that you like, that you think investors might consider for their taxable accounts, is JPMorgan Equity Income. Let's talk about why you think that could also work reasonably well if investors are looking for tax-efficient taxable holdings?

Kinnel: As you say, dividends do have some appeal in terms of being on par with capital gains.

Benz: The tax treatment is currently the same.

Kinnel: Right. And what I also like is that the manager, Clare Hart, has a very good record. She runs a low-turnover approach and has produced really nice conservative, consistent performance. It's got a lot of appeal. It's one that doesn't get a lot of attention, but I think it's a very solid fund.

Benz: It's gotten very large. The question is do you think it can repeat its strong past performance given how big it's gotten?

Kinnel: That's definitely one of the challenges it faces because people noticed that good record. But it's really fishing in a big pond in terms of large-cap-value names. It doesn't emphasize yields so much that it has to go into just a few utilities or something. It's really looking for companies with dividends, but also healthy balance sheets, as well, and that's a pretty big universe. So, I'm not too concerned yet.

Benz: The last idea, Russ, is USAA World Growth. Let's talk about that fund. It's also a fairly low-turnover fund. I assume you think that that's a benefit for investors who are looking to keep capital gains taxes down?

Kinnel: That's right. Low turnover certainly helps you out, and you don't often get low turnover in a growth fund. I also like the fact that you've got David Mannheim as one of the managers here. He is at MFS, and he has built a really good record at this fund as well as some other MFS funds. Yet the fund's only got about $1.5 billion in assets. So, it's just a very good, straightforward growth fund. If you look at the performance, you'll probably be surprised that you hadn't noticed the fund before.

Benz: Now, I know in the past there were some hurdles where people needed to have some military affiliation to buy USAA funds. Is that the case now?

Kinnel: No, it's not. In fact, you can buy this fund [as you would other no-transaction-fee mutual funds]. You don't have to have any particular military ties. Most of USAA's customers do, but they've taken down some of those barriers, so that it's really pretty accessible for everyone.

Benz: Russ. Thanks so much for being here to share some tax-efficient ideas.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

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