Homing In on Tax-Efficient Stock Funds

Conventional wisdom on asset location is that stocks are best held in taxable accounts. But not all stocks and stock funds are tax-efficient. Dividend yield from REITs, for example, is typically taxed as ordinary income, while high-turnover stock funds will rack up short-term gains that are also taxable at an investor's ordinary income tax rate.

That said, there are some simple and effective ways to limit the bite taxes take from your stock portfolio's return. Stock investors looking to shield their gains from taxes have a few different avenues--tax-managed funds, broad-market traditional index funds, and exchange-traded funds

First Stop: Tax-Managed Funds
Tax-managed funds can be a good starting point when searching for holdings for a taxable account. Such offerings deliberately strive to minimize the tax liability that shareholders can incur by keeping portfolio turnover low and realizing capital gains to offset losses.

To home in on some offerings that explicitly promise to protect against taxes, we used the  Premium Fund Screener to seek out domestic stock funds that had the word "tax" in their names. (While most funds are called "Tax-Managed," some go by "Tax-Efficient" or "Tax-Aware.") In addition to our name screen, we kicked out any load funds and focused on funds whose expense ratios are below the category average. When we streamlined the results by calling up just the distinct portfolios of funds that are open to new investments, the screener yielded 20 funds, one of which we feature below. Premium Members can  click here to replicate this screen.

 Vanguard Tax-Managed Capital Appreciation 
While this fund has a high correlation with the Russell 1000 Index, manager Michael Buek focuses on low- and no-dividend-yield stocks to limit taxes. He also strategically minimizes capital gains distributions by selling stocks at a loss to offset gains and liquidating the highest-cost shares first. The strategy has benefited investors on the tax front; the fund has never paid out a capital gains distribution since inception. Moreover, despite a higher minimum investment hurdle, cost-conscious investors will find this fund's low expenses particularly compelling. Investors who stick with this solid tax-efficient core holding will benefit from solid aftertax returns with minimal tax liabilities.

Tax-Friendly Traditional Index Funds
While not explicitly tax-managed, many traditional index funds can also be good options for taxable accounts. Because such funds passively track their benchmarks, trading is usually limited, which in turn limits taxable capital gains.

To help unearth traditional index mutual funds that could serve as core holdings in a taxable investment portfolio, we once again used the  Premium Fund Screener. We screened on low-cost (expense ratios of no more than 0.25%), no-load domestic index funds that our analysts have designated as core holdings. Additionally, we layered on screens for funds with minimum purchase requirements of no more than $10,000. The screener yielded seven funds, two of which we highlight below. Premium members can replicate this screen by  clicking here.

 Fidelity Spartan Total Market Index 
Investors who are seeking broad domestic stock exposure will find this Analyst Pick a worthy choice. It tracks the Dow Jones U.S. Total Stock Market Index, which is dominated by large-cap names but also gets a kick from small- and mid-cap stocks. So while the fund's heavy tilt toward large-cap stocks keeps the fund in close step with the blue-chip universe, its exposure to smaller-cap stocks has given it an edge during the last five years relative to its large-cap blend peers and S&P 500 index vehicles, as smaller stocks have outperformed large-cap equities. Its diversification benefits, with ultralow expenses to boot, make this offering a fine option for investors seeking a tax-efficient core holding.

Schwab S&P 500 Index (SWPPX)
For the cost-conscious, no-fuss, no-frills investor, there's much to like about this broadly diversified S&P 500 index tracker. Moreover, its low $100 investment minimum makes it a compelling choice for those who don't have a lot of money to invest. For hands-off investors with reasonable expectations about the market, Morningstar fund analyst Ryan Leggio asserts that this fund is the best one to own for those who want to track the S&P 500 Index.

ETFs: Core and Explore
If tax-efficiency is a priority, investors will also want to consider exchange-traded funds. True, not all ETFs are tax-efficient, but ETFs have some features that can help them on the tax-efficiency front, as outlined in this article. In practice, broad-market stock index funds and ETFs are roughly on par in terms of tax efficiency. But this does not mean that the two are necessarily interchangeable. Check out this article by Christine Benz for other key considerations investors should ponder before switching from a traditional index fund to an ETF.

Broad-market ETFs such as  iShares S&P 500 Index (IVV) and  Vanguard Total Stock Market ETF (VTI) make worthwhile core holdings for an investor's taxable account. But investors can also look to the ETF market when filling out noncore portions of their taxable portfolios. Morningstar's ETF analyst Sam Lee makes particular mention of  Vanguard Small Cap Value ETF (VBR), calling it a "cheap, liquid, tax-efficient way of tilting a portfolio to small-value stocks, which historically have enjoyed excess returns above the market."

Exchange-traded notes can also offer a tax-efficient spin on some generally tax-inefficient categories, such as commodities, assuming investors can get comfortable with the credit risk of ETNs.  iPath DJ-UBS Commodity Index ETN (DJP), for example, is among our analysts' favorites. This article details the ins and outs of tax efficiency and ETNs, and  click here for the full list of ETF Analyst Picks.