Top Picks for a Tax-Efficient Portfolio

Many investors focus solely on total return when assessing fund performance, which is understandable given that what drives them to invest in the first place is the potential for a fund to help their assets grow. However, looking at total return alone won't tell investors the whole story in terms of how much money the fund has made (or lost) them. That's because total-return statistics don't reflect how much of a fund's gains and income is lost to taxes.

All investments held in taxable accounts are, well, taxable. This means that when a fund held in a taxable account sells holdings that have appreciated in price (gains) or receives dividends or interest from its holdings (income) those gains and income are passed on to shareholders, who must then pay taxes on them. (This is not an issue for investments held in tax-advantaged accounts such as IRAs and 401(k)s.) That's in addition to any gains the shareholder must pay taxes on for selling his own shares of the fund.

What makes a fund tax-efficient? One way to answer this is to consider what sorts of activities can lead to big tax bills for shareholders. One of these is buying and selling securities frequently. Each time a security is bought and sold at a profit it triggers a capital gain, which is passed on to shareholders, who pay the taxes on that gain. Likewise, funds that focus on dividend-paying stocks or bonds that pay interest produce income on which shareholders end up paying taxes. Therefore, funds that are tax-efficient tend to have low turnover rates and low yields.

One of the most tax-efficient ways to invest is through index mutual funds and index exchange-traded funds. Because they track indexes rather than placing bets on specific stocks or bonds, these investment types tend to be particularly tax-efficient because they don't do much trading. There also are tax-managed funds that pursue strategies designed to keep tax costs low for their shareholders.

Although no one likes to lose part of their investment return to taxes, tax-efficiency tends to be of greater concern to those in higher tax brackets, who therefore stand to lose a higher percentage of their investment gains and income to taxes than those in lower tax brackets.

To offer some suggestions for quality funds that don't run up shareholders' tax bills, we offer the following portfolio building blocks. Each of these funds carries a Gold or Silver Morningstar Analyst Rating, meaning it is among the best of its kind, and has a tax-cost ratio that is below its category average (tax-cost ratio reflects the percentage of a fund's return lost to taxes and is calculated using the top tax rate in place at the time; some funds have had lower tax-cost ratios than normal in recent years because of capital losses carried over from the 2008-09 bear market). Funds are arranged based on their role in an investor's portfolio, and the list includes no-load funds only.

Core Domestic
 Fidelity Spartan Total Market Index
10-year tax-cost ratio: 0.60
As its name implies, this fund covers virtually the entire U.S. stock market, holding more than 3,000 securities. In addition to being used as a stand-alone allocation to U.S. equities, this fund could be appropriately paired with individual stocks or with active mutual funds, and a complete portfolio could be built by pairing it with bond funds and international-stock funds. Also consider:  Selected American Shares (SLASX),  Vanguard Dividend Growth (VDIGX),  Vanguard 500 Index (VFINX), Weitz Partners Value (WPVLX)

Core International
 Dodge & Cox International Stock (DODFX)
10-year tax-cost ratio: 0.74
The managers of this foreign-large blend fund look for companies they consider undervalued versus the companies' true long-range worth. That often leads the managers to very unpopular stocks, such as major pharmaceutical firms when concerns about the effects of health-care reform legislation and lackluster drug pipelines were rampant, or more recently, European banks. They then tend to stick with their holdings for years, as shown by the fund's recent 10% turnover rate.
Also consider:  Vanguard Total International Stock Index (VGTSX)

Core Fixed Income
 Vanguard Intermediate-Term Tax-Exempt (VWITX)
10-year tax-cost ratio: 0
This fund follows Vanguard's classic municipal-bond strategy, offering investors exposure to a broad but relatively conservative sample of the muni-bond universe at an affordable price. The fund's management team aims for the middle of the road with a high-quality portfolio, relying on the fund's cost advantage (expenses are just 0.20%) to beat the competition.
Also consider:   T. Rowe Price Summit Municipal Intermediate (PRSMX),  Vanguard Limited-Term Tax-Exempt (VMLTX)

Supporting Players
 Vanguard Tax-Managed Small-Cap (VTMSX)
10-year tax-cost ratio: 0.14
Manager Michael Buek uses a sampling technique to match the key characteristics of the S&P SmallCap 600 Index while being mindful of the tax consequences of trades. The index has less turnover than other small-cap indexes, which helps improve tax efficiency. To minimize capital gains distributions, the fund may sell stocks at a loss to offset gains, and it liquidates highest-cost shares first.

 Weitz Hickory
10-year tax-cost ratio: 0.12
This mid-blend fund's lead manager, Wally Weitz, oversees a concentrated portfolio using a contrarian investing philosophy while demonstrating strong stock-picking skills. The fund isn't managed for year-to-year consistency; the team is happy to ride out the lumpy returns common to contrarian strategies. They also are unafraid to hold cash, which made up about 30% of the portfolio as of Sept. 30. This fund has become a bit tamer since the credit crisis.
Also consider:  Conestoga Small Cap (CCASX),  Vanguard Small Cap Growth Index (VISGX)

Tax-cost ratios as of Oct. 31