These Funds Can Reduce Your Tax Headache
Even with the recent runup in stocks, these quality offerings have been tax-efficient.
Our Picks
Note: This article is part of Morningstar's February 2014 Tax Relief Week special report.
As anyone who's enjoyed themselves a little too much at a party knows, sometimes there's a hangover to be reckoned with. For many investors holding mutual funds in taxable accounts, the hangover from last year's market runup has been arriving in their mailboxes in the form of a tax form--a 1099, to be exact--telling them how much they owe in federal taxes on the capital gains and income distributions spun off by their holdings.
Even fund investors who didn't sell a single share last year will likely owe something in taxes. That's because as funds sell holdings throughout the year--perhaps because the fund manager decides they are no longer worth owning or to satisfy redemption requests from other shareholders--the capital gains embedded in those holdings must be paid by someone. (Spoiler alert: That someone is you, the shareholder.)
Likewise, income distributions that are paid out by the fund's holdings get passed on and may be paid out as income to shareholders or used by them to buy more shares in the fund. These payments, too, become part of the shareholders’ tax liabilities.
So what sorts of funds tend to be easier to own come tax time? Those that don't generate a lot of income, for one, which is why investors holding dividend-paying or high-yield investments in a taxable account need to pay special attention to the tax consequences. Another key statistic is turnover. Funds that do a lot of trading often deliver a bigger capital gains tax hit for shareholders than those that buy and hold. That's one reason why index funds, which do little trading, tend to be more tax-efficient than actively managed funds, in which managers may turn over parts of the portfolio in response to changing market conditions. Index funds generally only sell stocks to keep pace with the indexes they track or to meet redemptions.
As part of Morningstar's Tax Relief Week, we've used our Premium Fund Screener tool to identify stock funds that are easy to own come tax time. As our benchmark to beat, we've selected the three-year tax-cost ratio of Vanguard Total Stock Market Index (VTSMX), a widely owned fund that tracks the U.S. stock market. A fund's tax-cost ratio reflects the amount of its return lost to taxes for an investor in the highest tax bracket. For those in lower brackets, the actual tax cost may be lower. The fund's turnover rate is currently just 3%, so it does very little trading. Even so, its three-year tax-cost ratio is 0.40 (as of Jan. 31), reflecting in part the market's strong performance during that time.
On each mutual fund and exchange-traded fund page on Morningstar.com, under the Tax tab you’ll find the tax-cost metric for various time frames. We used the three-year time frame to reduce the effects of the 2008 downturn. Many funds incurred losses that year and were able to carry those losses forward to offset capital gains in the years that followed. But by now most funds have used up the losses that were carried forward.
In our screen, we stuck with funds with Morningstar Analyst Ratings of Bronze or better to ensure that they've been vetted for quality. We left out institutional funds, those that are closed to new investors, and those that charge a load under the assumption that investors who don't want to pay much in taxes probably don't want to pay a sales charge either. Along these same lines, we've screened on funds with below-category-average expense ratios. After all, what's the point of saving part of your return from taxes only to pay more in expenses?
Morningstar.com Premium Members can click here to see the full list. Below are a few of the funds that are included.
T. Rowe Price Blue Chip Growth (TRBCX)
This Silver-rated, large-growth fund has been remarkably consistent under manager Larry Puglia's tenure, beating its peers in rolling five-year time periods 93% of the time. Puglia focuses on firms with sustainable earnings, high returns on invested capital, and free cash growth. In recent years, the fund has taken on more of a growth-fueled bent than it had previously, with a notable overweighting in consumer cyclical stocks at 28% of the portfolio (as of Dec. 31), nearly 10 points more than the category average. One word of caution here: The fund is coming off a stellar 2013 in which it returned 42%, beating the S&P 500 by nine points, and that performance might be tough to repeat. Also, the fund's loss of 43% in the 2008 downturn lagged that of the market, and the fund carries an above-average Morningstar Risk rating. Expenses (0.74%) are below-average for a large-cap, no-load fund.
Vanguard Tax-Managed Small Cap (VTMSX)
As its name suggests, this Gold-rated, small-blend fund is run with the tax-conscious investor in mind. Manager Michael Buek matches key characteristics of the S&P SmallCap 600 Index but with an eye toward the tax impacts of trades--for example waiting to sell shares until they qualify for long-term capital gains rates and using high-cost-basis shares when selling at a loss to increase the tax benefit. This tax-conscious approach can be particularly beneficial in the small-cap arena, where holdings sometimes grow too large to fit into a fund's methodology and must be sold. The fund's three-year tax-adjusted return of 16.4% (as of Jan. 31) lands it in the top 10% of the small-blend group. Expenses are predictably low for a Vanguard fund at just 0.12%, but the fund does have a $10,000 account minimum and may not be suitable for those looking to invest smaller amounts.
Sound Shore (SSHFX)
The managers of this Silver-rated, large-value fund seek out stocks with solid fundamentals but that have fallen out of favor. The portfolio is relatively compact at 40 or so names, with none predominant. The fund was notably heavy in health care as of the end of September, at 23% of the portfolio versus 13% for the category average. The fund's 42% return last year beat its peer average by about 10 points, but long-term performance has been much closer to the category average, with a 10-year annualized return within one point. Expenses are in the average range for a large-cap, no-load fund at 0.94%, but the fund does require a $10,000 minimum to open an account.
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