Top Tax-Managed Funds
These three Morningstar Medalists proactively limit the tax collector's cut and generate solid risk-adjusted returns.
Note: This article is part of Morningstar's February 2016 Tax Relief Week special report.
For some people, a flu shot isn't enough. In addition to the annual injection, the bug-wary sip orange juice at breakfast, faithfully consume vitamins daily, and always carry hand sanitizer in their pockets.
Similarly, low-turnover index funds and exchange-traded funds don't always provide the sure-fire protection against taxes that some tax-cautious investors seek. True, broad-market trackers generally do a good job of minimizing the drag taxes can have on returns. And because tax efficiency is a byproduct of their low-turnover strategies, these funds are likely to remain tax-efficient over time. Nevertheless, tax reduction isn't an explicit goal for these funds.
Enter tax-managed funds. Managers of tax-managed funds do make a proactive effort to limit taxes when making investment decisions. Tax-friendly strategies may include underweighting dividend-paying stocks, harvesting capital losses to offset gains elsewhere in the portfolio, and delaying the sale of securities with embedded capital gains. As a result, tax-wary investors may find more peace of mind holding funds that expressly seek to dampen taxes as part of their mandates.
We screened Morningstar's database for tax-managed funds. We focused on no-load funds investing in equities. More than two dozen funds made the cut. Premium Members can click here to view the screen or adjust it to suit their own parameters.
Of course, effective tax management doesn't always yield better aftertax returns. As Morningstar's Russ Kinnel writes, "You can put money in shoe boxes in your closet and have great tax efficiency. But what you really want is aftertax returns."
He has a point. With a goal of superior aftertax returns in mind, here are three Morningstar Medalists that we expect to outperform on an aftertax basis over a full market cycle.
Vanguard Tax-Managed Capital Appreciation (VTCLX)
Category: Large Blend
This fund earns a Morningstar Analyst Rating of Gold, thanks to its low costs and terrific tax efficiency; it's also one of the holdings in Christine Benz's tax-efficient model portfolios for savers and retirees. The fund has outperformed more than 90% of its peers on an aftertax basis for the trailing three-, five-, and 10-year periods.
Analyst Mike Rawson says in his latest report:
"Manager Michael Buek builds a large-cap U.S. stock portfolio with similar characteristics to the Russell 1000 Index, modified slightly to improve tax efficiency. For instance, Buek keeps turnover to a minimum in order to reduce the likelihood of incurring capital gains. In addition, he regularly pares positions in the shares of poor-performing stocks with the highest cost basis in order to offset potential future realized capital gains from better-performing stocks.
"Although these tax-management tactics have allowed the fund to avoid paying capital gains distributions, they've also led to small biases in its portfolio relative to a pure index fund. For instance, by tilting away from dividend-paying stocks, the fund may lag when those stocks are in favor. Even a slight bias for or against certain segments of the market could result in performance that strays from the fund's benchmark. Investors here should be willing to accept some tracking error relative to the fund's bogy in exchange for improved tax efficiency."
Vanguard Tax-Managed Small Cap (VTMSX)
Category: Small Blend
Another holding in Christine Benz's tax-efficient portfolios, Gold-rated Vanguard Tax-Managed Small Cap boasts an experienced management team and, of course, Vanguard's low costs. The fund has outperformed more than 95% of its peers on an aftertax basis for the trailing three-, five-, and 10-year periods.
Rawson's latest report notes:
"Manager Michael Buek runs this fund with a keen eye on tax efficiency. If one of the stocks in the fund's portfolio drops substantially, Buek will sell some of the shares with the highest cost basis in order to generate capital losses that can be used to offset future capital gains. Since the fund is not technically an index fund, Buek has more flexibility in the timing of stock sales. He can extend his holding periods in order to qualify for long-term capital gains treatment. Buek has put these features to good use since the fund's 1999 inception; the fund has never distributed a capital gain to shareholders.
"In most other regards, though, the fund's holdings closely match the constituents of the S&P SmallCap 600 Index. The index is broadly diversified across individual holdings and sectors, but unlike other index providers, S&P requires index additions to have four consecutive quarters of profitability before they are added to the index. This results in a quality bias. For example, the fund has a lower weighting in companies with negative retained earnings than the Russell 2000 Index. In addition, S&P follows a less mechanical approach to index rebalancing. This promotes low turnover, which lowers trading costs and further boosts tax efficiency. Under normal financial conditions, the fund will look like a pure index fund, yet it may deviate from the index to improve tax efficiency."
DFA Tax-Managed US Targeted Value (DTMVX)
Category: Small Value
Silver-rated DFA Tax-Managed US Targeted Value provides exposure to value-oriented small- and mid-cap stocks. The fund has outperformed more than 93% of its peers during the trailing three- and five-year periods on an aftertax basis, and beats about 75% of its peers during the 10- and 15-year periods. While technically no-load funds, DFA's offerings are only available via qualified fee-only advisors or through some institutional accounts.
Analyst Alex Bryan writes in his latest report:
"This fund targets the cheaper half of the small- and mid-cap market segments based on price/book, but it excludes some of the least-profitable stocks from this group, which Dimensional believes have lower expected returns. It then weights these holdings by market capitalization. This gives the fund a comparable value orientation to the small-value Morningstar Category average. The fund extends its reach further up the market-cap ladder than many of its small-value peers, but it also ventures deeper into micro-cap territory.
"In order to improve tax efficiency, the managers may proactively sell securities to harvest capital losses, or hold on to stocks as they move out of its targeted style zone to defer capital gains. This could slightly reduce the fund's value orientation and detract from performance when value stocks outperform. Yet, about 95% of the fund's portfolio currently overlaps with its non-tax-managed counterpart, DFA US Targeted Value (DFFVX)."
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Susan Dziubinski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.