The Tax Man
Last week's column profiled Taylor Larimore’s recommended three-fund portfolio, which consists of three Vanguard offerings: Total Stock Market Index (VTSAX), Total International Stock Index (VTIAX), and Total Bond Market Index (VBTLX). That article generated a barrage of emails, most of which involved proposed modifications and comments about taxes.
About the latter, Rudy Nessel inquires, “How would I split my investments between taxable and IRA accounts?”
Good question. My tax expertise starts and ends with realizing that if I own shares of Berkshire Hathaway (BRK.B), I will be tax-free until I sell that position, since the company does not pay a dividend, and stocks, unlike mutual funds, are not forced to distribute their realized net capital gains. After that, I am pretty much lost.
A reader named Bruce Beaudin occupied the breach:
“There would be two "no brainers" for me in using the three-fund proposal. The Total International Stock fund would go into my taxable account (two reasons--I can then recover all or most of the foreign tax withholding as a tax credit on the 1040 and second I will get the qualified dividend rate). The other "no brainer" is placing the Total U.S. Bond fund into the IRA since that defers income that would be taxed at the full rate. Using only the three-fund approach, I would then fill each account with the Total U.S. Stock fund.”
Sounds reasonable. But then again, what do I know? I checked with Morningstar’s Christine Benz, who understands such matters. Christine mostly agrees with those suggestions, although she cautions that the Total International Stock fund placement is not quite that straightforward. Yes, slotting that fund into a taxable account gives “the full benefit of the tax credit.” However, as foreign stocks tend to pay higher dividends than do U.S. firms, “Their tax-cost ratios tend to be higher.” The decision cuts both ways.
(Side note: Christine studied the Certified Financial Planner curriculum, which means that she is not only well versed with taxes, but various other personal-finance topics, such as insurance, college-planning, and emergency funds. My background, in contrast, is strictly with investments, at one step removed from retail shareholders: working as a Morningstar fund researcher; preparing for the Chartered Financial Analyst tests; and obtaining an MBA. Thus, Christine’s column sometimes gives direct advice to individual investors, while this column does not.)
As for the three-fund portfolio itself, Bob Bucy comments, “You suggest that Vanguard should create a one-fund option containing these three asset classes. But haven’t they already accomplished this with their LifeStrategy funds? (Admittedly, those actually contain four asset classes, but the allocation to the International Bond Index is small.)”
Good point. I confess to having overlooked the LifeStrategy series. In that omission I have company. Between them, the four funds that make up the series possess $45 billion in assets--fairly small by Vanguard’s standards. That modest size is not because the funds are new. Quite the contrary; the funds will turn 25 years old next year. Rather, the asset base reflects the fact that the funds are not very popular. In recent years their inflows have been flat.
The LifeStrategy funds have been overtaken by Vanguard’s target-date series. That trend holds across the industry. Circa 2000, volatility-based funds such as the LifeStrategy series, which name themselves according to the risks that they assume (for example, “Growth” or “Conservative Growth”), vied with target-date funds to become the default investment for 401(k) plans. The target dates won. As a result, volatility-based funds tend to be legacy options, in older 401(k) plans that did not update their lineups.
Whether Vanguard or its rivals can resuscitate the fortunes of such funds, by selling them outside of 401(k) plans, remains to be seen. As my three-fund article suggests, I salute the concept. Most people seek simplicity. Give them one fund, to be purchased now and later. But for some reason, fund companies have had difficulty marketing that idea to IRA investors. It baffles me--and them, I suspect.
(For a counterargument against “autopilot” funds, see this riposte from Dan Wiener, who tracks Vanguard funds. The article was published a few years back, but the funds and issues haven’t changed. Nor, I imagine, have Dan’s views.)
Similarly, David Snowball (publisher of Mutual Fund Observer) writes, “Wouldn’t Fidelity Four-in-One Index (FFNOX) be your proposed “simpler solution” in response to Taylor’s argument?”
More shame, because I didn’t merely forget about this fund of funds. I hadn’t realized that it exists. Four-in-One owns large-company U.S. stocks, small-company U.S. stocks, international stocks, and U.S. high-grade. Thus, David is correct: This fund replicates Taylor’s three-fund strategy in a single place. Four-in-One is for fairly aggressive buyers, as its asset allocation consists of 85% stocks, 15% bonds.
This fund, too, has had trouble attracting investors: After almost 20 years in the marketplace, it holds $6 billion in assets. Granted, Fidelity hasn’t always been fully enthusiastic about selling index funds. But the company has become more agnostic over time, and it remains a giant. Yet another sign that one-stop fund shopping is far more popular within 401(k) plans than without.
That, John, is the worst fund name ever invented. It looks like a losing Scrabble hand. But the investment itself is fine. It is an index of Morgan Stanley Capital International’s (MSCI) All Country World Index (ACWI), delivered as an exchange-traded fund (ETF). Combing that fund with a bond fund would indeed make for a two-legged portfolio, with just under half the equity assets being from outside the U.S. That wasn’t quite a correction, as the three-fund column considered only mutual funds. But it was a useful addition, thanks much. There’s no reason not to include ETFs, should they fit the bill.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
John Rekenthaler has a position in the following securities mentioned above: BRK.B. Find out about Morningstar's editorial policies.