How Our Fidelity Tax-Efficient Bucket Portfolios Have Performed

Fidelity's August lunch of two index funds with zero minimum initial investment amounts and 0% expense ratios was the latest shot across the bow in the long-running index-fee wars.

But is it worth upending existing index-fund holdings to make way? My tax-efficient Bucket portfolios for Fidelity investors provide a worthy case study. That's because they include sizable weightings in Fidelity's other index funds, which themselves feature very low costs. Is it worth making the switch?

Ultimately, I concluded that trading into the new funds is probably not worth it for most investors, especially if they'll incur their own capital gains hit to make the switch. Part of the reason is philosophical: I've designed my tax-efficient portfolios to be ultra-minimalist, low-maintenance, and low-turnover, because there's no better way to trigger tax bills than to engage in frequent trading.

Moreover, the expense-ratio differential is minimal: The two equity positions in the portolio,

On the other hand, investors who are building their portfolios from scratch using Fidelity's brokerage platform can and should consider availing themselves of the new zero-cost funds. The advantages of the zero-cost share class relative to the share classes with costs, even low costs, really stack up for investors who have long expected holding periods.

Given Fidelity's news, as well as the fact that the portfolios now have three years' worth of history, it's a good time to conduct a thorough review of their holdings and their performance.

Cue the Buckets Setting an asset allocation can seem hopelessly black-boxy, which is why a Bucket strategy can be so compelling: It helps a retiree back into an appropriate asset allocation given his or her spending rate. In the Bucket framework I've used to build these portfolios, near-term spending needs go into cash (Bucket 1), intermediate-term spending needs go into high-quality bonds (Bucket 2), and the remainder of assets are deployed into higher-risk assets with higher return potential, mainly stocks. It's important to note that the retiree won't necessarily spend from his or her portfolio in this sequence--cash, then bonds, then stocks.

Right now, for example, I'd argue that the best strategy for retirees looking to extract cash flow from their portfolios is to harvest appreciated equity positions. But in a worst-case scenario in which a person retires into an extended bear market for equities, Buckets 1 and 2 would likely provide enough of a bulwark to prevent spending from the depressed equity component (Bucket 3). After all, it's a rare 10-year period when stocks have been in the red, and the Bucket Portfolios build in 10 years' worth of living expenses in cash and bonds.

As with the other model portfolios, I used Morningstar's Lifetime Allocation Indexes to guide their asset-class exposures and employed Morningstar's Medalist funds to populate them. In terms of asset allocation, however, I'd advise retirees to use their own annual cash-flow needs to drive the allocation to each of the buckets. My base case is a 4% initial portfolio withdrawal, which translates into 8% of the portfolio going into Bucket 1 to fund the first two years' worth of cash needs. A retiree spending just 3% of her portfolio per year would hold 6% in cash, however, and another 24% in bonds; the remaining 70% of the portfolio could go into higher-volatility investments with higher return potential.

Aggressive Tax-Efficient Bucket Portfolio

Bucket 1: Years 1-2 8%: Cash (money market funds and accounts, CDs, checking and savings accounts, and so forth; specific percentages will vary based on the amount of assets and the retiree's spending rate)

Bucket 2: Years 3-10

10%:

27%:

Bucket 3: Years 11 and Beyond 40%: Fidelity Total Market Index 15%: Fidelity Global Ex-US

Performance 3-Year Annualized Return: 8.27% 3-Year Tax-Cost Ratio (Portfolio): 0.49%

Fidelity Total Market Index was by far the portfolio's best performer over the past few years, gaining nearly double that of the Global ex-US Index fund over that time frame. Like all U.S. index funds that are organized by market capitalization, the fund has sizable positions in the stocks that have performed best in the U.S. market of late--

The bond funds performed in line with expectations over the three-year period: While the performance of Fidelity Intermediate Muni Income was better in absolute terms, the Limited Term fund's 1% annualized gain place it in the top 25% of its peer group over the past three years.

Taxable shareholders in the highest tax bracket would have ceded a half of a percentage point to taxes on an annualized basis over the past three years. Total Market Index had the worst tax efficiency of any of the holdings, with a three-year tax-cost ratio of 0.93%. That owed to its large gains over the time frame. Investors who would like to keep a tighter rein on their portfolio's tax efficiency could reasonably consider an ETF versus a traditional index fund. Fidelity doesn't offer a total stock market ETF, but

Changes I didn't make any changes to these portfolios, though I did look closely at a few key areas.

As discussed above, I decided to stand pat with the existing holdings versus swapping into Fidelity's zero-cost products. That's because the portfolios are designed to be low turnover, the expense ratio-differential is minor, and the capital gains costs associated with switching into the new zero-expense-ratio funds could easily swamp any expense-ratio savings. That said, investors who use Fidelity's brokerage platform and are assembling their portfolios from scratch can and should take a look at the zero-expense-ratio products.

On the bond side, I reviewed the portfolios' two muni funds in the wake of co-portfolio manager Mark Sommer's announced departure, scheduled for the end of 2018. Yet Morningstar's analyst team is still comfortable with the team and process in place at these and other Fidelity muni funds. Kevin Ramundo and Cormac Cullen remain on board, and Elizah McLaughlin joined the team at the beginning of September.

Moderate Tax-Efficient Bucket Portfolio

Bucket 1: Years 1-2 8%: Cash (money market funds and accounts, CDs, checking and savings accounts, and so forth; specific percentages will vary based on the amount of assets and the retiree's spending rate)

Bucket 2: Years 3-10 12%: Fidelity Limited Term Municipal Income 35%: Fidelity Intermediate Municipal Income

Bucket 3: Years 11 and Beyond 35%: Fidelity Total Market Index 10%: Fidelity Global ex-US

Performance 3-Year Annualized Return: 7.27% 3-Year Tax-Cost Ratio (Portfolio): 0.42%

With an equity weighting that's smaller by 10 percentage points, it's no surprise that this portfolio returned a bit less than its more aggressively positioned counterpart over the past three years. Like the Aggressive portfolio, this portfolio benefited most from its U.S. equity index exposure.

Because its equity weighting is lighter, its returns were lower, and most of the portfolios' tax costs come from equities, the Moderate portfolio had slightly better tax-efficiency statistics than its Aggressive counterpart over the past three years.

Changes None.

Conservative Bucket Portfolio

Bucket 1: Years 1-2 8%: Cash (money market funds and accounts, CDs, checking and savings accounts, and so forth; specific percentages will vary based on the amount of assets and the retiree's spending rate)

Bucket 2: Years 3-10 15%: Fidelity Limited Term Municipal Income 37%: Fidelity Intermediate Municipal Income

Bucket 3: Years 11 and Beyond 30%: Fidelity Total Market Index 10%: Fidelity Global ex-US Index

Performance 3-Year Annualized Return: 6.56% 3-Year Tax-Cost Ratio (Portfolio): 0.38%

With just 40% of its assets in strong-performing stocks, this portfolio's three-year annualized returns were the lowest of the three portfolios. Accordingly, however, its tax-cost ratio was also the lowest of the three.

Changes None.