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How Our Tax-Efficient Vanguard Bucket Portfolios Have Performed

Thanks to strong performance from tax-managed funds, our tax-efficient portfolios outperformed our tax-deferred ones.

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Note: Christine Benz's Portfolio Makeover Week is coming this fall. To learn more about having your portfolio considered for a makeover, click here.

Thanks to an exceptionally strong equity market and decent, if not spectacular, bond market performance, our tax-efficient Bucket Portfolios for Vanguard investors have delivered solid returns over the past three years.

The portfolios have performed so well, in fact, that they've beaten our model Vanguard portfolios that were created without regard for tax efficiency. A dash of small-cap exposure has been a boon, as has the fact that the two tax-managed U.S. equity funds in the portfolio both maintain a bias toward growth stocks, which have dramatically bested value and blend names over the trailing three-year period. The tax-efficient portfolios also have higher equity weightings overall, which has been a big reason for their outperformance.

Now that all of the model portfolios have three years' worth of performance under their belts, it's an opportune time to conduct a top-to-bottom review of the portfolios and of their holdings. While I made a modest adjustment to the tax-deferred versions of these portfolios, I haven't made any changes here. That's partly by design: Because these portfolios were assembled with an eye toward reducing the drag of taxes in taxable accounts, their holdings are ultraminimalist and low maintenance. I've used Vanguard's tax-managed funds, a foreign-stock index fund, and two sturdy municipal-bond funds. Given the no-nonsense nature of those building blocks, I would expect to make few, if any changes to them over time.

Cue the Buckets
With the equity market delivering screaming returns over the past decade, with only minor jolts along the way, many people in or approaching retirement might be inclined to let their equity winners ride. But the Bucket strategy calls for maintaining some liquidity in an in-retirement portfolio, to supply ongoing cash needs even if the longer-term portions of the portfolio hit a rough patch. In all of my model portfolios, I've maintained three buckets: Bucket 1, to meet near-term cash needs; Bucket 2, invested with an intermediate time horizon in mind; and Bucket 3 to supply the portfolio with growth potential, albeit with some volatility.

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. But I'd urge pre-retirees and retirees to use their own anticipated portfolio withdrawals to right-size their allocations to each of the buckets. The Aggressive portfolio assumes a retiree is withdrawing 4% of his portfolio in the first year of retirement, which is how I arrived at an 8% cash allocation and a 32% bond allocation, to cover eight years' worth of living expenses. But a retiree who's withdrawing just 2.5% of her portfolio per year would maintain smaller weightings to cash and bonds--a roughly 5% total cash allocation (2.5% times two years) and perhaps 20% in bonds (2.5% times eight years). The remainder of the assets could go into stocks, assuming the hypothetical retiree wouldn't be unduly bothered by the volatility that would accompany such a heavy equity weighting.

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.

Moreover, retirees should feel free to swap in their own like-minded holdings in place of the specific funds that I've included here. After all, making changes to a taxable portfolio can entail taxes, so if retirees are already holding reasonably tax-efficient investments, such as index funds or ETFs instead of the tax-managed funds, that should be just fine.

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%:  Vanguard Short-Term Tax-Exempt (VWSTX)
22%:  Vanguard Intermediate-Term Tax-Exempt (VWITX)

Bucket 3: Years 11 and Beyond
35%: Vanguard Tax-Managed Capital Appreciation (VTCLX)
10%:  Vanguard Tax-Managed Small Cap (VTMSX)
15%:  Vanguard FTSE All-World ex-US (VFWAX)

Performance
3-Year Annualized Return: 9.19%
3-Year Tax-Cost Ratio (Portfolio): 0.36%

Vanguard Tax-Managed Small Cap was by far the portfolio's best performer over the past few years, followed by Vanguard Tax-Managed Capital Appreciation. Both funds are managed with an eye toward reducing capital gains and dividend distributions. The latter emphasis, in particular, tends to give them a growth bias relative to the broad market. That has been a boon recently, as growth stocks have dramatically outperformed value. Of course, what goes up can come down, so it's worth noting that these funds could feel the pain in if technology-related stocks experienced a sell-off and stodgy dividend payers have a day in the sun. The goal of the Bucket setup, however, is that a retiree would never have to touch depreciated assets when they're in a trough; he or she could "spend through" the more conservative portions of the portfolio in such an instance.

The bond funds performed in line with expectations over the three-year period: All of Vanguard's high-quality muni funds are managed with a risk-conscious approach, so we wouldn't expect them to be standouts in the risk-on bond market that has prevailed recently.

Taxable shareholders in the highest tax bracket would have ceded less than a half of a percentage point to taxes on an annualized basis over the past three years. The muni funds have ultralow tax-cost ratios over the past three years. I've been keeping an eye on the tax-managed funds' tax efficiency relative to comparable ETFs at Vanguard, and they've been pretty close. Over the past three years, Vanguard Tax-Managed Capital Appreciation has had slightly worse tax efficiency than Vanguard Total Stock Market ETF VTI, but the former's pretax returns were also a bit higher so aftertax returns from the two funds were neck and neck. Vanguard Tax-Managed Small Cap, meanwhile, has a lower tax-cost ratio and much higher returns than Vanguard Small Cap ETF VB over the past three years, though that's largely a side effect of the Tax-Managed fund's bias against dividend payers.

Changes: None, though it's worth noting that Vanguard's municipal bond team has recently experienced some management changes, though Morningstar doesn't see significant repercussions for the firm's muni funds. Paul Malloy has replaced Chris Alwine as head of Vanguard's municipal bond group, but the two muni funds in these portfolios have retained their lead managers and employ consistent, risk-conscious approaches. Low expenses help ensure that they don't have to take extra risks to deliver competitive results, and both funds retain Silver ratings.

Moderate Tax-Efficient Bucket Portfolio
Bucket 1: Years 1-2
10%: 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%: Vanguard Short-Term Tax-Exempt
25%: Vanguard Intermediate-Term Tax-Exempt

Bucket 3: Years 11 and Beyond
35%: Vanguard Tax-Managed Capital Appreciation
5%: Vanguard Tax-Managed Small Cap
10%: Vanguard FTSE All-World ex-US

Performance
3-Year Annualized Return: 8.01%
3-Year Tax-Cost Ratio (Portfolio): 0.30%

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. One the one hand, it was hurt by its lower-weighting in the red-hot Tax-Managed Small Cap; on the other, it didn't hold as much in foreign stocks, which lagged U.S.

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

Changes: None.

Conservative Tax-Efficient Bucket Portfolio
Bucket 1: Years 1-2
12%: 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
20%: Vanguard Short-Term Tax-Exempt
28%: Vanguard Intermediate-Term Tax-Exempt

Bucket 3: Years 11 and Beyond
30%: Vanguard Tax-Managed Capital Appreciation
10%: Vanguard FTSE All-World ex-US

Performance
3-Year Annualized Return: 6.41%
3-Year Tax-Cost Ratio (Portfolio): 0.25%

With just 40% of its assets in strong-performing stocks and no holdings in the strong-performing Tax-Managed Small Cap, 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.

Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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