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Investing Specialists

How Our Tax-Efficient Vanguard Retirement Saver Portfolios Have Performed

In a rising equity market, core U.S. positions have given the most aggressive portfolios the biggest boost.

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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.

All of my model portfolios are designed to be low-turnover; my aim is to make changes only when there's been a significant fundamental development at one of the holdings.

That's especially true with my tax-efficient portfolios, because too-frequent trading has the potential to jack up tax costs, particularly in the kind of rising market we've experienced over the past decade.

Yet even though I didn't make any changes to the Tax-Efficient portfolios, the fact that they've now been around for three years makes it a good time to review their performance.

Thanks to terrific gains from broadly diversified U.S. equity funds like Vanguard Tax-Managed Capital Apprecation, as well as the fact that the taxable portfolios contain slightly more equity exposure than the tax-deferred portfolios, the tax-efficient portfolios all gained more than the analogous tax-deferred Vanguard Retirement Saver portfolios. The tax-efficient portfolios also limited the drag of taxes. Even the least tax-efficient of the three portfolios ceded 75 basis points or less to taxes on an annualized basis over the past three years. (The tax-cost ratio assumes that an investor pays the highest tax rates for income and capital gains; your own situation may vary.)

Portfolio Basics
To cater to Vanguard investors' taxable accounts, I created three tax-efficient Vanguard Saver portfolios: Aggressive, Moderate, and Conservative. I used Morningstar's Lifetime Allocation Indexes to help guide their asset allocations, and populated the portfolios with funds from the list of Morningstar Medalist funds.

As with all of these model portfolios, investors will want to bear their own situations in mind when determining whether a given asset mix makes sense for them. While younger investors should generally hold an equity-heavy portfolio for its better long-run return potential, they should make sure they can handle the high volatility of such a portfolio first. (That's one reason asset-allocation guru Bill Bernstein has suggested that younger investors might start out with lighter equity weightings than the standard stock-heavy prescription.) On the flip side, investors who are approaching retirement and will be able to rely on a pension may want to run with a higher stock weighting than shows up in the conservative mix below. If a pension and/or Social Security will supply most of their in-retirement income needs, they don't have to hold as much in cash and low-volatility fixed-income investments as pre-retirees who expect to rely mostly on their portfolios for retirement living expenses.

Investors will also want to take a look at their tax situation when determining whether to invest their taxable portfolios' bond positions in municipal-bond funds--which I've included here--or in taxable-bond funds. Most investors who are in a position to save in a taxable account--in other words, they've already maxed out their tax-advantaged options--are in a tax bracket where they'd benefit from holding municipal bonds versus taxable, but that's not always the case.

Aggressive Tax-Efficient Saver Portfolio
45%  Vanguard Tax-Managed Capital Appreciation (VTCLX)
15%  Vanguard Tax-Managed Small Cap (VTMSX)  
30%  Vanguard FTSE All-World ex-US Index (VFWIX)
10%  Vanguard Intermediate-Term Tax-Exempt (VWITX)

3-Year Annualized Return: 13.67%
3-Year Tax-Cost Ratio (Portfolio): 0.57%

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 if technology-related stocks experienced a sell-off and stodgy dividend payers have a day in the sun.

The muni bond fund 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 a bit more than a half of a percentage point to taxes on an annualized basis over the past three years. The muni fund has a zero tax cost ratio 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

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 Saver Portfolio
45%: Vanguard Tax-Managed Capital Appreciation
10%: Vanguard Tax-Managed Small Cap
25%: Vanguard FTSE All-World ex-US Index
20%: Vanguard Intermediate-Term Tax-Exempt 

3-Year Annualized Return: 12.43%
3-Year Tax-Cost Ratio (Portfolio): 0.51%

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 Saver Portfolio
15%:  Vanguard Short-Term Tax-Exempt (VWSTX)  
20%: Vanguard Intermediate-Term Tax-Exempt
15%: Vanguard FTSE All-World ex-US Index
45%: Vanguard Tax-Managed Capital Appreciation
5%: Vanguard Tax-Managed Small Cap

3-Year Annualized Return: 10.61%
3-Year Tax-Cost Ratio (Portfolio): 0.40%

With just 65% 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.

Christine Benz has a position in the following securities mentioned above: VWILX, VTRIX. Find out about Morningstar’s editorial policies.