3 Fine Tax-Managed Funds

Susan Dziubinski: It's capital gains distribution season, and many investors may find themselves paying taxes on distributions made by funds in their taxable accounts. Investors can limit the tax burden in their taxable accounts by favoring low-turnover, market-cap-weighted index funds and ETFs, which are generally pretty tax efficient. But for those seeking even more tax protection, tax-managed funds may fit the bill. Here to share three of his favorite tax-managed funds is Adam McCullough. He is an analyst in our manager research group focusing on passive strategies.

Adam, thank you for joining us today.

McCullough: Happy to be here, Susan.

Dziubinski: Now, your first pick receives a Morningstar Analyst Rating of Gold, and it lands in the large-blend category. Tell us about that one.

McCullough: That's right. This is Vanguard Tax-Managed Capital Appreciation Fund. What this fund does is it effectively tracks the Russell 1000 Index, so a large-cap index, but it takes two more steps to avoid taxes. One, it avoid stocks that pay higher than average dividend yields. So, dividends are taxed as they are paid out which gives the investor less control about their tax bill from dividends. This fund has a little bit lower dividend yield than the Russell 1000, about 2% versus 2.3% over the past 10 years, but it is less of a tax footprint to avoid those big dividend payers.

The second thing it does is, the portfolio managers keep track of the tax lots of the stocks in the fund. And so, it will look for stocks that have losses and harvest those to offset realized capital gains. It will look for small losses, harvest those, offset the future realized capital gains with those losses. So, it's two levers that the managers pull. But it's still going to have about 99% overlap with the Russell 1000. There won't be that much of a difference with this and the index fund, but it has been a little bit more tax-efficient over the long haul.

Dziubinski: The next fund you wanted to talk about invests in smaller companies.

McCullough: That's right. DFA Tax-Managed US Targeted Value Portfolio looks for stocks in the U.S. market that are cheaper, smaller, and more profitable than the average stock in the market. What this fund does is, it may avoid selling stocks that don't meet that bill, just to avoid realizing capital gains on those stocks in its portfolio. It won't have as pure of a small-cap value profitability tilt as the non-tax-managed version of this fund, but it will avoid some of the capital gains from selling those stocks as they shift out of the threshold.

This fund has distributed some capital gains over the past decade, but it has had less taxes than the actual non-tax-managed fund. Still, you are paying some taxes, but at the same time, you are targeting these cheaper, smaller stocks, so it's hard to avoid taxes when you are selling stocks that leave that area of the market.

Dziubinski: And your last pick today is also another small company fund. Now, how does that one differ?

McCullough: This is more of an index market cap-weighted based fund. This is Vanguard Tax-Managed Small Cap Fund. This fund looks for essentially the same stocks as the stocks in the S&P 600 Small Cap Index, and like the first Vanguard fund, it takes a few extra steps to avoid taxes. Since small-cap stocks pay less dividends than larger cap stocks, it doesn't use that method to avoid taxes. It just uses tax loss harvesting. What it will do is, if it sees that there are some tax lots that it can realize losses in, it will harvest those losses and then offset future gains in the fund.

This fund is still, like the first Vanguard fund, going to look a lot like the index, probably has a 99% overlap with the S&P 600 Small Cap Index, but it will be a little bit more tax efficient over the long haul.

Dziubinski: Great. Adam, thank you so much for sharing your ideas with us today.

McCullough: Thanks for having me here.

Dziubinski: I'm Susan Dziubinski for Morningstar.com. Thanks for watching.