A Fine Balanced Strategy With a Tax-Friendly Focus

The following is our latest Fund Analyst Report for Vanguard Tax-Managed Balanced VTMFX. Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.

Vanguard Tax-Managed Balanced's effective tax-management, seasoned managers, and low fees justify its Morningstar Analyst Rating of Gold.

This balanced fund is essentially a combination of Silver-rated muni fund Vanguard Intermediate-Term Tax-Exempt VWITX and Gold-rated equity fund Vanguard Tax-Managed Capital Appreciation VTCIX . The managers keep the fund's allocation fairly steady as they need to have at least 50% of assets in the muni sleeve in order to pass the tax-advantaged treatment of these distributions to fundholders. Since its inception in 1994, the fund has not distributed a capital gain and its 10-year tax-cost ratio of 0.58% is significantly below the allocation--30% to 50% equity Morningstar Category average of 1.21%. (The equity dividend income is still subject to taxes.) An investor attempting to replicate this strategy by holding the equity and muni-bond funds is more likely to realize capital gains during rebalances.

The bond side is managed by James D'Arcy, who has 20-plus years of investment experience and is supported by Vanguard's well-resourced muni bond team. To build the portfolio, he starts with the Bloomberg Barclays 1-15 Muni Index, but tilts toward high-quality and more-liquid instruments. Even with a higher credit quality portfolio, this sleeve's performance has been top-decile relative to the muni national intermediate category over the trailing five years coinciding with his tenure, thanks to good issue selection and minor duration adjustments. William Coleman and Donald Butler, members of Vanguard's equity index group, manage the equity sleeve. They seek to track the performance of the Russell 1000 Index but will slightly tilt away from dividend payers to reduce taxable dividend income, and also manage the fund's realized gains and losses. Even with these tweaks, the equity sleeve has closely tracked the index's performance. As for the fund, performance within the allocation--30%-50% equity has been top-decile over the trailing 10 years. Extremely low fees of 0.09% provide an additional edge.

Process Pillar:

Positive | Patricia Oey 07/02/2019 This fund employs an effective approach to keep taxes low, earning it a Positive Process rating.

The bond sleeve only holds municipal issues, which are exempt from federal income tax. Bond manager James D'Arcy starts with the Bloomberg Barclays 1-15 Year Muni Index and screens out lower-quality and less-liquid issuers. He then positions the portfolio relative to its benchmark, informed by Vanguard's hub-and-satellite approach. While the fund’s contour is determined by senior leadership (the hub), bottom-up issue selection is supported by a robustly staffed muni credit research team (the satellite), which narrows the opportunity set by feeding information through proprietary models to evaluate fit within the fund’s mandate.

On the equity side, the managers seek to track the Russell 1000 Index, with some adjustments to reduce taxes, within tracking error limits. First, they slightly underweight dividend payers to reduce taxable distributions. Second, they try to harvest tax losses. This has been challenging in the recent extended market rally, but the managers try to be opportunistic when possible. For example, in June 2016, they harvested some losses when the market declined following the U.K. vote to leave the EU. Finally, they strive to keep turnover low. Even with tax-related trading, the fund's turnover of around 9% a year is similar to that of large-blend index funds.

This fund has to maintain at least a 50% allocation to muni bonds so that it can pass through federal income tax-free distributions from that sleeve. Over the past decade, the fund's equity exposure has averaged 48%.

The fund's bond sleeve has an above-average credit quality, with over 70% of its holdings rated AAA or AA, versus the category average of around 45%. The sleeve is diversified by sector and region, and no position is larger than 1%. The fund's duration stays within a year of the bond sleeve’s Bloomberg Barclays Municipal 1-15 Year Index, and was 4.7 years as of May 2019. With such low fees, the fund does not need to take much risk to compete, and tends to tread lightly in, or avoid, areas such as municipal tobacco or debt from Puerto Rico.

The equity managers employ sampling to track the Russell 1000 Index. Given the tax-minimization mandate, the managers can deviate more from the benchmark than a pure index fund, but only to a small degree. Sector allocations have generally been within 1 percentage point of the benchmark's sector allocations. As for the sleeve's dividend distributions, the managers have been able to maintain a yield about 20 to 30 basis points below that of the Russell 1000 during the past decade, while generating total returns that are competitive with that of a standard Russell 1000 Index fund.

Performance Pillar:

Positive | Patricia Oey 07/02/2019 Top-tier performance on both a pre- and after-tax basis supports a Positive Performance rating.

From February 2002, when management extended the maturity of its underlying municipal bond sleeve, through June 2019, the fund's annualized return of 6.4% beat the 6.0% return of its benchmark (50% Bloomberg Barclays Municipal 1-15 Year Index/50% Russell 1000 Index). Additionally, the fund's trailing five-, 10-, and 15-year returns through June 2019 have been within the top decile in the allocation--30% to 50% equity category. The equity sleeve's performance hews very close to that of the Russell 1000, as the managers' tax management efforts are constrained by tracking error limits. The sleeve can slightly underperform when dividend stocks lead, as it slightly underweights these names. The bond sleeve's conservative bent may result in some middling performance when markets reward risk-on positioning, as in 2009 and 2010. But this trait helps in risk-off environments: In 2018, a year marked by concerns about rising interest rates, credit quality, and equity market volatility, the sleeve outperformed, and the fund turned in top-decile returns.

As for tax management, the fund has delivered on its mandate. It had the highest post-tax returns relative to its category peers over the trailing five and 15 years, and beat 98% of its peers on this basis over the trailing 10 years.

People Pillar:

Positive | Patricia Oey 07/02/2019 Vanguard’s seasoned managers share extensive trading infrastructure and align their interests with fundholders', supporting this fund’s Positive People rating.

Jim D’Arcy has run the municipal bond sleeve and Silver-rated Vanguard Intermediate-Term Tax-Exempt VWIUX since 2013. D’Arcy has ample support from a capable team of more than 20 municipal credit analysts and traders, in addition to senior fixed-income leaders who set overarching yield-curve and sector guidelines. D'Arcy invests $100,001 to $500,000 in the standalone intermediate-term fund.

Donald Butler and William Coleman became managers for the equity sleeve in April 2016 when prior manager Michael Perre moved on to manage international equity index funds. (Vanguard occasionally rotates managers across its funds to standardize best practices and strengthen teams’ skills.) Butler, a principal of Vanguard, has been with the firm since 1992 and has managed portfolios since 1997. Coleman joined Vanguard in 2006 and has comanaged the Gold-rated Vanguard Target Retirement funds since 2013. They comanage Vanguard's other tax-managed funds and work closely with the equity index team. The equity managers do not invest in the fund, but Vanguard’s compensation structure aligns managers' interests with fundholders' by rewarding managers for cost management and improving operational efficiency.

Parent Pillar:

Positive | 06/05/2018 The Vanguard Group is the world's biggest provider of open-end funds and its second-biggest provider of exchange-traded funds. Innovative and iconoclastic from its mid-1970s origins, the firm's mutual ownership structure, commitment to low fees, and sensible active and passive investment strategies are hallmarks that support its Positive Parent rating.

Vanguard is committed to serving all investors, not just its own. Indeed, the firm celebrates when its entry into an asset class prompts rivals to lower their fees to remain competitive, as occurred when Vanguard launched index funds in London in 2009 and factor-based strategies in the United States in early 2018.

New CEO Tim Buckley, Vanguard's fourth, faces the challenge of expanding the firm's mission to non-U.S. investors, who currently account for less than a tenth of the firm's $5 trillion in global assets under management. He must also navigate the tension between Vanguard's burgeoning discretionary asset-management business, Personal Advisor Services, and financial advisors who may feel threatened by the firm's efforts to lower the cost of investment advice. Perhaps Vanguard's greatest challenge, though, will be keeping pace with its own growth, especially in overcoming the service problems that have bedeviled the firm the past few years. Vanguard's 2017 implementation of client-experience testing labs should help the firm improve there, too.

Price Pillar:

Positive | Patricia Oey 07/02/2019 Very low fees earn this fund a Positive Price rating.

The fund's single share class--the Admiral shares--charges a 0.09% expense ratio, which is the lowest among no-load, moderately conservative allocation peers. The median fee for this group of funds is 0.76%.

In addition to low fees, the fund's tax-aware approach helps fundholders keep more dollars in their pocket by attempting to limit taxable distributions. Since its inception in 1994, this fund has not paid a capital gains distribution. As a result, its 10-year tax-cost ratio (an estimate of the taxes paid for capital gains and dividends, per year) of 0.58% is significantly lower than the 1.21% average of its allocation--30% to 50% equity peers.