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Investing Specialists

Should You Switch Funds?

Running through our checklist can help you arrive at the right answer for you.

"Would you recommend that people switch from Vanguard Dividend Appreciation (VDADX) into Vanguard Dividend Growth (VDIGX)?"

I started receiving that question from readers in the wake of Vanguard's announcement last week that it would be reopening its Dividend Growth fund to new investors. Vanguard Dividend Growth was the original anchor equity holding in my model "bucket" mutual fund portfolios for retirees, but it closed to new investors three years ago. At the time of the closure, I recommended that investors who were already in Vanguard Dividend Growth hang on. Even though the fund is pretty large, it's focused on large and mega-caps, and Morningstar senior analyst Alec Lucas didn't think its girth would be an impediment. But because my goal is for the model portfolios to be investable, I replaced it with Vanguard Dividend Appreciation. As a large-cap index tracker, asset capacity won't be an issue for Vanguard Dividend Appreciation, and it's a low-cost fund that tracks a sensibly constructed index. It was already the anchor U.S. equity holding in my ETF bucket portfolios, though I used the traditional index fund in my mutual fund portfolios.

The question about whether to switch into an actively managed fund from an index fund runs counter to prevailing trends: In recent years, many investors have been mulling and executing the opposite trade, chucking their actively managed funds for exchange-traded funds and index funds.

But whether you're going from index to active or vice versa, the basic calculus for making smart decisions about the swap is the same. First and foremost, there are individual-specific factors to consider, such as whether the trade will trigger any tax or transaction costs. If those cost hurdles are greater than what you could reasonably hope to make up in returns in the other fund, switching is a nonstarter. If tax or transaction costs aren't an issue, it's then worthwhile to compare the two funds closely: their expenses, strategies, and performance records, among other factors. You'll also want to examine your own motives to ensure that you're not using more substantive factors as a justification to performance-chase.

I've decided to stand pat with Vanguard Dividend Appreciation in my model bucket portfolios, in large part because my bias is to be hands-off with these portfolios unless there's a clear reason to take action. But either of these Gold-rated funds would make a solid core equity choice for a retiree (or an accumulator, for that matter). In order to make a methodical assessment about whether swapping from one fund to the next is the right move in your situation, here are the key questions to ask.

Question 1: What's the tax situation?
Where do you hold the fund? If the answer is in a tax-sheltered account like an IRA or a company retirement plan, tax considerations, whether taxes associated with the sale or the funds' tax efficiency going forward, shouldn't factor into your decision-making. As long as your dollars stay inside the tax-sheltered account, you're free to switch from one investment to the next without triggering tax costs. You'll owe taxes when you pull your money out, but any trading you did while you held the account won't affect the taxes you owe.

If you hold the fund in a taxable account, on the other hand, swapping into something else is a much bigger deal. After all, we're more than 10 years into the current bull market, and the S&P 500 has gained more than 13% on an annualized basis since mid-2009. If your existing holding has appreciated, you'll owe capital gains on the difference between your cost basis and the sale price.

A mitigating factor is if you've already been receiving hefty capital gains distributions from the fund you own and have reinvested them. In that instance, you've already paid taxes on some of those gains you've made and have received an increase in your cost basis to account for it, so the tax bill upon sale may not be as large as you imagine. (This article delves into that topic in greater detail.) That provides some comfort, but as a long-term investor, you should prefer that a fund lets its gains build up rather than paying them out to you regularly through capital gains distributions.

Another mitigating factor in the decision-making is that some investors won't owe taxes on their capital gains at all, even if they're selling from a taxable account. In 2019, the 0% rate on long-term capital gains applies to single filers with incomes of less than $39,375 and married couples filing jointly with taxable incomes of less than $78,750. If your income, including your capital gains, falls beneath those thresholds, selling won't trigger any extra tax costs.

In the case of the swap from Vanguard Dividend Appreciation to Vanguard Dividend Growth, taxable investors have good reason to pause. Because it's an index tracker with very low turnover, Vanguard Dividend Appreciation has made few taxable capital gains to shareholders. That means that investors mulling a sale now could owe a big tax bill because their gains have been building up in the fund rather than getting paid out to them. Moreover, Vanguard Dividend Appreciation has been a more tax-friendly fund than Vanguard Dividend Growth, which suggests the former will be a better fit than the latter for a taxable account on a going-forward basis, too. 

Tax considerations didn't play a role in my decision to hang onto Vanguard Dividend Appreciation in my portfolios, in that the baseline portfolios are created with tax-sheltered accounts in mind. I've developed a separate suite of tax-efficient portfolios for taxable accounts, both traditional mutual fund and ETF.

Question 2: Will I need to pay any transaction costs?
In some ways, transaction costs are feeling like a vestige of a bygone era; very few investors are paying full sales loads to buy or sell mutual funds, and many investment providers allow investors to trade certain funds, often a very long list, without any commissions or transaction fees. (This has been a particularly big boon to ETF investors, who in the past may have had to pay commissions to buy and sell.) Investors will rarely pay transaction costs when buying and selling within their company retirement plans, either. But it's still worth investigating whether you'll incur a commission to make a change; also take a look at whether the fund charges a redemption fee for shares that you've purchased recently.

In the case of Vanguard Dividend Appreciation, for example, if you own it on some platform other than Vanguard's, you're likely to pay a charge to sell and another to buy Vanguard Dividend Growth in its place. Neither fund levies a redemption fee, but other Vanguard funds do, to deter short-term trading activity that can hurt the long-term performance for all shareholders.

Question 3: How similar are the strategies and portfolios?
If you've decided to move forward with a swap, the next step is to consider how closely the funds match one another, assuming you would like to maintain exposure to that market segment in the first place. More often than not you'd want them to reside in the same Morningstar Category, but also consider the strategy in place and take a closer look at their portfolios. Morningstar's analyst reports do a good job of discussing strategies for both index and active funds in layperson's terms, and you can also compare their portfolio statistics head to head. The "ownership zone" and "centroids" for two portfolios are quick ways to compare equity portfolios' general styles and market caps. For bond funds, duration and average credit quality are key data points. Yield is another quickie way to determine if a fund is taking extra risks relative to another.

In the case of Vanguard Dividend Appreciation and Vanguard Dividend Growth, there are some striking similarities as well as a few notable differences. Of course, both funds share a focus on companies with a history of increasing their dividends, and their portfolios tend to be anchored in wide-moat, financially healthy U.S. large caps. However, Vanguard Dividend Growth's current portfolio lands in the large-growth square of the Morningstar Style Box, whereas Vanguard Dividend Appreciation's current portfolio lands in large blend. Perhaps more significantly, because Vanguard Dividend Appreciation tracks the Nasdaq U.S. Dividend Achievers Select Index, it obviously has less latitude to make changes in response to market conditions and other factors than the actively managed Vanguard Dividend Growth. Vanguard Dividend Appreciation is beholden to the composition of the index it tracks. That has pluses (very low costs, an extra level of discipline) but reduces flexibility somewhat. Vanguard Dividend Appreciation has small stakes in small- and midsize stocks, whereas Vanguard Dividend Growth is focused exclusively on mega- and large-cap stocks. In addition, Vanguard Dividend Growth has a higher weighting in foreign stocks than Vanguard Dividend Appreciation. The two funds' sector exposures also differ a bit.

Question 4: How do expenses compare?
This is a make-or-break figure when deciding whether to switch funds. After all, Morningstar research has repeatedly demonstrated that funds with lower expense ratios tend to outperform their higher-cost competitors. Higher-cost funds may be able to outperform over certain stretches, but that often owes to extra risk-taking; over time, those higher costs and/or extra risks tend to catch up with funds.

In the case of Vanguard Dividend Appreciation versus Vanguard Dividend Growth, both are quite cheap relative to their peers. The former, as an index fund, certainly has a cost edge, but Vanguard Dividend Growth's 0.22% expense ratio is ultra-cheap relative to actively managed products. Its manager's active decisions, rather than the expense differential, is likely to have a bigger impact on its performance relative to Vanguard Dividend Appreciation. While low expenses should provide Vanguard Dividend Appreciation with an ongoing advantage, I didn't place a big emphasis on the cost difference when deciding whether to stick with the index fund or opt for the active fund.

Question 5: Am I gaining or losing when it comes to ease of use and oversight?
This is an important question if you're contemplating a switch from an actively managed fund into an index product (or vice versa). One of the big benefits of index funds and ETFs relative to actively managed funds is that they allow you to be pretty hands-off, especially if you opt for index funds that track broad market segments like the U.S. stock market, international stocks, or high-quality U.S. bonds. If you buy such a fund, you can rest assured that you're going to obtain exposure to that market segment, less any expenses. You won't have to worry about the manager or strategy changes that can accompany actively managed funds.

The fact that Vanguard Dividend Appreciation tracks an index, albeit one more narrow than the S&P 500 or a total market index, means that its portfolio will deliver predictable exposure to dividend-growth stocks. Yet it's also worth noting that Vanguard Dividend Growth plies a highly disciplined strategy itself. I would expect both funds to continue to deliver reliable exposure to wide-moat, highly profitable dividend-growth stocks, though I'd give a slight advantage to the index tracker.

Question 6: How does performance compare?
It might be tempting to put the returns comparison at the top of your list when deciding whether to switch funds, but I would tend to put it near the bottom. My bias is to use performance as a lens into what kind of performance pattern to expect: Has one fund performed better during rallies, for example, while the other has tended to hold its ground better during market swoons?

In the case of raw returns, Vanguard Dividend Growth compares favorably to Vanguard Dividend Appreciation: Since the latter's inception in 2006, its returns have edged past those of the S&P 500, whereas Vanguard Dividend Growth has beaten both by a solid margin. Vanguard Dividend Growth also looks better on a risk-adjusted basis. Not only is its 10-year standard deviation lower, but it also fared better than Vanguard Dividend Appreciation during the financial crisis. That said, I would expect both funds to do a good job of holding their ground relative to their category peers and the S&P 500 in a big equity-market shock.

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