It depends. Vanguard currently offers three different “tax-managed” mutual funds whose objectives are to invest in a tax-efficient manner. The three funds are:
- Tax-managed Capital Appreciation Fund
- Tax-managed Small Cap Fund
- Tax-managed Balanced Fund
If you compare these funds to a typical actively managed mutual fund, they are dramatically more tax-efficient. However, if you compare them to what I usually recommend- a good low-cost, broadly diversified index mutual fund, they are slightly more expensive and only slightly more tax-efficient. Let's look at some numbers.
Tax-Managed Large Caps
First, we'll consider the Tax-managed Capital Appreciation Fund. What does this invest in? Well, if you look at its Portfolio, it invests in US large cap blend stocks, like the 500 Index Fund and the Total Stock Market Index Fund. The 500 fund has a slightly higher average stock capitalization and the TSM fund has a slightly lower one. Let's compare them:
| TMCA | 500 | TSM | |
| Avg Cap | $61B | $81B | $53B |
| Expense Ratio | 0.11% | 0.05% | 0.05% |
| Turnover | 9.80% | 3.40% | 3.50% |
| Yield | 1.80% | 2.07% | 1.95% |
| 1 year return | 4.02% | 4.48% | 4.24% |
| 5 year return | 13.54% | 13.53% | 13.31% |
| 10 year return | 6.91% | 6.69% | 6.91% |
| After tax 10 year return | 6.04% | 5.83% | 6.08% |
My kids prefer Banff to tax-managed funds
As you can see, the market cap is between 500 and TSM, the expense ratio is twice as high and the turnover is quite a bit higher. Hopefully, this is due to tax-loss harvesting within the fund. Returns are lower in the last year, but about the same in the long run. The proof is in the pudding with a tax-managed fund, of course. And what is the proof? It's the after-tax return. That assumes you pay taxes on all dividends and capital gains distributions at the highest possible rate, then at the end of ten years you sell and pay long-term capital gains at the highest possible rate. So what is the advantage of all that tax-management you're paying for? There basically isn't any. It's just another index fund performing about where you expect it to. Would it be the end of the world to use this fund? Of course not, but I wouldn't go out of my way to use the fund and it looks like I'm not alone judging by the fact that the other funds are 50 times as large as the tax-managed one.
What exactly are they trying to do in this fund? Well, if you read the prospectus you see they are trying to match the Russell 1000 index (the largest 1000 stocks) return by using stocks with dividends lower than average in that index. The theory is that if the dividend yield is lower, it will be more tax-efficient. It's a good theory. In the end, there are three things that matter with index funds:
- What index?
- How well is it tracked?
- At what cost?
I would argue that all three of those matter more than trying to keep the yield low. I'm not a big fan of the Russell indices and the fund does a poor job of tracking it anyway. Not as bad as an actively managed fund, but bad enough that you wonder if it is really an index fund at all. The cost is also quite low, although it is still twice the cost of the other funds. But the bottom line here is that these other two funds are just so tax-efficient already thanks to their low-turnover index strategy, our current low dividend yield environment, and their broad diversification. Why take the risk that the tax-management screws something up? I see no reason. I would pass on this tax-managed fund.
Tax-Managed Small Caps
Next, let's turn to the Tax-Managed Small Cap Fund. This fund is even smaller than the large cap one, about half the size. It invests in US small cap stocks, per Morningstar, about 95% of the stocks are small cap with a median market cap of just $1.5 Billion. It has quite a high turnover, 33%, and is reportedly trying to track the S&P 600 index. So what should we compare it to? We could compare it to the Vanguard small cap index fund, but that fund is significantly different. For instance, only 59% of the stocks in it are small cap stocks so it has average market cap twice as high as the tax-managed fund. We could also compare it to the Bridgeway Ultra Small Market Fund but that not only has a much higher expense ratio, but also a market cap 1/10th the size. Bottom line, there is no great comparison due to the different portfolios these funds hold. If the portfolio you desire is the one the Tax-Managed fund is tracking, it may be a reasonable choice. But let's take a look anyway.
| TMSC | Vanguard SC | Bridgeway | |
| Avg Cap | $1.5B | $3.3B | $151 M |
| Expense Ratio | 0.11% | 0.08% | 0.78% |
| Turnover | 33.00% | 11.00% | 41.00% |
| Yield | 1.20% | 1.54% | 0.81% |
| 1-year return | 5.74% | 4.31% | 15.47% |
| 5 year return | 13.47% | 12.50% | 17.29% |
| 10-year return | 7.77% | 7.43% | 5.62% |
| After tax 10-year return | 7.16% | 6.76% | 4.18% |
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It is really hard to do any kind of comparison here. Due to the different indices being followed here, the portfolios are really quite different. I used to use the Bridgeway fund in my portfolio, but if someone was looking for a small-cap fund rather than a microcap fund, I think the tax-managed fund is a better choice than the “vanilla” small cap fund. Not because of the tax management, but because of the different index which I prefer. How much does the tax management add to the after-tax return? Probably not much. The regular fund loses 0.76% per year to taxes whereas the tax-managed fund loses 0.61%. Pretty trivial difference in my view, but again supports using the tax-managed fund, at least in a taxable account.
Tax-Managed Balanced Fund
The tax-managed balanced fund is a little easier to analyze. It is 48% US Large Cap Stocks and 52% muni bonds. Unfortunately, the non-tax-managed fund is 60% stocks and 40% bonds, so it makes it tough to do an apples to oranges comparison. Like with the tax-managed large-cap fund, it follows the Russell 1000 index, which I don't like. The bond portion is basically the intermediate tax-exempt bond fund, which is fine if that is what you want to own. I'm not a huge fan of balanced funds in general, unless it's a “one-stop shopping” type fund like a target retirement or life strategy fund, so I'd pass on this just like I'd pass on the non-tax-managed version. It doesn't meet the needs of someone looking for a “one fund” solution as it has no international stocks at all.
| TM Balanced | Balanced | |
| Expense Ratio | 0.11% | 0.08% |
| 10 year return | 6.30% | 6.78% |
| After tax 10 year return | 5.35% | 5.19% |
As expected, the regular fund with its more aggressive asset allocation has a higher long-term return. However, the tax-managed fund shows its value in that it only loses 0.95% to taxes instead of 1.59%. So if you want a balanced index fund with a 50/50 asset allocation in taxable, the tax-managed one is a good choice. I just don't think there are very many people out there looking for that.
So, while you can do far worse than the Vanguard tax-managed funds, they have remained unpopular for good reasons. I do not use them in my portfolio, but it wouldn't be unreasonable for someone to do so in a taxable account.
What do you think? Do you use the tax-managed funds? Why or why not? Comment below!
I have some clients in the tax managed balance fund. The 50-50 simplicity and auto balance appeals to some people. Are the bottom line returns you quote above after sale of the fund? If so, I would make the point that most investors don’t use the funds that way and it is not the appropriate comparison. Most investors buy and hold and live off the dividends, or sell only some of the principal to pay the bills. What specific 60-40 fund are you using as the comparison to the tax managed balanced? Can you run the numbers with .5 of the 60-40 and .5 of the 40-60 in order to get the approximate 50-50 allocation of the tax managed balance fund? If you are using the Vanguard Life Strategy 60-40, I don’t think that is a valid comparison because that does contain international. One question I have for the WCI is: What is your view point on Jack Bogle and his view that you don’t need international? Of course, I understand the math, but what I struggle with is that it is hard to ignore this thought leader and his view point. Same with Buffett, time and time again it is the U.S. index fund he recommends. Don’t get me wrong, my clients do wind up getting significant international exposure, however this is a conundrum that must be exposed and grappled with.
I was just comparing with the 60/40 balanced index fund, which also doesn’t contain international. Yes, I did assume the fund was sold at the end of the periods. Holding until death does increase the tax-efficiency, but that’s the same for any fund so I’m still doing an apples to apples comparison, even if you wanted to see the oranges to oranges comparison.
I disagree with Jack on the international point. I see no reason to ignore half the investable equity universe just because some big US companies sell their products overseas. I think you should have 20-50% of your equity in international stocks.
But is it crazy not to invest in international? No. It’ll probably work if coupled with an adequate savings rate and good investing behavior and reasonable goals.
I have that opinion as well, however when two superior investor (Buffett and Bogle), it makes me question that opinion. Buffett says that the U.S. has the best accounting rules, rule of law, security, etc…The cognitive psychologists would say that Buffett and Bogle have the “home bias.”
I agree it’s difficult to ignore the advice of these two gentleman on this point. Perhaps there’s also an element of recency bias.
Some argue against a lot of international since when an American retires they need U.S. dollars. International funds often have currency risk.
Good timing for me with this article, as I am just about ready to start funding a Vanguard taxable account. I was going to just do a 80/20 split of the TSM/Muni. Assuming highest tax bracket, is there any difference between TSM fund and the ETF? Along the same lines, if you only had 3k to invest initially would you invest in the ETF or wait until you had 10k (maybe the next month or two) to invest in the admiral shares?
The only difference is one is an ETF (and you may pay bid-ask spreads and commissions) and the other is a fund which if you don’t have $10K has a higher ER.
All else being equal I prefer Admiral>ETF>Investor shares assuming you’re not paying a commission for any of them. If I had $3K and it was going to TSM and I knew I was going to be over $10K in a couple months, I’d just put it into investor shares and convert the shares when I hit $10K rather than messing with the ETF. But you may end up going TSM investor–> 500 Index —> TSM admiral if there is a tax loss harvesting opportunity.
Seth,
It is hard to give a complete answer without knowing your big picture, however by the intelligence of your question you know by now it is not rocket science or harder than learning about the nephron. Generally, if you buy a Vanguard TSM investor share, once you hit 10k, Vanguard will convert it to the lower cost admiral shares without any cost or tax consequences to you. They do this automatically without you asking! That is a reasonable approach. This is a good strategy for a busy doc because you can auto invest from your bank account and check in about once a year. However, theoretically, if you want to get fancy, put your 3k into the Vanguard Total Stock ETF, because the E.R. is only .04, and there is no commission if you buy it through the Vanguard platform. That compares to the .15 percent Vanguard Total Stock. As you may know, Schwab has an identical Total Stock fund that has an ER of .03 percent. There is no minimum, and therefore, because in investing the fee is EVERYTHING, plopping your 3k into this Schwab fund and adding to it regularly is a reasonable option, and perhaps even the best option. Do be aware, there is a theoretical advantage to the ETF (versus the Schwab fund) in that capital gains are not expressed to you in an ETF versus the index fund. That is, the ETF is in theory more tax efficient. ETFs allow an “in kind” exchange which allows the fund to avoid capital gains when they do have to sell. Without getting into too much detail, the Vanguard TSM is linked to the ETF so this is less a concern for their products. In summary, don’t wait, get started with an ETF or TSM index fund and add to it in piecemeal fashion. The probability is high that you will get a satisfactory result over a 7 to 10 year period. Think of it like this, during my ICU rounds this morning, I could Rx atenolol or lopressor, and the difference in the result should be negligible. Good luck!
Thanks. Appreciate the advice from both.
Vanguard won’t convert investor shares to admiral shares automatically, it requires a couple clicks and approving the conversion…
I bought tax managed small cap because of the tiny after tax advantage; with the recent huge run up in small caps, I’m probably holding forever now to avoid cap gains punishment (not complaining!).
My analysis of the other two was essentially the same as your conclusion.
Now, what is the best vanguard bond fund to hold in taxable…?
I like the intermediate tax exempt, but the answer to that question is probably state dependent, no?
The expense ratios for all 3 funds is 0.09 rather than the 0.11 listed. While it a minimal change it does further diminish the cost differential between the tax managed and more conventional funds.
Personally I use the tax-managed funds for the US portion of my equity portfolio to take advantage of the theoretical benefits of loss harvesting and minimizing capital gains realizing that it may indeed be very small as you nicely showed.
It also serves the secondary benefit of increasing the diversification of my holdings rather than buying into the same conventional index funds that are in my retirement accounts.
In terms of the Balanced fund I agree that I do not see who that is aimed at. I think most investors would be better suited investing in a state-specific municipal bond fund (assuming that your state taxes investment income).
Yes, the ERs have fallen since the article was written. That’s one problem with getting months ahead on articles and that pesky Vanguard company constantly lowering their costs.
There isn’t much tax loss harvesting going on there that’s passed on to you as near as I can tell and you’re certainly not getting some significant diversification benefit compared to more typical index funds. In fact, in the past these tax managed funds made tax loss harvesting more difficult due to a 5 year holding requirement. I think that’s gone now though.
My favorite “tax-managed fund” isn’t a fund at all, but a single stock that has ownership in many companies and pays no dividend.
Berkshire Hathaway is the only individual stock I own, and it more tax-efficient than any of the tax-managed funds available. I understand it doesn’t track an index and there is more inherent risk, but when you look at the holdings, they represent a broad swath of industries.
Best,
-PoF
Agreed. While I do have a modest portfolio of individual stocks, I buy more BRK.B every quarter. I’m interested in seeing what happens when Buffett/Munger depart. Obviously, quantitatively, nothing has changed. Qualitatively, I wonder what will happen to the stock price, both immediately and going forward….
You seriously wonder about that? I can tell you exactly what is going to happen immediately. Do you really think the company will be more valuable (or even just as valuable) without Buffett/Munger? The price will drop.
In the long-term, hopefully people will be more rational, but I’m not sure I’d like to have any significant portion of my portfolio in this single company despite its obvious fund-like qualities.
Sounds like it will be a good opportunity to buy more BRK.B! But that would be market timing, wouldn’t it?
Forgive the typo above. I’m typing with 9 fingers thanks to a tuft fracture I gave myself yesterday adjusting my bike’s disc brakes. Pretty sure that was my first ever ER experience as a patient. I almost went to urgent care and probably could have. Live and learn.
I thought it would go down upon Buffett’s death too. However, at the annual meeting this year Buffett made the comment that if he died over the weekend, on Monday he believes the stock WOULD GO UP. He said the reason is that because there would be all kinds of speculation that they would break up the company and do some spin offs. That really caught me by surprise, in a major way. He also said in the 50 year review letter that the chance of a permanent loss of capital is close to negligible, for what that is worth. Totally agree about the PoF comment about the tax efficiency of Berkshire. It is about as good as it gets. He even tells you the price you should buy it (1.2 book value). That is the price he would buy in terms of share re-purchases.
We’ll know soon, won’t we? He’s no Spring chicken.
Until then it’s all speculation, but I certainly expect to see a lot of volatility!
Maybe. Buffett says it will go up upon his death.
https://www.bloomberg.com/news/articles/2017-05-06/buffett-says-berkshire-stock-will-gain-the-morning-after-he-dies
There is a pretty good comparison out there for the tax-managed small cap fund. Vanguard has an ETF, VIOO, that tracks the same index. iShares has an ETF like that too.
I won’t post the numbers here but readers can go to Vanguard to look at the after-tax returns. They are basically the same.
Thanks for sharing.
I pretty much agree with this. I am heavily invested by now and it doesn’t make sense to sell my TM funds. Some of this may depend on your tax bracket too?
https://www.bogleheads.org/wiki/Tax-managed_fund_comparison
At the highest tax bracket there can be a minuscule advantaged to the TM funds. I like the TM Balanced fund personally. I don’t think there are enough options out there for the 50:50 investor. One stop DIY shop. Simple and easy.
I am also a big fan of the TM Balanced, and it has been a core holding of mine for over 15 years. One thing that I appreciate, admittedly a heuristic of sorts, is that in times when the stock market is going down the tubes, it is nice to have a holding (other than cash) that seems to be holding up a little better than most.
It is a good building block, too, to diversify around. 50% in TM Balanced, 10% Dividend Growth Index (or social responsibility index or midcap value or your favorite US factor), 10% small cap value, 20% international developed, 10% Emerging Markets, and you have an excellent, tax efficient, diversified 75:25 portfolio.
BTW, if you look at the 10 year return, it is less than a percent (annualized) less than the TSM (6.9% vs 6.3%) with less volatility along the way. One could do a lot worse than investing in the TM Balanced fund as a core holding.
I like to have control over the asset allocation in my taxable account (stocks vs. bonds, domestic vs. international). Therefore, I don’t use the tax-managed balanced fund. Rather, I use a simple 3-fund portfolio that’s about as tax efficient as you can get:
1. Total Stock Market Index
2. Total International Stock Market Index
3. Intermediate Term Municipal bond index
What’s wrong with the Russell indices? I couldn’t find an article or forum post on the topic
They get front-run like the S&P 500 for one thing.
…Whitecoat, what does ‘front-run’ mean? Thank you!
If someone finds out a stock is going to be added to an index like the S&P 500, they buy it and then when all the index funds add it the price goes up a little from all the buying.