Tax Managed Funds

Q.

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Should I Be Using a Tax-Managed Fund in My Taxable Account?

A.

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

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!