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If you are looking for a tax-efficient fund, you can just
rank funds by tax efficiency and be done, right?
No, in reality, tax efficiency isn’t all that helpful.
The goal is to maximize aftertax returns, not tax effi-
ciency (setting aside risk and goals, of course). There
is a big difference between the two. You can put
money in shoeboxes in your closet and have great tax
efficiency. What you really want is aftertax returns.
If one fund has aftertax returns of
10%
annualized
over the next
10
years and another has
8%
, you want
the one with
10%
, regardless of whether you paid
more taxes along the way. Vanguard is always eager
to make this point because plain-old tax-efficiency
measures actually penalize a lower-cost fund, as
expenses are taken out of income; therefore, low-cost
funds deliver higher aftertax returns but lower
tax efficiency.
Second, past tax efficiency can often be the result of
random accidents like when a fund was launched
or the amount of inflows it had, but those elements of
luck won’t continue into the future.
To find funds with a good chance of outperforming on
an aftertax basis, I screened for Morningstar Medalist
funds with below-average expense ratios; net inflows;
potential capital gains exposure, or
PCGE
, below
25%
;
10
-year aftertax returns that rank in the top third of
their Morningstar Category; and turnover below
50%
.
Put all that together, and you have a much better
formula than tax efficiency.
I screened for inflows because outflows can lead to
larger capital gains distributions than you’d expect
from returns alone. When money leaves a fund, the
manager may have to sell stocks held at a profit but
then distribute those gains to a smaller shareholder
base. Thus, those who stayed with the fund may get
a hefty tax bill. We’ve seen more of this, as I detailed
in
Morningstar FundInvestor
’s April
2015
cover story.
Conversely, sizable inflows can water down tax bills
for shareholders.
PCGE
tells you the amount of built-
up gains a fund has.
Here, then, are four funds that look like good bets and
which passed all my screens:
T. Rowe Price Qm US Small-Cap Growth Eq
PRDSX
This fund’s newfound popularity means it has had
lots of inflows to water down gains. It has only a
7%
PCGE
. To be sure, you wouldn’t want the fund to
grow so big that it has to alter its strategy, but, as the
name says, it is diversified. Sudhir Nanda’s quantita-
tive models have run circles around the competition
since he took over in
2006
.
PRIMECAP Odyssey Growth
POGRX
Of course I will plug a Primecap fund whenever I can.
It runs outstanding funds, including this excellent
large-growth fund. The fund is low-cost, low-turnover,
and high-integrity. Our analyst David Kathman sums
it up nicely as patient contrarian growth. The strategy
will have its off years (it has started
2016
in a hole),
but its investment chops show up in the long run.
Vanguard Equity-Income
VEIPX
Like a number of Vanguard funds, this one is dull but
effective. The fund’s two subadvisors run a diversi-
fied portfolio of dividend-paying stocks. Michael Reck-
meyer of Wellington and a trio of managers from
Vanguard’s quant group run the portfolio. With a low
expense ratio of
0
.
26%
, the fund has built a top-
decile record during the past five-,
10
-, and
15
-year
periods, and it looks even better on an aftertax basis.
Fidelity Tax-Free Bond
FTABX
If you are building up a portfolio in a taxable account,
munis make a lot of sense. Even after a recent run
of outperformance versus taxable bonds, they still are
pretty attractive when you factor in taxes. Jamie
Pagliocco runs the fund to the cautious side of the
market, so he sacrifices a bit of yield for better
downside protection. The fund doesn’t buy bonds
subject to the Alternative Minimum Tax, so it is a
good idea if you are in
AMT
territory.
K
Four Tax-Appealing Medalists
Tracking Morningstar Analyst Ratings
|
Russel Kinnel
What Are Morningstar
Analyst Ratings?
Our ratings are chosen for long-
term success. Analysts assess
a fund’s competitive advantages
by analyzing people, process,
parent, performance, and price.
They do rigorous analysis and
then submit their ratings to a
committee that vets their work
for thoroughness and consistency.