(PUB) Investing 2016

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index absolutely outperformed, hit-

ting an MCL (Maximum Cumulative

Loss) of -52.2% compared to the CRSP

index’s -58.7% MCL. But over other

down-market periods, the S&P index

didn’t do any better, and sometimes it

did worse than the CRSP index, so it’s

closer to a toss-up on the risk side.

One other factor that I think is worth

noting is that the companies in the S&P

index are much smaller than those in

the CRSP index. The median company

in the S&P index is currently $3.8 bil-

lion in size, while the median CRSP

index company weighs in at $10.2

billion. To my way of thinking, we’re

getting more mid-caps and maybe a

few smaller companies in the portfolio

than the CRSP index offers. Plus, the

companies in the S&P index are chosen

by a committee of humans, not comput-

ers. Don’t forget that. So we’re actually

choosing to side with an actively man-

aged index rather than a computer-man-

aged one. How’s that for an oxymoron?

In any case, that’s some of the analy-

sis that Jeff and I went through in mak-

ing this decision, which was something

we thought long and hard about.

Action Items

So, in sum, as noted in the April 28

Hotline

, Jeff and I think it’s the right

move to trade out of

SelectedValue

and

into

S&P Mid-Cap 400 Value ETF

Some of you will have large gains in

Selected Value and will be wary of tak-

ing the tax hit. I get that. One alterna-

tive is to stop reinvesting in Selected

Value and direct your new money and

distributions into the S&P ETF.

Others of you may wish to stick with

open-end mutual funds and not buy an

ETF at all. I can understand that, though

it doesn’t cost anything to buy an ETF if

your account’s at Vanguard. But if you

decide you simply won’t buy an ETF,

or it’s not available in your 401(k) plan,

there’s nothing wrong with MidCap

Value Index. In the end, I think the dif-

ferences over time will be small.

But in the

Model Portfolios,

we’ve

sold Selected Value and bought S&P

MidCap 400 Value ETF.

THOSE MASSIVE LOSSES

“earned”

during the financial crisis and linger-

ing in our mutual funds’ portfolios are

(for the most part) long gone now that

we’re seven years into this bull market.

Other than

Precious Metals & Mining

which is sitting on realized and unreal-

ized losses equal to an astounding 105%

of its portfolio value (yes, really!), and a

number of international stock funds that

haven’t seen the massive run-ups of their

domestic counterparts, most funds are

sitting on unrealized gains—capital gains

in stocks that haven’t been sold yet.

That’s why it’s a good time to think,

once again, about taxes and, more impor-

tantly, the concept of tax efficiency. You

see, what many investors think they

know about taxes and mutual funds is, in

many cases, dead wrong. Now’s the time

to give this a thorough look-see and to

strike down the accepted wisdom.

Now that Tax Day has passed, there’s

little you or I can do about what hap-

pened in 2015. But as the tax reporting

deadline fades, I can fully appreciate

you might be wondering how to reduce

or even eliminate future tax bills.

But that’s not the way to think about

it. Indulge me for a moment. The goal

of investing isn’t to avoid taxes, but

to maximize wealth after you’re done

paying your taxes. Keeping an eye on

the taxes you pay certainly should be a

factor in your investment strategy, but

it’s not the whole story.

As I’ve noted in years past, most of

Vanguard’s funds have been quite good

at shielding a majority of their share-

holders’ returns from the IRS, earning

high marks for tax efficiency. While

this was largely thanks to big losses

realized during the bear market, it’s

also a testimony to smart and selective

selling by some of the funds’ managers

and their long-term investment style, as

they have not yet “realized” the gains

they’ve been building for us.

Still, as I’ve said many times before,

focusing on tax efficiency is the wrong

way to look at the bite taxes take out of

your investments. You want to focus on

after-tax returns.

I often say that the focus on tax effi-

ciency can lead you down the wrong

path. For instance, a couple of years

ago, I noted that

U.S. Growth

was

Vanguard’s single most tax-efficient

fund over the three years ending in

2013, as the portfolio managers took

advantage of millions in realized losses,

having not paid out capital gains since

2000. I also said those losses were pret-

ty much used up, and to expect capital

gains in 2014. Bingo! That’s exactly

what happened, and what had been the

most super-tax-efficient fund all of a

sudden wasn’t.

Today, Vanguard’s most tax-efficient

fund is

Market Neutral

. The fund

barely pays out a distribution, and when

it does, it’s fractional. So, investors

here get to keep almost every dollar

they earn. The problem is, they don’t

earn that much. So why would we use

a close to 100% tax-efficiency measure

to choose an investment? Well, you

wouldn’t, or at least you shouldn’t.

Focusing on tax efficiency is like focus-

ing on the top-performing fund over the

most recent three years or the last six

months—meaningless, absent context.

Plus, how do you really distinguish

between funds when so many have

similar tax efficiency ratios? In any

given three- or five-year period, better

than half of Vanguard’s funds, whether

indexed or actively managed, typically

show tax-efficiency rates of 90% or

better. That means investors kept 90%

or more of the funds’ returns even after

paying taxes. So that’s not a very dis-

cerning metric for picking funds.

TAX EFFICIENCY

After-Tax Tales