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The Independent Adviser for Vanguard Investors
•
May 2016
•
7
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Is low or negative tax efficiency anoth-
er story, though? Funds like Precious
Metals & Mining,
Emerging Markets
Select Stock, Emerging Markets
Index, Energy Index
and
Energy
have
been pretty lousy for investors over
the past several years, and taxes made
performance even worse. Some funds’
small pre-tax gains turned into losses
once the tax-man got his share.
Total
International Stock Index
, for example,
gained an annualized 0.7% over the past
three years and 0.6% over the past five
through March. After taxes on its dis-
tributions, those positive (albeit small)
returns turned into fractional losses. The
same held true for
World ex-U.S. Index
and some other foreign index funds.
Energy shareholders, who saw annu-
alized losses before taxes of 6.7% and
5.6%, respectively, over the past three and
five years through March 31, lost even
more once the tax man got his share, with
after-tax losses of 7.6% and 6.5%.
Of course, falling oil prices played
a big part in Energy’s losses, but the
additional hit shareholders took due
to taxes probably stung pretty hard.
Yet, had you looked at Energy in the
earlier part of this decade, when oil
prices were rising and the fund’s for-
tunes were soaring, you’d have found
that its tax efficiency ran better than
95%. Was that a good reason to buy
the fund? As I said, tax efficiency, like
so many performance measures based
on single points in time or single time
periods, is quite susceptible to dramatic
change, and doesn’t make for a good
fund-selection metric.
Besides, low tax efficiency isn’t
always a bad thing unless observed in a
vacuum. Take
Convertible Securities
, a
chronic underachiever in the tax-efficien-
cy hunt. Many investors use the fund pre-
cisely for its income-generating charac-
teristics. And in our tax system, income
gets taxed pretty heavily. Yes, the fund
can also produce some capital gains, as
well. Over the past three years, the fund’s
tax efficiency has run 36%; over the
past five, it’s run 43%; and over the past
seven, 78%. Its after-tax returns of 1.2%,
1.6% and 8.4% might look miserly, but
compared to
Total Bond Market
’s after-
tax returns of 1.2%, 2.5% and 3.2% over
the same periods, Convertible Securities
doesn’t look like such a bad income play
after all. (Note that the tables on pages 12
and 13 only show Vanguard’s stock and
balanced funds.)
Now, to be perfectly clear, all tax
efficiency numbers as well as after-tax
returns need to be taken with a grain of
salt, because they are time dependent.
Remember, these are point-in-time cal-
culations, not rolling returns. So, again,
it’s not tax efficiency that matters; it’s
after-tax returns, and even these need
to be regarded with one eye on the
time period being measured. I’ll show
you why.
Efficient Investing
Before we get into the nitty-gritty of
the data, let’s back up and talk about tax
In the February
Adviser
, the article on rebalancing uses a 50/50
portfolio for comparison purposes. But your
Model Portfolios
seem very heavily weighted to equities. For example, the
Conservative Growth Model
appears to have only 14% in bonds.
Can you explain how (or if) the
Models
compare to more tra-
ditional ones, in which a conservative growth portfolio would
probably contain closer to 50% bonds?
—R. E., Huntington Beach, CA
THANK YOU FOR YOUR QUESTION. Yes, it’s true that the
Model
Portfolios
are more heavily weighted to equities than a 50/50 portfolio,
with allocations of about 60% to 95% as of the end of March. This
reflects my longstanding belief that the best way to build wealth over
the long term is to have a large allocation to stocks, rather than bonds.
That’s particularly true given the current low-interest-rate environment
we find ourselves in today.
As for the allocation in the
Conservative Growth Model Portfolio
, I
guess it all depends on your definitions of “conservative” and “growth.”
Since we could all have different interpretations of what “conservative”
means, I would pay closer attention to the allocations you mentioned,
as well as their long-term records for risk. Note that, for instance, the
Conservative Growth Model Portfolio’
s relative volatility has run about
82% (0.82) of the stock market’s volatility since inception in January
1991. At the nadir of the financial crisis, the portfolio was down 44.5%,
compared to
Total Stock Market
’
s 51.0% decline. (Just to give
another comparison, a 50/50 portfolio would have dropped 34.5%.) That
means the model dropped about 87% as much as the stock market. The
reason it fell more than its relative volatility of 0.82 would imply is that
the model also held foreign stocks (about 18%) and bonds (about 14%).
While the bond market fell just 5.8% at its worst, foreign markets
dropped almost 59%. So the relative volatility number gives at least a
good estimate of the risk that might be encountered in this model.
The
Income Model Portfolio’
s long-term risk number comes in around
60% (0.60), and sure enough, its maximum loss of 32.5% during the
financial crisis was about 64% of the loss in the stock market.
Believe it or not, some academics have argued that long-term inves-
tors building retirement savings should invest 100% of their money in
the stock market. While the math behind their arguments is strong,
what the calculus doesn’t take into consideration is human behavior.
It’s one thing to “know” that your retirement account allocated com-
pletely to stocks is the “best” way to go, but it’s quite another to stom-
ach the wrenching losses that you’ll inevitably suffer over the course
of what may be several market cycles during your investment lifetime.
The Greek aphorism “know thyself” has had many interpretations. I
think it’s particularly apt when an investor applies it to their investment
goals and the risks they are willing to endure.
MAILBOX
Equity Allocations
>
SEE
TALES
PAGE 12