(PUB) Investing 2016

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Four Tax-Appealing Medalists Tracking Morningstar Analyst Ratings | Russel Kinnel

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:

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

What Are Morningstar Analyst Ratings?

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

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.