The trouble with financial services is that they’ll claim anything – anything – to sell you their more expensive services.
The latest example came in a reader email. He’s a successful investor, happily retired. He was quite satisfied with his mostly index fund portfolio. He had invested this way for decades.
Then he inherited some managed funds for a taxable account.
An “adviser” opportunity
That’s when an adviser saw a sales opportunity.
It was time, the reader was told, that he took advantage of the new tax-managed funds. They were the latest investor blessing in professional money management.
If you haven’t heard of tax-managed funds, the premise is simple. If your professional money manager pays attention to “harvesting” losses, they can offset some, or all, of the capital gains that are realized. That means a lower tax bill and greater tax efficiency. Your investment can grow without the burden of a worrisome annual bill for capital gains taxes.
A great problem to have
Tax management could nearly eliminate the involuntary and unexpected capital gains distributions that cause millions of retirees to have higher income tax bills than they expected.
This, of course, is a nice, first-world kind of problem to have.
To praise tax management is kind of like saying, “I love my prime rib-eyes, but my personal chef oversalted it last night.”
Or, “I swear, the only airport I hate having our jet land at more than Aspen is Virgin Gorda.”
It means you have some capital. That it has grown in value. And that the ever-insightful manager of a brilliant fund has spotted a better horse to ride while realizing a loss on a horse that turned out to be a nag.
Index funds are naturally tax efficient
What the adviser didn’t know is that while tax-management and loss harvesting may benefit traditional managed funds, it is virtually useless for most index funds. How can that be?
Simple. Basic index mutual funds are inherently tax-efficient due to their low portfolio turnover. Better still, index exchange-traded funds are even more tax-efficient due to their structure.
Here’s an example. The once-great Fidelity Magellan fund is an all-out growth fund. Its distributions from dividends have been well under 1 percent in each of the last five years, according to the prospectus on the Fidelity website.
No tax problem there.
A tax in-efficient fund
But the prospectus also tells us that the fund’s portfolio turnover rate was high. It ranged from 42 percent to 106 percent a year. That usually means a lot of capital gains were realized.
That’s exactly what the prospectus figures show: From a starting value of $9.32 a share at the end of March 2016 to the end of March 2020, the fund made $4.47 in taxable capital gains distributions.
In other words, taxable capital gains distributions were nearly half of the fund’s starting value per share, 47 percent. If a shareholder paid capital gains taxes at a 20 percent rate, 9.4 percent of the original investment would have been paid out in taxes.
Quite a lump.
When taxable distributions cost more than fund management
During the same five-year period, net fund management expenses averaged 0.72 percent a year, a total of 3.61 percent of fund assets. So the cost of realized capital gains was far more than the cost of management!
This, it turns out, is higher than most managed funds, but not very unusual. According to a discussion of tax efficiency on the iShares website, the annual tax cost of typical capital gains realizations in managed funds is about twice the cost of annual expenses, an average of 1.77 percent versus 0.91 percent.
Given those figures, it isn’t hard to see that talking about tax efficiency and loss harvesting could be a great marketing ploy. It draws attention from the cost of management. And puts it on the greater evil of taxes.
Think of the PowerPoint slides for the Training Room!
But there’s a problem.
The whole idea falls flat on its face when you compare the virtues of tax-managed funds to broad index exchange-traded funds.
The innate tax efficiency of index funds
The Vanguard Total Stock Market ETF, a fund I have mentioned more than any other over the last 10 or 15 years, made dividend distributions around 2 percent a year. That’s nearly twice the rate of Fidelity Magellan.
But it made no other distributions. No capital gains distributions whatsoever. Indeed, according to a list on the Bogleheads.org website, the ETF hasn’t made a capital gains distribution since 2001.
That’s tax efficient.
But let’s make a more apple-to-apples comparison. A growth-oriented index fund, such as Vanguard Growth Index ETF, had dividend distributions a bit over 1 percent a year.
But, like the Total Stock Market ETF, no capital gains distributions.
Nada.
That’s tax efficient.
Not to mention dirt cheap at 0.04 percent a year in expenses.
Related columns:
Scott Burns, The Simplicity Manifesto, 3/31/2019 https://scottburns.com/the-simplicity-manifesto/
Sources and References:
Link to Fidelity Magellan Fund webpage https://fundresearch.fidelity.com/mutual-funds/summary/316184100
Link to Vanguard Index ETFs prospectus page https://personal.vanguard.com/us/faces/JSP/Funds/ProspRep/FundProspectusReportsWinJSP.jsp?fundId=0970&isReqFromProducts=true
Bogleheads page on Vanguard Total Stock Market Index distributions: https://www.bogleheads.org/wiki/Vanguard_Total_Stock_Market_Index_Fund_tax_distributions
Link to iShares tax efficiency discussion page for ETFs https://www.ishares.com/us/education/etfs-and-taxes
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
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(c) Scott Burns, 2021