Home Adviser Fund Update Vanguard’s Least Tax Efficient Funds Published May 22, 2015 Vanguard Postpones Muni ETFA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). For example, one popular ETF tracks the companies in the S&P 500, so buying a share of the ETF gets an investor exposure to all 500 companies in the index. Launch In January, Vanguard announced plans to launch a new municipal bondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. index fund and ETF, Tax-Exempt BondA financial instrument representing an IOU from the borrower to the lender. Bond issuers promise to pay bond holders a given amount of interest for a pre-determined amount of time until the loan is repaid in full (otherwise known as the maturity date). Bonds can have a fixed or floating interest rate. Fixed-rate bonds pay out a pre-determined amount of interest each year, while floating-rate bonds can pay higher or lower interest each year depending on prevailing market interest rates. Index, on May 15 (you can read our coverage here). But the scheduled debut has come and gone without the fund—at the last minute, Vanguard filed with the Securities and Exchange Commission to put off Tax-Exempt Bond Index’s introduction for at least another month. The delay adds to a curious pattern of postponements and cancellations in Vanguard’s attempts to bring bond funds to market over the last five years. In June 2010, Vanguard filed an SEC proposal to offer short-, intermediate- and long-term bond index funds before withdrawing the plan in early 2011. And the introductions of Vanguard’s two international bond funds also saw two delays in 2012 ahead of their eventual May 2013 opening. It’s not like there isn’t a ready market for this product. Tax-Exempt Bond Index—which will have an expense ratio of 20 basis points for Investor class shares and 12 basis points for Admiral class and ETF shares, with a 50 basis-point front-end load on the open-end shares—will undoubtedly see most flows go into the ETF share class (assuming it eventually launches). That’s stiff competition for the comparable iShares National AMT-Free Muni Bond ETF, which currently has about $4.9 billion in assets and, at 25 basis points in operating expenses, costs more than twice Vanguard’s planned addition. Vanguard says Tax-Exempt Bond Index will now debut on June 12. Given its track record, we’ll take a wait-and-see approach. Tax Efficiency: Fidelity and Vanguard Funds Now that the sting of paying 2014 taxes is behind us, we thought it might be useful to look at ways to minimize tax bills in the years ahead. Here at Adviser Investments, we feel the main goal of investing isn’t to avoid taxes, but to maximize wealth. That said, careful consideration of tax burdens should be part of any investment decisions. In an Adviser Fund Update last year, we discussed the effects of taxes on portfolio returns and some of the consensus thinking on asset placement. This week, we thought it’d be useful to look at the tax efficiency of funds from Fidelity and Vanguard over the three years through April. Before we dig into the data, it’s important to note that tax efficiency for funds is generally calculated in one of two ways. The first assumes you still own your shares at the end of the period, paying taxes on distributions along the way; this is the method we used to calculate the percentages you’ll see below. The second assumes that you’ve sold all shares, meaning that it also accounts for any additional short- or long-term capital gains you’ve realized since you bought the fund (tax efficiency will generally be considerably lower using this method if your investment has gained value). Because of Adviser Investments’ long-term investment philosophy, we think it’s more useful to look at the tax efficiency of funds you plan to hold on to. (When our clients are drawing down their accounts with us, however, we do consider how taxes will come into play when deciding what to sell, and together work out a plan that best meets each client’s needs.) Fidelity: Most and Least Tax-Efficient Funds Fund Symbol 3-Year Return Tax-Adjusted 3-Year Return Tax Efficiency Fifty FFTYX 14.2% 14.2% 99.6% Growth Discovery FDSVX 15.6% 15.5% 99.4% Growth Strategies FDEGX 18.3% 18.2% 99.2% Leveraged Company StockA financial instrument giving the holder a proportion of the ownership and earnings of a company. FLVCX 18.8% 18.5% 98.4% Value Strategies FSLSX 17.3% 16.9% 97.8% Independence FDFFX 18.4% 17.9% 96.9% Nasdaq Composite Index FNCMX 18.8% 18.2% 96.9% Select Air Transportation FSAIX 25.2% 24.4% 96.8% Value FDVLX 19.5% 18.9% 96.8% International Growth FIGFX 10.9% 10.5% 96.7% Select Consumer Finance FSVLX 17.6% 12.9% 73.3% Capital & Income FAGIX 9.3% 6.8% 72.7% Asset Manager 20% FASIX 4.7% 3.4% 71.9% Global Balanced FGBLX 6.9% 5.0% 71.7% Freedom 2000 FFFBX 4.5% 3.2% 71.4% Export & Multinational FEXPX 13.8% 9.8% 71.3% Canada FICDX 5.0% 3.6% 71.0% Global Strategies FDYSX 6.7% 4.3% 64.1% Select Energy FSENX 5.6% 3.5% 62.5% EMEA FEMEX 2.2% 1.3% 58.0% Source: Morningstar. Note: Three-year returns are annualized through April 2015. After-tax returns assume the highest applicable tax rate for each distribution and reinvestment of whatever’s left after taxes. Funds with losses over the period were excluded from the table. One thing that you might notice in the tables is that a handful of funds from each family have achieved excellent tax efficiency, but that their after-tax returns over the period were weaker than some of the funds that were less efficient. The starkest example of this is Vanguard Market Neutral, which let investors keep 99.3% of their gains after taxes on distributions, making it the firm’s most tax-efficient fund over the period. But unfortunately for investors, it only generated a 3.5% average gain per year while doing so. Compare that to the small-cap Explorer fund, which was one of the 10 worst funds for tax-efficiency due to a couple of big capital gains distributions, but still gained 14.2% a year after taxes, more than quadrupling Market Neutral’s return. Vanguard: Most and Least Tax-Efficient Funds Fund Symbol 3-Year Return Tax-Adjusted 3-Year Return Tax Efficiency Market Neutral VMNFX 3.5% 3.5% 99.3% Mid-Cap Growth Index VMGIX 16.6% 16.3% 98.4% Small-Cap Growth Index VISGX 15.8% 15.5% 98.2% Tax-Managed Small Cap VTMSX 16.9% 16.5% 97.6% Mid-Cap Index VIMSX 17.8% 17.4% 97.5% Extended Market Index VEXMX 17.1% 16.6% 97.2% Growth Index VIGRX 16.4% 15.9% 97.2% FTSE Social Index VFTSX 19.2% 18.7% 97.2% Small-Cap Index NAESX 17.1% 16.6% 96.8% Tax-Managed Capital Appreciation VTCLX 17.0% 16.3% 96.3% Explorer VEXPX 16.8% 14.2% 84.4% Wellington VWELX 12.0% 10.1% 84.4% Global ex-U.S. Real Estate Index VGXRX 12.2% 10.2% 84.0% Capital Value VCVLX 20.0% 16.7% 83.4% LifeStrategy Conservative Growth VSCGX 7.4% 6.2% 83.2% Mid-Cap Growth VMGRX 15.7% 12.9% 82.1% Emerging Markets Stock Index VEIEX 3.5% 2.6% 74.6% Managed Payout VPGDX 9.4% 6.9% 73.5% Convertible Securities VCVSX 10.9% 7.9% 72.9% Energy VGENX 3.2% 1.8% 58.2% Source: Morningstar. Note: Three-year returns are annualized through April 2015. After-tax returns assume the highest applicable tax rate for each distribution and reinvestment of whatever’s left after taxes. Funds with losses over the period were excluded from the table. You might also notice that there are no funds with negative returns listed. This is not because there weren’t any funds from the two firms that lost money over the period. (At Fidelity, three stockA financial instrument giving the holder a proportion of the ownership and earnings of a company. funds were in negative territory over the three years through April: Global Commodity Stock, Latin America and Select Gold; while there was one from Vanguard: Precious Metals and Mining.) We left these funds off of the list because investors had nothing to show at the end of the period, even though in every case they were stuck paying taxes on distributions, which resulted in negative tax efficiency. (A fund can also have negative tax efficiency if it has a positive pre-tax return that becomes a loss after taxes, though this did not happen at either fund family over the period covered in this update.) Looking at the tax efficiency of both family’s stock funds over the last three years, on the whole, investors have not lost too much to taxes. Nearly 40% of the Fidelity funds we included in our calculations (62 of 168) had a tax efficiency of 90% or better, while more than 60% of Vanguard’s funds (49 of 82) surpassed that mark. Not bad, especially as gains accumulated during the markets’ sustained bull run since the market bottomed in March 2009 have largely been realized and the funds have fewer losses on the books with which to offset them. If you own a fund not included in either of these tables and would like to see its after-tax returns, both Fidelity and Vanguard publish this information on their websites for a handful of different periods. You can find the information by going to an individual fund’s “performance” page—both firms show after-tax returns before and after the sale of shares. To calculate tax efficiency, simply divide the after-tax return by the pre-tax return for a given period. Tax efficiency is important, but it is just one consideration of many we use when selecting funds and managers to invest with. After a long period of gains, you may owe (or have paid) a sizeable amount in taxes, but in our experience, most investors are happier with more money in their pockets after taxes than holding onto tax-efficient investments that leave them with less. e about our 401(k) planA 401(k) plan is a retirement account that a company sets up on behalf of its employees. Both the participant and the employer can contribute to the account. There are two types of 401(k)s, traditional and Roth. Income invested in traditional 401(k)s isn’t taxed while it’s invested, but is taxed when it’s withdrawn. Income invested in a Roth 401(k) is taxed before it’s invested, but no tax is paid when it is withdrawn. construction, please feel free to contact us at (800) 492-6868. We also regularly helps clients build portfolios within their existing retirement plans to match their investment objectives. About Adviser Investments Adviser Investments is a full service wealth management firm, offering investment management, financial and tax planning, managed individual bond portfolios, and 401(k) advisory services. We’ve been helping individuals, trustsA legal document that functions as an instruction manual to how you want your money managed and spent in your later years as well as how your assets should be distributed after your death. Assets placed in a trust are generally safe from creditors and can be sold by the trustee in short order, avoiding the lengthy and costly probate process., institutions and foundations since 1994, and have more than 3,500 clients across the country and over $6 billion in assets under management. Our portfolios encompass actively managed funds, ETFsA type of security which allows investors to indirectly invest in an underlying basket of financial instruments (these may include stocks, bonds, commodities or other types of instruments). Shares in an ETF are publicly traded on an exchange, and the price of an ETF’s shares will fluctuate throughout the trading day (traditional mutual funds trade only once a day). For example, one popular ETF tracks the companies in the S&P 500, so buying a share of the ETF gets an investor exposure to all 500 companies in the index., socially responsible investments and tactical asset allocation strategies, with particular expertise in Fidelity and Vanguard mutual funds. We take pride in being The Adviser You Can Talk To. Our minimum account size is $350,000. To see a full list of our awards and recognitions, click here, and for more information, please visit www.adviserinvestments.com or call 800-492-6868. Disclaimer: This material is distributed for informational purposes only. The investment ideas and expressions of opinion may contain certain forward-looking statements and should not be viewed as recommendations, personal investment advice or considered an offer to buy or sell specific securities. Data and statistics contained in this report are obtained from what we believe to be reliable sources; however, their accuracy, completeness or reliability cannot be guaranteed. Our statements and opinions are subject to change without notice and should be considered only as part of a diversified portfolio. You may request a free copy of the firm’s Form ADV Part 2, which describes, among other items, risk factors, strategies, affiliations, services offered and fees charged. Past performance is not an indication of future returns. The tax information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. We do not provide legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation. The Barron’s rankings consider factors such as assets under management, revenue produced for the firm, regulatory record, quality of practice and philanthropic work. 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