Reel in a Few Tax-Friendly Funds
Use this screen to uncover more-tax-efficient offerings.
With the ides of April almost upon us, taxes are front-and-center in many investors' minds. Fund investors with taxable accounts must pay taxes on gains that funds distribute to them. The funds parcel out to shareholders the dividends they receive from stock and bond holdings, as well as capital gains that they earn from their holdings. To keep the tax-man at bay, you can use the Premium Screener to find some more-tax-efficient options for your portfolio. (For more ideas, check our our video report on tapping into tax-managed funds, and for your tax-deferred accounts, check out our six picks for your IRA.)
We wanted to find the funds with the best returns on a tax-adjusted basis. There are quite a few criteria to include here, so let's start by zeroing in on a fairly specific group: diversified domestic large-cap funds. Two of the key criteria are five- and 10-year aftertax returns that assume that the investor doesn't sell any shares (the menu choices are "10 Yr After Tax Return (no sale)" and "5 Yr After Tax Return (no sale)"). For each of these, we selected greater than category average. And because strong tax efficiency might be the result of tax-loss carry-forwards, where the fund can use past losses to offset future gains, we required that these funds post top-third five- and 10-year category rankings and made sure that the current manager was responsible for the record.
Because funds can generate taxable distributions by trading their holdings, we wanted to find offerings that don't trade excessively. The fund's turnover percentage indicates how often the manager trades, so a high turnover percentage indicates that there may be more gains from trades that are subject to taxes. Turnover for the average large-cap fund clocks in at 77%, so we set this screen for funds with less than 50% annual turnover.
Finally, to find the best options available to new investors, we required investment minimums of $10,000 or less, and we kept it to the most reasonably priced funds by requiring annual expense ratios of 1.00% or less. Because we're already worried about taxes eating away at returns, we don't want hefty expense ratios to make a big dent either.
The Premium Screener pulled 14 large-cap funds as of April 8, 2008. To see the full list, click here.
We'll highlight a couple of these. As its name implies, Vanguard Tax-Managed Capital Appreciation (VMCAX) is run with the aim of minimizing Uncle Sam's take. Longtime manager Michael Buek runs this large-blend fund using a sampling technique, and the resulting portfolio of stocks has a lot in common with the Russell 1000 Index. Because the fund has extremely low turnover (5% annually at last count) and because its stocks tend to generate low-dividend payments, the fund's 4.5% 10-year annualized returns after taxes beat out more than 80% of its peers'. We'd also point to the fund's 10-year tax/cost ratio of 0.21. This shows you the percentage-point reduction in annualized return that is paid out in taxes. So, over the past 10 years, shareholders in this fund lost about 0.21% of assets annually to taxes, whereas the typical large-blend fund has given up 0.95% annually.
Another example of tax efficiency is found at Homestead Value (HOVLX). Thanks to the patience of managers Stuart Teach and Peter Morris, this fund's turnover almost always stays below 20%. Teach and Morris are always on the look-out for battered stocks across the market-cap spectrum. They run a fairly compact portfolio of around 50 stocks, and they have proved that their stock-picking is on target more often than not. And in spite of holding more small-cap names and nontraditional value stocks, such as recent purchase Intel (INTC), the fund's returns haven't been more volatile than the typical peer. So, even though the fund is not explicitly dubbed "tax-managed," the low-turnover approach has certainly kept a lid on taxes over the long haul.
Keep in mind that this screen can also be run for mid- or small-cap stocks, in addition to subsets of the international-stock, taxable-bond, muni-bond, or balanced categories. We suggest that you modify the criteria for fixed-income funds, though, by eliminating the turnover criteria and setting a lower expense ratio (the Premium Screener will automatically give you the range of the cheapest quartile). And for more ideas on how to make your portfolio more tax-efficient, check out this recent article by my colleague Christopher Davis.
Morningstar.com Premium Members can run this screen themselves by clicking here. Not a Premium Member? You can still run this screen by taking a free, 14-day Premium Membership trial. (Note that the results may change as funds come in or drop out of the screen over time.)
Karin Anderson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.