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Fund Spy: Morningstar Medalist Edition

6 Funds for Strong Aftertax Returns in the U.S.

Hint: Tax efficiency is not the right goal.

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If you are looking for a tax-efficient fund, you can just rank by tax efficiency and be done, right? No, in reality, tax efficiency isn’t all that helpful for a couple of reasons:

1) The goal is to maximize aftertax returns, not maximize tax efficiency (setting aside risk and goals, of course). There is a big difference between the two. You can put money in shoe boxes in your closet and have great tax efficiency. But what you really want is aftertax returns. If one fund has aftertax returns of 10% annualized 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.

2) Past tax efficiency can often be the result of random accidents like when a fund was launched or how much inflows it had, but those elements of luck won’t continue into the future.

To find funds with a good shot of outperforming on an aftertax basis, I screened for Morningstar Medalist funds with below-average expense ratios, net inflows, potential capital gains exposure 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 in this article last year. Conversely, sizable inflows can water down tax bills for shareholders.

Potential capital gains exposure tells you how much built-up gains a fund has. Mutual funds report the figure once a year, and we update them monthly based on how much a fund has appreciated or depreciated. You can find it on the Tax tab of a fund’s report. For example, T. Rowe Price Health Sciences (PRHSX) has a built-up gain of 28% and  Fidelity Contrafund (FCNTX) has a PCGE of 39%. Larger potential capital gains could lead to bigger tax bills down the road. However, if a fund is an active manager of tax losses, then PCGE might not be a big problem. These funds can go on for a very long time without paying capital gains because they realize lots of losses in bear markets. Thus, my last two picks will be Medalists that meet all of these tests excluding PCGE.

Here, then, are four funds that look like good bets and passed all my screens:

 T. Rowe Price Diversified Small Cap Growth (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. Sudir Nanda’s quantitative models have run circles around the competition since he took over in 2006.

 Primecap Odyssey Growth (POGRX)
Of course I’m going to plug a Primecap fund whenever I get the chance. It runs outstanding funds, including this excellent large-growth fund. The fund is low-cost, low-turnover, and high-integrity. 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 is dull but effective. The fund’s two subadvisors run a diversified portfolio of dividend-paying stocks. Michael Reckmeyer 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 over 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.

 Vanguard Tax-Managed Capital Appreciation (VTCLX)
This fund has a 46% PCGE, but in this case it might not matter. It has never paid out capital gains, so its 6.5% annualized pretax return through January 2016 falls only to 6.09% after taxes. Dividend income accounts for the modest difference between the two figures. The fund starts with the Russell 1000 benchmark and tilts slightly away from dividend-paying stocks to reduce the tax bill. Manager Michael Buek actively harvests losses in order to avoid making any capital gains distributions, and it has worked quite well.

 Vanguard Total Stock Market Index (VTSAX)
This fund has a different benchmark from the above fund and is more constrained with regard to tax management, but its 10-year aftertax returns are nearly identical: 6.06%. Vanguard can’t harvest losses quite as easily given the tracking mandate, but it does manage stock lots so that, when it needs to sell, it avoids those with the lowest cost and generally sells at the highest cost. In addition, it can move lower-cost shares to its exchange-traded fund share class when it is in redemptions. Thus, the fund has avoided capital gains quite well. Its PCGE of 25% is smaller than its tax-managed counterpart because it has huge inflows.

For a list of the open-end funds we cover, click here.
For a list of the closed-end funds we cover, click here.
For a list of the exchange-traded funds we cover, click here.
For information on the Morningstar Analyst Ratings, click here.

Russel Kinnel has a position in the following securities mentioned above: FTABX, VTCLX. Find out about Morningstar’s editorial policies.