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This Fine Fund Takes a Belt-and-Suspenders Approach to Tax Management

Gold-rated Vanguard Tax-Managed Capital Appreciation effectively diversifies risk while taking a prudent approach to improving tax efficiency.

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Vanguard Tax-Managed Capital Appreciation is an excellent choice for tax-efficient exposure to large- and mid-cap U.S. stocks. The fund's low fee, broad diversification, and effective tax management underpin its Morningstar Analyst Rating of Gold.

The fund seeks to track the Russell 1000 Index while minimizing the tax consequences. To manage taxes, portfolio managers underweight stocks with higher-than-average dividend yields and harvest capital losses to offset realized capital gains. Because dividend payments are taxed when they are distributed, a lower dividend yield reduces investors' tax bills. But this lower yield tilt could modestly hinder performance when dividend stocks are in favor.

Although the managers have discretion around their use of tax-management strategies, they are constrained by strict tracking-error limits to the Russell 1000 Index. Consequently, the fund looks a lot like this benchmark, though it does carry a slightly lower dividend yield. This is as far as the fund strays from the index. During the past decade through February 2019, this fund's tracking error with the Russell 1000 Index measured less than 0.5%. The fund's sector allocations have been consistently within plus/minus 1% of the benchmark's. Individual stock weightings line up with those of the Russell 1000 Index.

So far, the fund has tightly tracked the Russell 1000 Index in a tax-efficient manner. It has not distributed a capital gain since its inception in 2001. Its post-tax returns ranked in the top decile of the large-cap blend Morningstar Category during the past decade through February 2019. On a pretax basis, the fund outpaced its average large-blend category peer by 1.6 percentage points annually with similar risk over the same period. Much of this relative outperformance can be attributed to the fund's sizable fee advantage. The fund’s tax-loss harvesting strategy may not be able to completely offset capital gains if it experiences large net outflows after a market runup, since managers must sell positions to meet fundholders' redemptions.

Process Pillar: Positive | Adam McCullough, CFA 03/26/2019
This fund effectively diversifies risk while taking a prudent approach to improving tax efficiency. It earns a Positive Process Pillar rating.

The fund tracks the broadly diversified, market-cap-weighted Russell 1000 Index in a tax-efficient manner. To accomplish this goal, the managers sample the index using an optimization framework that aims to reduce taxable dividends and capital gains while limiting tracking error to the index. Given the tax-minimization mandate, the managers can deviate more from the benchmark than a pure index fund, but only to a small degree. To reduce tax consequences, the fund employs two strategies: investing in stocks that pay lower dividends within the index and harvesting available tax losses to offset realized capital gains.

Lower dividend payments increase the tax efficiency of the fund because these payments create an immediate taxable event, unlike capital gains, which the managers can defer or offset. To minimize capital gains distributions, the fund sells its highest-cost-basis shares first. This helps the fund minimize realized capital gains and accumulate capital losses it can use to offset gains. Although the managers have discretion around their use of tax-management strategies, they are constrained by strict tracking-error limits to the Russell 1000 Index.

The fund's tilt away from high-dividend-paying stocks is evident in its lower dividend yield, which averaged 20 to 30 basis points below the Russell 1000 Index's during the past decade through February 2019. This is the biggest difference between the fund and its index. Its sector allocations have been consistently within 1 percentage point of the benchmark's sector allocations. At the end of February 2019, more than 99% of the fund's portfolio overlapped with that of the Russell 1000 Index.

Broad market-cap-weighted funds tend to have low turnover rates, and this fund is no exception. Over the past decade through February 2019, its turnover measured a small fraction of its average category peer. Low turnover promotes tax efficiency because managers do not frequently buy and sell stocks that can generate capital gains. The fund has not distributed a capital gain since the its inception, but its potential capital gains exposure is near 60%. This is a natural byproduct of tax-loss harvesting. Unrealized capital gains build over time as they are deferred and not recognized. The fund's portfolio managers use index derivatives to keep it fully invested and manage redemptions. This small cash drag helps performance during bull markets but can hurt it during bear markets.

Performance Pillar: Positive | Adam McCullough, CFA 03/26/2019
The fund has generated attractive returns--before and after taxes--compared with its category peers while closely tracking its benchmark. It earns a Positive Performance Pillar rating.

During the past decade through February 2019, the fund’s returns bested the large-blend category's average return by 1.6 percentage points with similar risk. Its aftertax performance looks even better. Since its inception in 2001, this fund hasn't distributed a capital gain. The fund's post-tax annualized return ranked in the top decile of the category over the past decade through February 2019. Applying the highest marginal tax bracket, the fund's 10-year annualized post-tax return outpaced the average large-blend fund by 1.9 percentage points. The annualized tax-cost ratio, a measure of the portion of the fund's returns forgone to taxes, measured 0.8 percentage points lower than the average fund in the category over the same period.

A sizable cost advantage and low cash drag have helped the fund post strong returns. Given the tight fund constraints, sector and security selection do not move the needle. The fund's tracking error with the Russell 1000 Index measured 0.4% over the past decade through February 2019, so its portfolio managers have also delivered on its index-tracking mandate.

People Pillar: Positive | Adam McCullough, CFA 03/26/2019
A well-equipped group manages all of Vanguard's equity index funds. The team's extensive experience, deep bench of talent, and strong trading infrastructure underpin this fund's Positive People Pillar rating.

Donald Butler and William Coleman replaced Michael Buek as the named managers on the fund in April 2016. Buek, a veteran Vanguard manager, remains a co-head of the equity index group and trading teams. Vanguard occasionally rotates managers across its equity index funds to broaden portfolio managers' skill sets. Butler is a principal of Vanguard, has been with the firm since 1992, and has managed investment portfolios since 1997. Coleman joined Vanguard in 2006 and became a listed portfolio manager in 2013. In addition to comanaging this fund, he is a listed portfolio manager on Vanguard STAR (VGSTX), the Vanguard Target Retirement series of funds, and several small-cap index funds.

Vanguard links the managers' compensation to index-tracking performance, which aligns their interests with investors'. Minimizing tracking error is their primary objective, while keeping transaction costs down and tax efficiency are secondary goals. Vanguard has automated much of this process and provides the managers with robust tools to handle flows, corporate actions, and benchmark changes.

Parent Pillar: Positive | 06/05/2018
The Vanguard Group is the world's biggest provider of open-end funds and its second-biggest provider of exchange-traded funds. Innovative and iconoclastic from its mid-1970s origins, the firm's mutual ownership structure, commitment to low fees, and sensible active and passive investment strategies are hallmarks that support its Positive Parent rating.

Vanguard is committed to serving all investors, not just its own. Indeed, the firm celebrates when its entry into an asset class prompts rivals to lower their fees to remain competitive, as occurred when Vanguard launched index funds in London in 2009 and factor-based strategies in the United States in early 2018.

New CEO Tim Buckley, Vanguard's fourth, faces the challenge of expanding the firm's mission to non-U.S. investors, who currently account for less than a tenth of the firm's $5 trillion in global assets under management. He must also navigate the tension between Vanguard's burgeoning discretionary asset-management business, Personal Advisor Services, and financial advisors who may feel threatened by the firm's efforts to lower the cost of investment advice. Perhaps Vanguard's greatest challenge, though, will be keeping pace with its own growth, especially in overcoming the service problems that have bedeviled the firm the past few years. Vanguard's 2017 implementation of client-experience testing labs should help the firm improve there, too.

Price Pillar: Positive | Adam McCullough, CFA 03/26/2019
This is among the cheapest market-cap-weighted large-cap blend funds available, which supports its Positive Price Pillar rating.

Vanguard charges 0.09% for the fund's Admiral share class, which carries a $10,000 minimum initial investment. The Institutional share class levies an annual fee of 0.06% and may be available to investors through select 401(k) platforms. Vanguard Russell 1000 ETF (VONE) is an exchange-traded fund that tracks the Russell 1000 Index. The ETF structure allows the same tax benefits that this fund offers without reducing dividend yield, but Vanguard charges 0.12%.


Adam McCullough does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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