Tag Archives: vanguard

Tax Efficiency: A Decisive Advantage For Some Index Stock Funds

Key highlights “Tax cost”-the difference between the before-tax return of a fund and its preliquidation after-tax return-is a way to gauge a fund’s tax efficiency. Vanguard analysis found that, for the 15 years ended November 30, 2015, the median tax cost of domestic actively managed stock funds was 27 basis points higher than that of domestic index stock funds. Some index stock funds can be tax-inefficient as well, especially those that seek to track more narrowly focused benchmarks, such as those in the mid- and small-capitalization markets. Broad-market index stock funds and ETFs may be more tax-efficient than actively managed stock funds and ETFs. Just as some ways of managing investments are more tax-efficient than others, certain types of investments are, by their nature, more tax-efficient as well. What makes one mutual fund more tax-efficient than another? Some relevant factors include a portfolio’s management strategy, the turnover or trading strategy, the accounting methodology used, and the activity of the fund’s investors. “One way that a fund’s tax efficiency can be measured is with its ‘tax cost,’ ” said Scott Donaldson of Vanguard Investment Strategy Group. “Tax cost refers to the before-tax return of a fund minus its preliquidation after-tax return. It represents a very high hurdle for active fund managers to overcome, in addition to their ongoing fund management expenses.” The illustration below shows a decisive tax advantage for index stock funds: The median tax cost for index stock funds (left side, green) was 71 basis points, whereas the median tax cost for actively managed stock funds (right side, green) was 98 basis points. Thus, for the funds in the data set, the median tax cost of domestic actively managed stock funds was 27 basis points higher than that of domestic index stock funds. The gap can be even larger: Note the 295 basis-point difference between the worst tax costs (shown in blue) of domestic actively managed and index stock funds. Moreover, the chart shows a much narrower range in tax cost in the index category. Why index stock funds may have the upper hand Because active managers make decisions based on a security’s potential to outperform, they can be more inclined to make specific, concentrated purchases in fewer stocks and to liquidate entire holdings more often than managers of broad-market index stock funds would. In making wholesale liquidations, active managers can be much more likely to realize capital gains, since an entire position’s gain could be realized at once. The tax efficiency of actively managed stock funds could, therefore, be much less stable, and the lack of depth and breadth of share lots in actively managed stock funds could negatively affect their future tax efficiency. Actively managed stock funds also have the potential for manager changes, resulting in new managers completely restructuring the portfolio, which could cause realization of gains from past investment success. Granted, some index stock funds can be tax-inefficient as well (see chart above). For example, stock funds that seek to track more narrowly focused benchmarks, such as those in the mid- and small-capitalization markets, fall into the bottom quartile in Vanguard’s tax-cost analysis. “Much more broadly based index stock funds will typically be more tax-efficient because they change their holdings less often,” Donaldson said. “Moreover, not all ETFs or conventional index stock funds are the same. Even stock funds that seek to track the same index can have different performance. The bottom line is, while Vanguard believes it’s much more important to manage the overall allocation of assets in your portfolio than it is to manage exclusively for taxes, your portfolio’s tax efficiency is important to take into account.” Aside from choosing stock funds that are more tax-efficient, investors can also engage in other best practices to minimize their taxes: Use tax-advantaged accounts. Maximize the use of tax-advantaged accounts, such as 401(k) plans and IRAs (both traditional and Roth) and 529 college savings plans. Be a tax-efficient investor. Use tax-advantaged accounts to rebalance an asset allocation or to sell appreciated positions that may provide better after-tax returns than completing similar transactions in a taxable account. Pay attention to asset location. Purchase tax-efficient investments in taxable accounts and tax-inefficient investments in tax-advantaged accounts, which can help you keep additional returns. Those incremental differences can have a powerful compounding effect over the long run. Notes: All investing is subject to risk, including the possible loss of the money you invest. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. We recommend you consult an independent tax advisor for specific advice about your individual situation. Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Looking For Value From Vanguard

My article last week looked at the long-term benefits to holding a diversified portfolio that included a tilt to large cap and small cap value stocks globally. To illustrate the results, I used the structured asset class mutual funds from Dimensional Fund Advisors (DFA) as my proxies for the value stock categories, unlike the market indexes, where I substituted Vanguard index funds. Why not use Vanguard results across the board? Vanguard has an obvious expense ratio advantage over DFA and just about everyone else, and investors have voted with their wallets – Vanguard has more assets than any other mutual fund company. The issue is, when you look to Vanguard for value, they either don’t measure up or don’t even offer strategies for a given asset class. Take a look at the table below. FUND/Index 3/1993-12/2015 6/1998-12/2015 1/1995-12/2015 DFA US Large Cap Value fund (MUTF: DFLVX ) +9.8% Vanguard S&P 500 fund (MUTF: VFINX ) +9.0% Vanguard Value Index (MUTF: VIVAX ) +8.8% DFA US Small Value fund (MUTF: DFSVX ) +9.1% DFA US Small Cap fund (MUTF: DFSTX ) +8.5% Vanguard Small Value Index (MUTF: VISVX ) +8.1% DFA Int’l Value fund (MUTF: DFIVX ) +6.0% MSCI EAFE Index +4.7% MSCI EAFE Value Index +5.3% DFA Int’l Small Value fund (MUTF: DISVX ) +7.4% MSCI EAFE Small Cap Value Index +7.0% Vanguard manages index funds in the US covering large and small value stocks. But they don’t capture as much of the value “premium” as the asset class funds from DFA do. Since 1993 (DFLVX inception), the DFA US Large Value fund outpaced the Vanguard Value Index (net of a higher expense ratio) by 1% per year. Since 1998 (VISVX inception), the DFA US Small Value fund outpaced the Vanguard Small Value Index (net of a higher expense ratio), again by 1% per year. Surprisingly, the Vanguard value funds even underperformed the S&P 500 and small cap “market” funds, despite the fact that these “neutral” (holding both growth and value) funds obviously have less exposure to value stocks than the Vanguard value indexes. This should dispel any myth that the Vanguard underperformance is due solely to “less exposure to the value factor.” Things get considerably more challenging with Vanguard once we leave the US market. Vanguard doesn’t offer an index fund that buys international large value stocks or small value stocks. You’re stuck with a plain-vanilla market index like the MSCI EAFE. The chart above finds, since 1995 (DISVX inception), the DFA Int’l Value fund bested the EAFE Index (before expenses associated with an actual index fund that buys EAFE stocks) by 1.3% per year. The DFA Int’l Small Value fund did 2.7% per year better. Clearly, there’s a significant cost (return drag) to investing only in international market indexes that doesn’t show up in simplistic expense ratio comparisons. But what if Vanguard did offer large and small value indexes in foreign markets? Would they be worth a look? Here I’ve reproduced the returns on a likely index provider – the MSCI EAFE Value and EAFE Small Value Indexes – for comparison purposes ( source: DFA ReturnsWeb ). These indexes don’t have any fees, and any index fund or ETF that tracks them would likely trail the index return by 0.2% to 0.3% or so. Even still, the apples (net of fee DFA fund return) to oranges (gross of fee index returns) comparison shows a clear advantage to DFA : The DFA Int’l Value fund did +0.7% per year better than the EAFE Value Index while the DFA Int’l Small Value fund did +0.4% per year better than the EAFE Small Value Index. The lack of value stock indexes from Vanguard in non-US markets isn’t just a return issue, either. Large and small foreign value stocks also have lower correlations to US asset classes and have provided an additional diversification benefit. What accounts for these significant net-of-fee differences that are consistent across geographical regions over meaningfully long periods of time? First, as previously mentioned, DFA does hold a deeper subset of the lowest-priced value stocks, about the cheapest 30% compared to the cheapest 50% for Vanguard. And the small cap funds hold almost purely small and micro cap stocks compared to small and mid cap stocks for Vanguard. DFA screens out stocks with low-to-negative profitability and when buying and selling, they do so patiently throughout the year, hanging on to companies with positive momentum while waiting to buy stocks with the strongest negative momentum. And, finally, DFA is a more active security lender, earning a few more basis points on average from lending out stocks overnight and earning a return (that gets credited back to the fund) for doing so. All of this adds up to much purer asset class exposure with noticeably better long-term returns that is not isolated to just one area of the market. I like Vanguard . T hey’ve done a good job of educating investors on the importance of broad diversification and minimizing fees. But given the option, in the crucial asset classes that belong in a “core” diversified portfolio*, I just don’t see the value in using Vanguard. *I would add that the DFA US Large Cap Equity fund (MUTF: DUSQX ) and DFA Five-Year Global fund (MUTF: DFGBX ), which cover the other two core asset classes not discussed in this article, represent superior options to the Vanguard S&P 500 fund and the Vanguard Short-term Bond Index fund as well, but the reasons are beyond the scope of this article. Past performance is not a guarantee of future results. Mutual fund performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services. Disclosure: I am/we are long DUSQX, DFLVX, DFSVX, DFIVX, DISVX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

To Be (The Market) Or Not To Be?

Key highlights After significant losses by large-capitalization and growth stocks during the 2000-2002 bear market, investors have become increasingly interested in non-market-cap index-weighting strategies that intentionally divorce a security’s index weighting from its price. Such rules-based alternatives to market-cap-weighted indexes include strategies labeled alternative indexing, fundamental indexing or, more commonly used, smart beta. Vanguard believes strongly that, by definition, smart beta indexes should be considered rules-based active strategies because their methodologies tend to generate meaningful security-level deviations, or tracking error, compared with a broad market-cap index. Our research shows that such strategies’ “excess return” can be partly (and in some cases largely) explained by time-varying exposures to various risk factors, such as size and style. Place “the market” in front of a mirror and what would you see? A perfect reflection of that market-same size and shape, nothing added, nothing taken away. If you wanted the reflection to show something different from the market-something better?-you’d need to place something different in front of the mirror. That’s the puzzle of smart beta, whose providers often suggest that they’re “like the market,” only better. If you’re looking to get different returns from, for example, the U.K. stock market, “you have to look different in some way, shape, or form,” said Don Bennyhoff, senior investment analyst in Vanguard Investment Strategy Group. “The first thing smart beta providers do is modify what the market looks like, based on their own active choices and biases.” Recent research by Bennyhoff and his colleagues Christopher Philips, Fran Kinniry, Todd Schlanger, and Paul Chin found that the rules-based methodologies employed by alternatives to market-cap-weighted indexes tend to generate meaningful tracking error compared with broad market-cap indexes. The methodologies may weight securities differently from their market-cap weighting. Or they may exclude securities that feature in a benchmark and include securities that aren’t part of the benchmark. “In our opinion,” Bennyhoff said, “these rules-based strategies are active, which means they’re not asset-class beta or ‘the market’ in the traditional sense.” The sources of outperformance “These strategies tend to result in portfolios that emphasize smaller-cap or value stocks, which have performed very well since the early 2000s,” Bennyhoff said. “So the question is, ‘Are these higher returns the result of higher risks?’ There is rigorous debate about that topic. But when we look at risk-adjusted returns, the excess return tends to go away, and maybe that’s a meaningful finding.” Moreover, as the figure below shows, smart beta strategies’ exposures to risk factors change over time. Non-market-cap-weighted strategies’ exposures to risk factors are time-varying 60-month rolling style and size exposure of alternative index versus broad developed-equity market, 1999-2014 Source: Illustration by Vanguard, based on data from MSCI, FTSE, S&P Dow Jones Indices, and Thomson Reuters Datastream. Figure displays 60-month rolling inferred benchmark weights resulting from tracking error minimization for each index across size and style indexes. Factors are represented by the following benchmarks: fundamental-weighted-FTSE RAFI Developed 1000 Index; equal-weighted-MSCI World Equal Weighted Index; GDP-weighted-MSCI World GDP Weighted Index; minimum volatility-MSCI World Minimum Volatility Index; risk-weighted-MSCI World Risk Weighted Index; dividend-weighted-STOXX Global Select Dividend 100 Index. “We’re not saying that paying attention to factors or tilting on value or small-cap is necessarily a bad thing,” Bennyhoff said. “Whether they pay off in the future as they’ve paid off in the past remains to be seen. But instead of putting together a strategy where the factor exposure is a by-product of the weighting scheme or the security-selection scheme, maybe it should be the primary focus .” And if you’re looking to capture the risk and reward of an asset class, Bennyhoff says, “the only way you can reflect that aggregate capital invested in the asset class is through market-cap weighting.” Interested in an overview of smart beta and other rules-based active strategies? Read our research brief . Notes: All investing is subject to risk, including possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.