A tax-efficient portfolio is important for investors who have money in taxable accounts whether an advisors clients are in the preretirement accumulation phase of life, or are drawing money out of their retirement portfolios.
It behooves clients to understand the tax implications of the various asset classes in their portfolios. One place to start is to focus on two primary ingredients in nearly all portfolios: U.S. stock funds and U.S. bond funds.
Read more: Most Suspicious IRS Audit Triggers
To understand which funds offer the greatest tax efficiency for investors, I compared the five-year tax efficiency of the largest 10 funds (based on assets) in four different fund categories: large-cap, mid-cap and small-cap U.S. equity, and U.S. core bond funds. The funds that were candidates in this analysis had to have at least five years of performance as of Dec. 31, 2014.
Tax efficiency is calculated by dividing the five-year after-tax total annualized return by the five-year total annualized return. I obtained both pre- and post-tax return figures from the Lipper for Investment Management database.
After-tax performance (as calculated by Lipper) is a calculation of returns that takes into account maximum applicable tax rates and assumes all proceeds have been sold at the end of the time period specified. All sales loads were accounted for in the five-year performance results, which covered both before- and after-tax performance. Thus, the measure of tax efficiency is net of any sales loads.
A tax-efficiency score of 1.0 would indicate that the after-tax return is the same as the pretax return. A score of 0.5 would indicate that half of the gross return was lost to taxes.
The Tax Drag chart below shows the results of the analysis. One surprising finding was that tax efficiency among the largest U.S. equity funds was remarkably similar even in the mid- and small-cap categories.
Lets start with large-cap U.S. stock funds: those categorized as large-cap core, growth and value; S&P 500 index funds; and multi-cap core, growth and value. (I included multi-cap funds with large-cap funds because they are generally market-cap weighted, which leads to a distinct large-cap tilt.) The table shows the 10 biggest large-cap funds and they are huge. At the end of 2014, SPDR S&P 500 ETF Trust (SPY) held over $215 billion in net assets. (Asset totals refer to primary share class only.)
For the biggest large-cap U.S. stock funds, tax efficiency ranges from 0.76 to 0.81, with an average of 0.79. For all 965 funds in this category of large-cap and multi-cap U.S. stock funds, the average five-year tax efficiency score was essentially the same just a tad below 0.8.
The next category is mid-cap U.S. equity funds, a group that includes mid-cap growth, core and value. Average tax efficiency of the 10 largest mid-cap funds indeed, for all 255 mid-cap U.S. equity funds was also around 0.8.
For small-cap U.S. equity funds, too, the five-year tax efficiency hovered around 0.8 both for the 10 largest funds and across the 438 funds categorized as small-cap growth, core or value.
Across these three equity fund categories, tax drag reduced net returns by roughly 20% on average.
U.S. bonds, however, are a different story, as you can see from the section of the table that appears on this page.
The 168 U.S. bond funds fell into three Lipper bond fund categories:
- Core bond funds, with holdings comparable to an aggregate bond index.
- Core plus bond funds, which have added high-yield bonds or emerging-market debt but still have the bulk of their assets in core U.S. bond holdings.
- General bond funds, which do not have any quality or maturity restrictions and keep a bulk of assets in corporate and government debt issues.
No surprise here: Among the largest funds within each category, U.S. bond funds were uniformly less tax efficient than U.S. stock funds, with the 10 largest bond funds consistently showing tax efficiency in the 65% to 68% range.
Among the largest 10 bond funds, Loomis Sayles Bond Fund (LSBDX) had a five-year gross annualized return of 8.51%, well above the other nine funds; it had an after-tax return of 5.72%, for a tax efficiency rating of 0.67. Average tax efficiency for the largest 10 bond funds as well as for all 168 U.S. bond funds was also 0.67.
For investors using large, well-known U.S. equity funds, tax efficiency is not likely going to be a differentiator. Other fund characteristics, such as raw performance, expense ratio, portfolio turnover, management tenure, sales loads and correlation to the other portions of a portfolio, are likely to be more fruitful areas to examine if looking for differentiation among these types of U.S. equity and U.S. bond funds.
Advisors, should, however, monitor the tax efficiency of various funds to make the best decisions regarding asset location. Its worth noting, for instance, that at the extremes, the most-tax-efficient bond fund is more tax efficient than the least efficient U.S. stock fund. (And inside tax-deferred accounts 401(k)s, deductible IRAs and tax-exempt accounts like Roth IRAs, of course, the issue of tax efficiency is of no practical concern.)
One final note: An obvious wild card when contemplating tax efficiency is the uncertainty about what future tax rates will be and how they will be applied to the various aspects of investment returns (dividends, short-term gains, long-term gains and so on). Clearly, though, if rates increase in the future, the importance of identifying and using tax-efficient investment vehicles becomes even more important.
Craig L. Israelsen, a Financial Planning contributing writer in Springville, Utah, is an executive in residence in the personal financial planning program at the Woodbury School of Business at Utah Valley University. He is also the developer of the 7Twelve portfolio.
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