Tax efficiency is a fine thing, but not if the price is lower returns. Profit is a dollar you can spend—unlike tax-efficiency, which you can't. That's why I've said for years it isn't tax efficiency that investors should strive for, it's after-tax returns.
And Vanguard has finally gotten the after-tax religion. In fact, Vanguard wrote that focusing on a low turnover rate as the key to fending off distributions was a "flawed" approach. So what should you focus on? Simple: how much you keep after you pay Uncle Sam.
Every year in The Independent Adviser for Vanguard Investors, I take a look at the tax-efficiency and after-tax returns of all Vanguard funds for three-year and five-year periods. Instead of showing you what's popular with the press, like low turnover ratios and low capital gains distributions, I show you what funds have given the most bang for your buck over the long term when all is said and done, including your taxes.
As you can see from just the top 5 funds over in the three-year table, the most tax-efficient funds and the best performers are completely different.
| Three-Year Tax-Efficiency and Tax-Adjusted Returns | ||||||||
| 3-Year Return |
Tax-Adj. Return |
3-Year Tax-Eff. |
3-Year Return |
Tax-Adj. Return |
3-Year Tax-Eff. |
|||
| Vanguard Growth Equity | 6.5% | 6.4% | 99.9% | Vanguard Energy | 33.2% | 32.5% | 98.0% | |
| Vanguard SmallCap Growth Idx. | 12.2% | 12.1% | 99.7% | Vanguard Emerging Mkts. Idx. | 29.2% | 28.7% | 98.4% | |
| Vanguard U.S. Growth | 6.6% | 6.5% | 99.2% | Vanguard Precious Metals | 27.8% | 26.3% | 94.5% | |
| Vanguard T-M SmallCap | 14.7% | 14.6% | 99.1% | Vanguard International Explorer | 27.4% | 25.6% | 93.4% | |
| Vanguard MidCap Index | 15.9% | 15.7% | 98.6% | Vanguard REIT Index | 25.5% | 23.7% | 92.9% | |
For the five-year period, while several of the same funds show up, the story hasn't changed: The most tax-efficient funds don't necessarily leave the most profits in your pocket after you've paid your dues.
| Five-Year Tax-Efficiency and Tax-Adjusted Returns | ||||||||
| 5-Year Return |
Tax-Adj. Return |
5-Year Tax-Eff. |
5-Year Return |
Tax-Adj. Return |
5-Year Tax-Eff. |
|||
| Vanguard SmallCap Growth Idx. | 11.3% | 11.2% | 99.7% | Vanguard Precious Metals | 34.7% | 33.2% | 95.5% | |
| Vanguard Growth Equity | 2.9% | 2.9% | 99.4% | Vanguard Emerging Mkts. Idx. | 25.8% | 25.3% | 98.4% | |
| Vanguard T-M SmallCap | 12.4% | 12.2% | 99.0% | Vanguard Energy | 25.7% | 24.9% | 96.5% | |
| Vanguard Emerging Mkts. Idx. | 25.8% | 25.3% | 98.4% | Vanguard International Explorer | 22.9% | 21.8% | 95.2% | |
| Vanguard Extended Mkt. Idx. | 11.9% | 11.7% | 98.3% | Vanguard REIT Index | 22.7% | 21.0% | 92.6% | |
You need look no further than a fund like Vanguard Growth Equity , with its 99.9% three-year tax efficiency and 99.4% five-year tax efficiency, to get the point. While the fund's shareholders weren't paying much in the way of taxes over the past five years, they also weren't earning much in the way of returns. Over five years, Growth Equity's after-tax return was second-worst only to Vanguard U.S. Growth , which both lost money and paid out a tiny bit of income. U.S. Growth ended up with negative tax efficiency.
Analysis that shows where to find strong after-tax returns is also one reason why I've told my subscribers for years now that investing in index funds is not the path to guaranteed outperformance. Just because many index funds are "tax efficient" and have low turnover doesn't mean they'll make you richer, faster, as Vanguard Extended-Market Index and Vanguard SmallCap Growth Index demonstrate.
So this distribution season, as you make decisions about how to reallocate your portfolio and what funds to buy or sell, don't let the tax tail wag the profit dog. Instead, be a tax-smart investor, and consider what you keep after you pay the tax man.
