How to pass the tax-efficient test

Feburary 12, 2018


Due to the continued strength of the bull market, your taxable clients may face capital gains in 2017. Some active funds in particular may issue large capital gains distributions. When you analyze your clients' potential tax liability as they prepare tax forms ahead of the filing deadline in April, here are some tips to consider now and going forward:

Location, location, location

We believe the best way for advisors to help their clients manage capital gains and investment income is through asset location. You can possibly add to your clients' net returns by holding the least tax-efficient investments, including some active strategies, in tax-advantaged accounts.1

The table below shows how you might improve the tax efficiency of your clients' portfolios through a strategic approach to asset location:

Strategic approach to asset location

Focus on broad-market ETFs

Active equity funds have tended to have higher portfolio turnover than index funds and, therefore, have historically distributed more capital gains.3 Moreover, net redemptions from active equity mutual funds, usually in favor of index funds, ETFs, or lower-cost actively managed options, have been a trend in investment flows in recent years.4 Outflows from high-cost active equity mutual funds continued in 2017 at about the pace of 2016, resulting in managers having to sell positions that have risen in value to meet withdrawals. And that triggers capital gains distributions.4

Focus on after-tax returns

In portfolios that deploy both passive and active strategies, a disciplined approach to both asset allocation and asset location can make a significant difference in terms of what your clients reap in net returns.

The graphic below of ten-year outcomes for four hypothetical $1 million 60% equity/40% bond portfolios shows the value of rigorous asset location to minimize the tax toll and thereby maximize after-tax returns.

Ten-year outcomes for four hypothetical $1 million 60% equity/40% bond portfolios

But while you zero in on tax efficiency, don't be too distracted by capital gains. Your clients' after-tax returns are more important. As the old axiom makes clear it's not what you earn, but what you keep. In other words, high costs can hurt more than capital gains taxes, and low costs have been a greater contributor to after-tax returns than taxes.5

Vanguard funds score highly on both fronts. While only one Vanguard equity ETF had capital gains distributions in the past six years,6 simultaneously Vanguard ETFs® are frequently among the lowest-cost funds available, period.7

For a closer look at what these characteristics mean in a portfolio, let's look at a comparison of two hypothetical portfolios, one indexed and the other actively managed.

Comparison of a two hypothetical portfolios, one indexed and the other actively managed

Test portfolio tax efficiency

The above figure shows median tax cost for a portfolio of index and active stock funds for the 15 years ended October 31, 2017. The median tax cost for the portfolio of index stock funds was 69 basis points, while the median tax cost for the actively managed portfolio of stock funds was 109 basis points. Tax cost in this example refers to the before-tax return of a fund minus its preliquidation after-tax return.

While your clients' particular allocations may vary, and while tax initiatives could affect clients in different ways, tax cost represents a very high hurdle for higher-cost active managers to overcome. But by being disciplined about crucial variables such as asset location, we believe your clients' tax liability may be reduced. In the meantime, Vanguard will keep advisors updated on potential tax reform.

To learn more about how your clients' allocations stack up from a tax efficiency perspective, please contact your Vanguard sales executive at 800-997-2798 or

1 Garrett Harbron, 2016. Help your clients with 5 tax planning tips. Valley Forge, Pa.: The Vanguard Group.

2 Scott Donaldson, 2016. Tax efficiency: A decisive advantage for some index stock funds. Valley Forge, Pa.: The Vanguard Group.

3 Morningstar, Inc., and Vanguard.

4 Christine Benz, 2017. Brace yourself for another nasty capital gains season. Morningstar, Inc.

5 Scott Donaldson, Francis Kinniry Jr., David Walker, Justin Wagner, 2015. Tax-efficient equity investing: Solutions for maximizing after-tax returns. Valley Forge, Pa.: The Vanguard Group.

6 Vanguard, 2017. Don’t let capital gains distract your clients. Valley Forge, Pa.: The Vanguard Group.

7 Eight Vanguard fixed income ETFs paid capital gains in 2016, compared with the 20 equity and fixed income BlackRock ETFs that paid capital gains of up to 26.6% of NAV. The only Vanguard equity ETF to pay capital gains taxes in 2016 was the REIT ETF, which invests only in real estate investments. As of December 31, 2016, the average expense ratio of Vanguard ETFs on an asset-weighted basis was 9 basis points, compared with 18 basis points for State Street Global Advisors ETFs and 25 basis points (the industry average) for ETFs from BlackRock (iShares).


  • We recommend that you consult a tax or financial advisor about your individual situation.
  • All investing is subject to risk, including possible loss of principal.
  • There may be other material differences between products that must be considered prior to investing.
  • Past performance is no guarantee of future results.
  • 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.


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Advisor's Digest

for March 12, 2018

Advisor's Digest for March 12, 2018

Advisor's Digest

for March 12, 2018