Because I recommend no-load, low-expense mutual funds, I also recommend Mutual Funds Magazine (call 800-442-9000 and ask for a low-expense $9.97 “charter subscription”). The current issue (March) has a chart that compares “tax efficiency” of various funds.

The point is: it’s not what your fund earns for you before tax that matters (unless you hold it within a tax-sheltered retirement account), it’s how it grows after tax.

A fund whose gains come all from taxable interest or dividends isn’t as good, after tax, as one that grows mainly with realized and unrealized capital gains.

I like “index funds,” because of their low expenses and high tax efficiency. Index funds have high tax efficiency because they tend not to sell, and therefore not to realize gains. And sure enough, the Mutual Funds chart shows the Vanguard Index 500 with a 91% tax efficiency. That is, its after-tax return for an upper-middle-class couple is almost as great — well, 91% as great — as its pre-tax return. By comparison, Vanguard Windsor — a fine fund but with more turnover — has a rather miserable 75% efficiency.

Another fund family recommended in my book is Twentieth Century. Its Twentieth Century Ultra fund actually beat the Vanguard Index efficiency with an aftertax return of 93%. Mutual Funds suggests that the reason for this is Ultra’s low portfolio turnover. But as my savvy friend Less Antman pointed out to me upon seeing this explanation: “Baloney. Over the period examined in the article, Ultra’s portfolio turnover averaged over 90% per year. Its tax efficiency is the result of the fact that it invests in non-dividend paying growth stocks, and follows a momentum investing style, which causes it to sell losers quickly and hold winners for a long time.”

In other words, the tax losses from the losers sop up most of the realized taxable gains. At least for now. (You do have to beware of buying into a fund with tremendous unrealized gains. By doing so, you “own” the eventual tax liability for those gains, even though you didn’t realize them yourself. Then again, you can always sell before they are realized, and pass them on to the next guy.)

Don’t let the tax tail wag the investment dog. But tax efficiency is something to be aware of (although not a factor in a tax-sheltered retirement account) — and one more reason to go with low-expense index funds.

Tomorrow: A way to make Index Funds more exciting

 

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