IFA's Use of Tax-Managed Funds

IFA's Use of Tax-Managed Funds

IFA's Use of Tax-Managed Funds

For investors with taxable accounts, IFA has long advised the use of tax-managed funds for the purpose of maximizing after-tax returns. Please note that this is not the same goal as minimizing taxes. The five tax-managed funds that IFA advises for our clients each cover a specific asset class that is utilized in the standard IFA Index Portfolios. The returns reported throughout IFA’s Website are for the standard IFA Index Portfolios and do not include the impact of taxes. In some years (such as 2013), the tax-managed funds have higher returns than the standard funds, and in other years (such as 2009 and the first six months of 2014), they have lower returns. Since returns are very noisy, we expect this to happen, but we also expect that, over the long-term, the tax-managed funds will produce higher after-tax returns than the corresponding standard funds. The chart below shows that this has, indeed, been the case for the past eleven calendar years.

To understand why there is sometimes a substantial difference between the returns of tax-managed and standard funds, it is important to understand how they differ in methodology. Essentially, a tax-managed fund has an additional layer of management whose purpose is to limit realized capital gains. This may result in some securities being held for a longer period than they would be held in a standard fund. Furthermore, the manager of a tax-managed fund will harvest losses whenever they are readily available. This may result in some securities being held for a shorter time period compared to a standard fund. Aside from these differences, there is a completely random element that results from the fact that tax-managed funds may receive cash inflows (or suffer cash outflows) on different days and the securities that are bought or sold on those days would depend on which companies have good liquidity for that side of the trade. To summarize, a tax-managed fund will continuously make trade-offs between tracking its targeted asset class and minimizing taxes that are passed on to shareholders as well as transaction costs that detract from returns received by shareholders. Even though Morningstar classifies tax-managed funds as actively managed, we consider them to be index funds because they still follow a rules-based approach to construction, and these rules do not change with market conditions.

To see how these differences have worked with respect to the five tax-managed funds in the first half of 2014, we used Morningstar Direct to run a performance attribution analysis of these funds vs. their non-tax-managed counterpart. Below is a summary of what we found:

  • The U.S. Large Blend category lagged by 0.48%. About half of this difference was due to the tax-managed fund not having an allocation to REITs (because they are highly tax-inefficient) and the standard fund having about a 2% allocation to it. The other half was due to lower returns received by the technology stocks in the tax-managed fund vs. the standard fund.
  • The U.S. Large Value category lagged by 1.03%. About one-third of this difference was due to lower returns received by the technology stocks in the tax-managed fund vs. the standard fund. Another one-third was due to having a lower allocation to energy stocks in the tax-managed fund, and the final one-third was due to having a higher allocation to consumer cyclical stocks.
  • The U.S. Small Blend category lagged by 0.96%. The majority of this difference was due to lower returns received by the technology stocks in the tax-managed fund vs. the standard fund.
  • The U.S. Small Value category lagged by 0.67%. The majority of this difference was due to lower returns received by the energy stocks in the tax-managed fund vs. the standard fund.
  • The International Value category lagged by 0.23%. The majority of this difference was due to lower returns received by the financial stocks in the tax-managed fund vs. the standard fund.

While the first six months of 2014 have been a rough period for the tax-managed funds, 2013 was an equally good period. Only one category (International Value) lagged its non-tax-managed counterpart (by 0.47%), and in the U.S. Large Blend category, the tax-managed fund exceeded its non-tax-managed counterpart by 1.84%.

Regardless of what happened in a six-month or a one-year period, it is our opinion that the tax-managed funds still make sense going forward. In taxable accounts, avoiding taxes is a known benefit, while the tracking error to the non-tax-managed fund is random, unknown and diminishes with time. IFA advises our clients to take full advantage of the known tax-reduction benefit.