Build a Tax-Smart Fund Portfolio

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Build a Tax-Smart Fund Portfolio
by James D. Peterson, Ph.D., Vice President, Investment Manager Research, Schwab Center for Financial Research
Updated April 20, 2009

Most investors are aware of the many marvels of mutual fund investing—professional management, comparatively low costs and portfolio diversification, to name just a few. And if you have a relatively small amount of money to invest but still wish to participate in the stock market, mutual funds can be a great way to get started investing.

However, one of the downsides of mutual fund investing can be taxes. When you own individual stocks, only you decide when to sell them—and when to take any taxable capital gains. But with a mutual fund, you can wind up paying taxes on fund distributions, even if you don't sell shares.

The good news is that there are strategies for building a fund portfolio that reduce the tax bite—potentially boosting long-term returns. Here, I'll examine how the investment process changes when your funds are held in a taxable account.

It still starts with asset allocation
Regardless of tax status, the foundation of any investor's portfolio should be asset allocation—the mix and proportion of large- and small-cap U.S. stocks, international stocks, bonds and cash. Your allocation determines the overall risk level of your portfolio (which should match your risk profile), so establishing the proper allocation is the first step in constructing a diversified portfolio.

However, in the next step of the process—actually picking which mutual funds to purchase—things change. In choosing funds to buy in a taxable account, our research shows that you'd be wise to pay heed to both the fund's tax cost ratio and its after-tax returns.¹

Tax cost ratio
The tax cost ratio represents the percentage-point reduction in returns resulting from federal income taxes—before shares are sold, and assuming the highest federal tax bracket. For example, a fund with a 10% pretax return where taxes reduce the return to 9% has a tax cost ratio of approximately 1%. Tax cost ratio is our preferred measure of tax efficiency. Generally speaking, you want to focus on tax cost ratios measured over longer time periods—preferably at least three years.

You can find a fund's tax cost ratio by logging in to Schwab.com and going to Quotes & Research > Mutual Funds. Then, just enter a fund's ticker symbol into the box and click on the Risk & Tax Analysis tab. You'll find the tax cost ratios for one, five and 10 years, along with the respective category averages, in the box in the upper left corner.

Don't fall into the "tax efficiency" trap
However, some investors get so caught up in finding tax-efficient funds that they lose sight of what really matters: after-tax returns. The illustration "It's not what you make, but what you keep" provides an example of how this works: Fund B clearly is a more tax-efficient fund, with a tax cost ratio of less than 1%. But Fund A actually provides a higher after-tax return—and the ultimate objective is to take home the most money after good old Uncle Sam has taken his share.

It's not what you make, but what you keep
Fund	Tax cost ratio	Pretax return	After-tax return
A	2.7%	15%	12%
B	0.9%	10%	9%

Tax cost ratio compounded on an annual basis.

When picking a mutual fund, compare its tax cost ratio to its category average—ideally a fund's ratio will fall below the category average. But remember to consider all of the factors that can influence after-tax returns—the manager's track record, pretax performance, expenses, etc.—and not just tax efficiency. After all, some funds can have a low tax cost ratio simply by losing money every year!

Tip: Avoid funds with recent large net redemptions. When investors sell fund shares, fund managers typically generate the cash they need to meet the redemptions by selling off their highest-cost-basis stock. This lowers immediate gains, leaving the fund exposed to ever-widening capital gains—which are then picked up by the remaining shareholders.

Munis or taxable bonds?
For the fixed income portion of your asset allocation, you'll want to first determine if you're in a high enough federal income tax bracket to potentially benefit from choosing municipal bonds over taxable bonds.

If you live in a high-tax state, you might want to consider a state-specific muni-bond fund, which would be exempt from both federal and state income tax. However, if you're subject to the alternative minimum tax (AMT), beware of funds that invest in private-activity muni bonds, whose interest is subject to the AMT.

Tip: Beware of making year-end purchases. If it's late in the year (November or December), it's best to check mutual fund company websites for information about that year's estimated capital gains distributions. Fund managers who know that they're going to distribute a lot of gains will often disclose this information in advance—and if they do, consider waiting to buy until after the fund has paid the distribution. Otherwise, you'll owe taxes on the whole distribution—without having benefitted from any of the gains!

A Tax-Efficient Portfolio With Moderate Risk

Constructing a portfolio of funds
The pie chart above shows a hypothetical portfolio as an example of a highly taxed investor with moderate risk tolerance, using funds from Schwab's first-quarter 2009 Mutual Fund OneSource Select List®. When Schwab picks funds for the Select List, taxes aren't the primary consideration. But for this exercise, we chose funds with a five-year tax cost ratio below their category average—though not always the lowest tax cost ratio in their category. See the table below for more details on the eight funds you might consider for taxable accounts.

Great funds to consider for taxable accounts
Category	Fund (Ticker)	Percentage of portfolio*	Five-year tax cost ratio	Category average tax cost ratio
Large Blend	Schwab Core Equity (SWANX)	15%	0.39%	0.86%
Large Growth	American Century Growth Inv (TWCGX)	10%	0.08%	0.38%
Large Value	Schwab Dividend Equity Fund Inv (SWDIX)	10%	0.90%	1.24%
Small Value	Northern Small Cap Value (NOSGX)	5%	1.30%	1.71%
Small Growth	TCW Small Cap Growth N (TGSNX)	5%	0.00%	0.94%
Foreign Large Blend	SSgA International Stock Selection (SSAIX)	15%	0.92%	1.16%
Muni National Interm	American Century Tax-Free Bond (TWTIX)	18%	0.00%	0.03%
Muni National Interm	Federated Intermediate Municipal (FIMTX)	17%	0.00%	0.03%

		Annualized after-tax total returns
		One-year	Five-year	10-year
Large Blend	Schwab Core Equity (SWANX)	-38.92%	-3.70%	-1.63%
Large Growth	American Century Growth Inv (TWCGX)	-33.72%	-2.68%	-3.36%
Large Value	Schwab Dividend Equity Fund Inv (SWDIX)	-33.22%	-2.39%	N/A
Small Value	Northern Small Cap Value (NOSGX)	-35.51%	-3.28%	5.57%
Small Growth	TCW Small Cap Growth N (TGSNX)	-31.03%	-1.89%	-3.86%
Foreign Large Blend	SSgA International Stock Selection (SSAIX)	-46.52%	-1.47%	0.29%
Muni National Interm	American Century Tax-Free Bond (TWTIX)	1.61%	2.86%	4.16%
Muni National Interm	Federated Intermediate Municipal (FIMTX)	1.76%	1.67%	3.16%

Data from Morningstar, Inc.; tax cost ratio data as of February 28, 2009; return data as of February 28, 2009. After-tax returns are calculated using the historical highest individual federal marginal income tax rates and do not reflect state and local taxes or AMT. Actual returns may differ from those shown. Performance data quoted represents past performance and does not indicate future results. Current performance may be lower or higher than the stated performance. Visit Schwab.com for month-end performance information. *Remaining 5% allocated to cash.

Why? Some funds may have a low tax cost ratio because of tax-loss carryforwards (associated with poor past performance), and not because they truly invest in a tax-efficient way. For this reason, we also considered the fund's investment strategy. Generally speaking, for taxable portfolios we prefer managers who invest with a longer-term horizon—which typically results in lower turnover.

When putting together the portfolio, we also tried to achieve a balance between value and growth. We didn't include equity income funds, because we find such funds tend to be tax-inefficient. The muni funds we included are exempt from federal taxes and don't currently invest in bonds with interest subject to the AMT. However, investors who live in high-tax states may wish to consider state-specific funds, which may be exempt from state and federal taxes.

Tip: Think location. If you have both taxable and tax-advantaged accounts, hold tax-efficient equities in taxable accounts, and hold less-tax-efficient equities and taxable bonds in tax-advantaged accounts—within the context of your overall asset allocation.

Rebalancing
Tax-smart portfolio management doesn't stop once a portfolio is created—it's also important to monitor on an ongoing basis. Consider selling a fund if there's been a change in management, organization or strategy, or if you foresee a significant deterioration in the fund's prospects.

As a rule of thumb, we recommend rebalancing your portfolio once a year—actually, 12 months and a day for taxable accounts, so any capital gains accrued will be classified as long-term. Here are other tax-saving tips to remember when rebalancing a taxable account:

Direct new money into underweighted asset classes to avoid generating rebalancing trades.
When sensible, execute trades generating tax losses that could then be used to offset any capital gains.
Whenever possible, be patient and wait until you're eligible for long-term capital gains treatment.
If taxable and tax-deferred accounts are both allocated toward the same goal, have the tax-deferred account bear as much of the rebalancing load as possible.

The bottom line
If you're planning to buy mutual funds for taxable accounts, we think you want to focus on the factors influencing after-tax returns. To start with a list of funds Schwab believes will outperform their peers on a pretax basis, log in to the Schwab Mutual Fund OneSource Select List at Schwab.com/selectlist.

Once you've found funds that fit your portfolio needs, consider factors that influence after-tax returns, such as the tax cost ratio and the tax efficiency of the fund's investment strategy. And if you don't have the time, desire or expertise to construct, monitor and rebalance a portfolio of mutual funds for a taxable account, a Schwab consultant can help.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

The current and future portfolio holdings contained in a mutual fund is subject to risk you should be aware of prior to making an investment decision. Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost. See Schwab.com for more recent performance.

1. Source: James D. Peterson, Paul Pietranico, Mark W. Riepe and Fran Xu, 2002, "Explaining the After-Tax Performance of Equity Mutual Funds," Financial Analysts Journal 58(1), 1975–1986.

Approximately 2,100 funds participate in the Mutual Fund OneSource® service. Only these funds, including Schwab Affiliate Funds, are eligible for the Mutual Fund OneSource Select List. Schwab receives remuneration from fund companies, and/or their affiliates, in the Mutual Fund OneSource service for recordkeeping, shareholder services and other administrative services.

After-tax returns are calculated using the historical highest individual federal marginal income tax rates and do not reflect the impact of state and local taxes or the alternative minimum tax (AMT). Actual returns depend on an investor's situation and may differ from those shown. After-tax returns may not be relevant to investors who hold their fund shares through tax-deferred arrangements. The after-tax performance figures provided may vary from the after-tax performance figures provided by other sources if those figures include certain additional tax credits.

The aggregate fees Schwab or its affiliates receive from Schwab Affiliate Funds (see fund prospectuses for more details) are greater than the remuneration Schwab receives from fund companies participating in Schwab's Mutual Fund OneSource service.

A bond fund's Net Asset Value will fluctuate with the price of the underlying bonds and portfolio turnover activity. Return of principal is not guaranteed. Bond fund shares are subject to increased loss of principal during periods of increasing interest rates.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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