Tax-Efficiency: VTI vs. VBK

[moda0306]

I was thinking about a mixed-allocation investor who's got taxable, non-taxable (Roth), and tax-deferred (Traditional IRA) pots where he/she's putting their money.  If someone were in a position where they had to hold a chunk of their stocks in their taxable portfolio, I thought maybe a small-cap growth fund would supply very low dividends and still keep within the normal bounds of what we want our "prosperity asset" to do.  I noticed that the dividend yields on those two funds are VTI at 1.73% vs VBK (Small-Cap Growth) at .41%.  On the surface, it might seem wise to tilt your taxable stocks towards growth, while keeping your non-taxable or tax-deferred stocks a more traditional Total Stock Market or tilted away from small-cap.

One thing I'm not savvy enough to find, though, is the turnover of those two funds.  Is this going to eliminate my dividend advantages?  I'm sure between that and the higher fund expense ratio that I'm splitting hairs here.

This is probably more important in a high-dividend environment.

[stone]

Clive, for a UK investor, I guess it is important to try and increase the cumulative ISA value you have so that you have a tax free pot when you come to draw it down? If you pay in the full ISA allowance each year and have the ISA just having long dated gilts, then a few years down the line, the cumulative ISA holding might be less than what it would have been had the ISA contained the mix of stocks, gold and bonds and been rebalanced?

[stone]

Clive, about having all of the ISA being taken by the long term gilts portion- Isn't it possible to envisage a situation where a few years down the line, someone actually has more long term gilts in an ISA that had a mix of gilts with stocks and gold, than they would have done had  the entire ISA been long term gilts (due to better PP performance than that of a 100% long term gilt portfolio).

[dualstow]

I was thinking about a mixed-allocation investor who's got taxable, non-taxable (Roth), and tax-deferred (Traditional IRA) pots where he/she's putting their money.  If someone were in a position where they had to hold a chunk of their stocks in their taxable portfolio, I thought maybe a small-cap growth fund would supply very low dividends and still keep within the normal bounds of what we want our "prosperity asset" to do.  I noticed that the dividend yields on those two funds are VTI at 1.73% vs VBK (Small-Cap Growth) at .41%.  On the surface, it might seem wise to tilt your taxable stocks towards growth, while keeping your non-taxable or tax-deferred stocks a more traditional Total Stock Market or tilted away from small-cap.
...

I had a similar discussion in the bogleheads forum. Someone (probably David Grabiner) suggested growth in taxable and value in tax-deferred. VTI is probably still the best way to go, but for those of us who need to play, it's not a terrible idea.
My 401(K) and IRAs are small, so they're mostly full of long bonds.

1-2% dividends aren't that bad anyway, are they?

@Clive: and Harry Browne advocated investing *nothing* in real estate, right?
P.S. Why does this forum show you having only 76 posts?

[moda0306]

It appears the turnover on the Small Cap Growth Fund/ETF at vanguard is a WHOPPING 34%...

That's definitely wipes out my idea.  I thought it was a typo but it seems to be what they're saying.

[moda0306]

It's probably the leveraged nature of closely-held property transactions that gives them their ROI.  I'm not saying that's "cheating" but it's far different in nature than going into stocks/bonds.  Also, it was fed by a wealthy demographic hike  (40-50 year-old boomers buying a lake home or some hunting land) that might look a lot less likely given the demographics of today).

I guess it just comes down to the fact that real-estate speculation comes down to a lot of searching for property, leverage, and property management in one form or another, and some people are extremely good at this.

[Greg]

I currently own about 4% of my portfolio in VBK. I was looking just now at the now 40% turnover. Are there any ad-hoc formulas that are used to determine how much higher the expense ratio would "actually" be if you were to factor in the taxable nature of turning over that much of the portfolio?

For instance something like: T = E + Q*(U);

where T is the expense that is taken out of your returns each year, E is the Expense Ratio, Q is the gain or multiplicative factor (not sure what this would be, if this would be constant for most stock funds, etc. or not) and U is the yearly turnover rate.

Any thoughts?

Also on the subject of REIT, has anyone thought of keeping the ETF "REM" in their ROTH for the free-lunch aspects stated before on this forum for a high-dividend REIT as a VP play?

[moda0306]

Investor,

I like REITS in tax-deferred or Roth accounts for non homeowners, or those whose home is a very small part of their net worth.  I just don't see a huge value in stocking up on something similar to what you're most-likely leveraged into.

[Greg]

moda,

I was looking at the tax cost ratio on Fidelity of VTI (Total Stock Market), VOO (S&P 500), and VBK (Small-Cap Growth)

Here's what I found:

                          VTI                  VOO                VBK
Tax Cost Ratio:    .29                    .31                  .1
Turnover:            5%                    4%                  40%

The Tax Cost Ratio according to Fidelity is:

"The Morningstar Tax Cost Ratio measures how much a fund's annualized return is reduced by the taxes investors pay on distributions. Mutual funds regularly distribute stock dividends, bond dividends and capital gains to their shareholders. Investors then must pay taxes on those distributions during the year they were received.

Like an expense ratio, the tax cost ratio is a measure of how one factor can negatively impact performance. Also like an expense ratio, it is usually concentrated in the range of 0-5%. 0% indicates that the fund had no taxable distributions and 5% indicates that the fund was less tax efficient.

For example, if a fund had a 2% tax cost ratio (presumably a value of 2.0 as a value for tax-cost ratio above) for the three-year time period, it means that on average each year, investors in that fund lost 2% of their assets to taxes. If the fund had a three-year annualized pre-tax return of 10%, an investor in the fund took home about 8% on an after-tax basis. (Because the returns are compounded, the after-tax return is actually 7.8%.)"



Based on this, even though VBK has 8 times the turnover that VTI has, it still has less taxes that you'd pay every year on it. Does my understanding of this make sense?

[moda0306]

This is pretty good... I think you have it right.

Though, in times of bullish stock markets (sustained), I wonder if this will go up significantly with a fund that has a 40% turnover ratio... though I'd imagine a "good" fund would take that into consideration.

[Greg]

I'd agree with you that a "good" fund should take those into consideration and normally I feel Vanguard does a pretty good job about being responsible with taxes.

Ideally, having some of your portfolio in VBK would allow for a lot of capital gains and much less dividends so in conjunction with VTI, etc. could lower your effective taxes while maintaining the same exposure towards prosperity in the PP.

I'm also normally in the boat of for a $1 million dollar company, it is much easier for them to grow to a $2 million company versus a $50 million company growing to $100 million (both doubling in size).

I also keep a small percentage of my portfolio in VWO since in the long run I feel emerging markets will be the big growth areas in the next 10-20 years. I'm keeping this in my mind as part of my VP however to not anger the PP gods (since it does have a speculative element to it).

[Pointedstick]

I also keep a small percentage of my portfolio in VWO since in the long run I feel emerging markets will be the big growth areas in the next 10-20 years. I'm keeping this in my mind as part of my VP however to not anger the PP gods (since it does have a speculative element to it).

If you want to talk about angering the PP gods, 45% of my investments are in AAPL. Thankfully, the other 55% are now in 3 PPs, and I'm selling the AAPL soon. It's been a fun roller coaster ride, but a bit more stability will be nice!

[Greg]

I also keep a small percentage of my portfolio in VWO since in the long run I feel emerging markets will be the big growth areas in the next 10-20 years. I'm keeping this in my mind as part of my VP however to not anger the PP gods (since it does have a speculative element to it).

If you want to talk about angering the PP gods, 45% of my investments are in AAPL. Thankfully, the other 55% are now in 3 PPs, and I'm selling the AAPL soon. It's been a fun roller coaster ride, but a bit more stability will be nice!

Wow! Now my guess is that it is that large of a percentage because it has (hopefully) accumulated a lot since when you purchased it. And when you say 3 PPs? Do you mean the other 3 parts of the PP, or 3 individual PPs?

So is your Total Stock Market Component of the PP just ONE stock then??? (I think many of the PPers on here will have a heart attack from reading your statement. Either that or from the "bad" saturated fat) hahahah

[craigr]

moda,

I was looking at the tax cost ratio on Fidelity of VTI (Total Stock Market), VOO (S&P 500), and VBK (Small-Cap Growth)

Here's what I found:

                         VTI                   VOO                 VBK
Tax Cost Ratio:     .29                    .31                  .1
Turnover:             5%                    4%                  40%

VBK is too new and not enough data through a bull and bear market. Only when a fund rides through the ups and downs can you get a feel for the tax efficiency. Minimum for me is at least 10 years of data to trust tax numbers. Longer is better.

Generally speaking, higher turnover means worse tax performance for a stock fund. The VBK fund only has five years of data that has had a very lackluster market so lots of ability to offset gains. During a bull market the worm will turn.

For comparison, it's best to use a Vanguard fund like NAESX which is their small cap blend fund with over 15 years of existence. Or if you really want the small cap experience, then go for small cap value VISVX for comparison. If you do that you'll see the tax costs are higher, but still may be manageable if you felt like taking the risk:

Vanguard Small Cap Blend NAESX:

http://performance.morningstar.com/fund ... region=USA

Vanguard Small Cap Value VISVX:

http://performance.morningstar.com/fund ... region=USA

Vanguard Total Stock VTSMX:

http://performance.morningstar.com/fund ... region=USA

Overall I'm not a fan of holding a bunch of stock asset classes and prefer the simplicity of the total stock market fund. But, if you *really* just have to have small cap exposure, the small cap index funds are much better than the active alternatives.

EDIT: VBK is a share class of Vanguard's Small Cap Growth index VISGX. So tax info from that fund may apply:

http://performance.morningstar.com/fund ... ture=en-US

But again I would just caution that generally broadly based index funds with lower turnover and less need to buy and sell securities to maintain the index are going to be more efficient long term.

[Pointedstick]

I also keep a small percentage of my portfolio in VWO since in the long run I feel emerging markets will be the big growth areas in the next 10-20 years. I'm keeping this in my mind as part of my VP however to not anger the PP gods (since it does have a speculative element to it).

If you want to talk about angering the PP gods, 45% of my investments are in AAPL. Thankfully, the other 55% are now in 3 PPs, and I'm selling the AAPL soon. It's been a fun roller coaster ride, but a bit more stability will be nice!

Wow! Now my guess is that it is that large of a percentage because it has (hopefully) accumulated a lot since when you purchased it. And when you say 3 PPs? Do you mean the other 3 parts of the PP, or 3 individual PPs?

So is your Total Stock Market Component of the PP just ONE stock then??? (I think many of the PPers on here will have a heart attack from reading your statement. Either that or from the "bad" saturated fat) hahahah

The AAPL was purchased before I knew about the PP, and yes, it's grown a heck of a lot. I'm not suicidal enough to consider that my stock allocation, thankfully! If anything, the AAPL is a big scary VP.

And yes, I do have three separate PPs. I have one taxable PP, one whole PP in my 401(k), and another PP split between my wife and my Roth IRAs. The taxable PP's money is earmarked for earlier expenses than retirement, and the two remaining PPs are due to the retirement accounts' differing tax treatments. I didn't want to be in the situation where my sole monolithic PP was doing great, but half the assets were in an account that I'd eventually have to pay income tax on the withdrawn gains. So I made the tax-deferred 401(k) its own self-contained PP, and the Roth IRAs work together to be a fully tax-free PP. Each PP is with a different brokerage house, and they all use a variety of funds from a variety of companies. I'm pretty heavily in Vanguard funds, but there are a few iShares funds, some Schwab, and 3 different gold ETFs (GTU in taxable, IAU and SGOL in the others). I haven't gotten around to buying any bullion yet, but that's on the to-do list.

[Greg]

The AAPL was purchased before I knew about the PP, and yes, it's grown a heck of a lot. I'm not suicidal enough to consider that my stock allocation, thankfully! If anything, the AAPL is a big scary VP.

And yes, I do have three separate PPs. I have one taxable PP, one whole PP in my 401(k), and another PP split between my wife and my Roth IRAs. The taxable PP's money is earmarked for earlier expenses than retirement, and the two remaining PPs are due to the retirement accounts' differing tax treatments. I didn't want to be in the situation where my sole monolithic PP was doing great, but half the assets were in an account that I'd eventually have to pay income tax on the withdrawn gains. So I made the tax-deferred 401(k) its own self-contained PP, and the Roth IRAs work together to be a fully tax-free PP. Each PP is with a different brokerage house, and they all use a variety of funds from a variety of companies. I'm pretty heavily in Vanguard funds, but there are a few iShares funds, some Schwab, and 3 different gold ETFs (GTU in taxable, IAU and SGOL in the others). I haven't gotten around to buying any bullion yet, but that's on the to-do list.

That seems like a good plan. I was wondering though about what you're doing for myself. I'm going to be starting up a 401k soon (job starts in July), and then a Roth-IRA. As for the 401k (well, TSP, the government) I'll be putting in there stocks, and a total bond market since the options are semi-limited. The plus side is they are all index funds with super low expense ratios (around 0.025%). As for the Roth, I'm only about 10% of my portfolio in LT bonds right now so wasn't sure if I should just load that all in for my first $5k into there or just purchase a mini-PP in there.

As for the OP and craigr's comments, I was looking into those mutual funds. I was also looking at VXF which doesn't look too bad tax-wise. They are a small-cap growth as well with a .22 Tax Cost Ratio, an expense ratio of .14%, and only 14% turnover each year. They've also been around since 2001. Perhaps not a bad choice for the small growth portion of either the PP or the VP, depending on how you play.

[craigr]

If I was using a small cap strategy, I would lean towards small cap value and not growth.

Then again, there is are good arguments that total market funds are optimally efficient and that's where I find myself:

http://www.norstad.org/finance/total.html

[lazyboy]

If I was using a small cap strategy, I would lean towards small cap value and not growth.

Then again, there is are good arguments that total market funds are optimally efficient and that's where I find myself:

http://www.norstad.org/finance/total.html

Thanks, craig. The article has very sound arguments to keep it simple. Considering that the PP only has a 25% (actually 15% to 35%) weighting in stocks, I don't see the value of trying to boost returns with small cap indexing or other strategies. I am lazy, so I don't even add an international stock index to my portfolio. Personally, I think VTI is enough. This may be a timing argument, but I have not yet seen the value of adding international stocks.

[craigr]

If I was using a small cap strategy, I would lean towards small cap value and not growth.

Then again, there is are good arguments that total market funds are optimally efficient and that's where I find myself:

http://www.norstad.org/finance/total.html

Thanks, craig. The article has very sound arguments to keep it simple. Considering that the PP only has a 25% (actually 15% to 35%) weighting in stocks, I don't see the value of trying to boost returns with small cap indexing or other strategies. I am lazy, so I don't even add an international stock index to my portfolio. Personally, I think VTI is enough. This may be a timing argument, but I have not yet seen the value of adding international stocks.

I own a very small allocation to international, but honestly for US investors it's probably not terribly important. The main reason being that US companies represent about 50% of the world economic output and derive a lot of profits from overseas operations. So even if you own US companies here (Apple, Microsoft, Caterpillar, International Paper, Johnson & Johnson, etc.) chances are those products are being used and sold overseas as well. So you likely have a lot of international exposure in your stocks already if you own US companies.

Simplest of all allocations could be Vanguard Total World (Ticker: VT), but it's kind of new so I have generally avoided it. But it's old enough now that some people may want to use it and call it a day if they really wanted more broad diversification internationally.

[lazyboy]

VT may someday replace VTI as a recommended choice if the long term trend toward internationalization continues, so I'll be watching it, but have some resistance for now. It is an elegant and simple solution but I wonder if the international percentage is a bit too large, theoretically speaking, for the HBPP and it's a wee bit more expensive, not really an issue. From a timing or trend perspective, I'd wait and see what happens in the Eurozone.

[Greg]

VT may someday replace VTI as a recommended choice if the long term trend toward internationalization continues, so I'll be watching it, but have some resistance for now. It is an elegant and simple solution but I wonder if the international percentage is a bit too large, theoretically speaking, for the HBPP and it's a wee bit more expensive, not really an issue. From a timing or trend perspective, I'd wait and see what happens in the Eurozone.

Regarding the theme of the OP though, my guess is that VTI will still be much more tax efficient than VT for a reasonable amount of time. As globalization continues however and it becomes easier and easier for exchanges, perhaps this advantage will go down.

I forget who said it on this forum but there was something about if you said you owned stock in the U.S. versus stock in Europe of companies, that this almost be equal to just saying you own a bunch of companies with one in U.S. Dollars and the other in a foreign currency. From this, you could use it as a currency diversifier.

Other than that though, if speaking about broad countries, I have a hard time thinking if you took the 500 largest companies in the U.S. against the 500 largest in Europe, that there is going to be that big of an efficiency and productive asset growth difference. Just a difference in currency. This could be useful however if you're in a tax-deferred system with limited options for not being able to buy gold, so you buy international as a currency hedge.

I'm not sure though where this breaks down however for emerging markets. I would think with that, if you took 500 companies of U.S. vs. 500 of emerging markets companies, there could be a significant difference between the two. Whether this means additional growth for Emerging since they are relatively "small" right now, remains to be seen.