One of the more popular mutual fund styles are so-called tax-advantaged funds. Folks who are investing in accounts outside of their tax advantaged accounts such as 401(k)s and IRAs often invest in these funds to try to reduce their tax burdens a bit.
These funds are ostensibly managed with a department pouring over the tax code and determining the most efficient way, tax-wise, to buy and sell underlying holdings – and, of course avoiding asset classes which don’t get favorable tax treatment.
Are Tax-Advantaged Funds Working?
Well, no, not lately…
A recent article published in the Journal of Wealth Management (and I first saw highlighted in the Wall Street Journal) ran the numbers on a selection of passive, active, and tax-aware funds for the period of 2009-2014, and found that, surprisingly, tax-aware funds often cost more in fees than the amount saved in taxes. Furthermore, from that 5 year span, tax-aware funds were only the cheapest funds tax-wise for 2 of the 5.
The Top Tax-Advantaged Funds… and All The Rest
This math was based upon a worst case scenario – highest marginal rate taxpayers invested in the universe of tax-aware funds. Ironically, then, taxpayers earning less (and therefore in lower marginal tax brackets) would be disadvantaged even more relative to other fund types like the passive funds.
Of course, the poor showing wasn’t universal – the authors, Dale Domian, Philip Gibson, and David Nanigian also found that there are high quality tax-advantaged funds that do perform as specified. The category itself though is under-performing other fund types which don’t state their tax goals upfront.
Of course, that caveat applies for all sorts of funds – there are index funds which charge higher fees, just as there are active funds which basically parrot index funds and charge active fund management fees. (I guess, as always, caveat emptor)
Watch Your Portfolio Closely
The key takeaway? If you’ve got any tax-advantaged funds, which many DQYDJ readers might after filling their tax-advantaged account caps, you should take a look at how they are doing versus, say, other passive funds in a similar category. It looks like, unfortunately, this isn’t a set it and forget it type allocation.
And, as seems to be the case quite often, this story seems to give a lot of credit to passive investing. We concur – for the typical investor, passive investing is the best option. Even if you hold some individual equity (such as employer funds), do consider making the bulk of your portfolio passive investments.
Sure, it’s boring – but here index funds are once again coming up smelling beautifully in a study designed to test something else.