(PUB) Investing 2016

than the CRSP index offers. Plus, the companies in the S&P index are chosen by a committee of humans, not comput- ers. Don’t forget that. So we’re actually choosing to side with an actively man- aged index rather than a computer-man- aged one. How’s that for an oxymoron? In any case, that’s some of the analy- sis that Jeff and I went through in mak- ing this decision, which was something we thought long and hard about. Action Items So, in sum, as noted in the April 28 Hotline , Jeff and I think it’s the right move to trade out of SelectedValue and into S&P Mid-Cap 400 Value ETF . Some of you will have large gains in to maximize wealth after you’re done paying your taxes. Keeping an eye on the taxes you pay certainly should be a factor in your investment strategy, but it’s not the whole story. As I’ve noted in years past, most of Vanguard’s funds have been quite good at shielding a majority of their share- holders’ returns from the IRS, earning high marks for tax efficiency. While this was largely thanks to big losses realized during the bear market, it’s also a testimony to smart and selective selling by some of the funds’ managers and their long-term investment style, as they have not yet “realized” the gains they’ve been building for us. Still, as I’ve said many times before, focusing on tax efficiency is the wrong way to look at the bite taxes take out of your investments. You want to focus on after-tax returns. I often say that the focus on tax effi- ciency can lead you down the wrong path. For instance, a couple of years ago, I noted that U.S. Growth was Vanguard’s single most tax-efficient fund over the three years ending in 2013, as the portfolio managers took advantage of millions in realized losses, having not paid out capital gains since

Selected Value and will be wary of tak- ing the tax hit. I get that. One alterna- tive is to stop reinvesting in Selected Value and direct your new money and distributions into the S&P ETF. Others of you may wish to stick with open-end mutual funds and not buy an ETF at all. I can understand that, though it doesn’t cost anything to buy an ETF if your account’s at Vanguard. But if you decide you simply won’t buy an ETF, or it’s not available in your 401(k) plan, there’s nothing wrong with MidCap Value Index. In the end, I think the dif- ferences over time will be small. But in the Model Portfolios, we’ve sold Selected Value and bought S&P MidCap 400 Value ETF. n 2000. I also said those losses were pret- ty much used up, and to expect capital gains in 2014. Bingo! That’s exactly what happened, and what had been the most super-tax-efficient fund all of a sudden wasn’t. Today, Vanguard’s most tax-efficient fund is Market Neutral . The fund barely pays out a distribution, and when it does, it’s fractional. So, investors here get to keep almost every dollar they earn. The problem is, they don’t earn that much. So why would we use a close to 100% tax-efficiency measure to choose an investment? Well, you wouldn’t, or at least you shouldn’t. Focusing on tax efficiency is like focus- ing on the top-performing fund over the most recent three years or the last six months—meaningless, absent context. Plus, how do you really distinguish between funds when so many have similar tax efficiency ratios? In any given three- or five-year period, better than half of Vanguard’s funds, whether indexed or actively managed, typically show tax-efficiency rates of 90% or better. That means investors kept 90% or more of the funds’ returns even after paying taxes. So that’s not a very dis- cerning metric for picking funds.

index absolutely outperformed, hit- ting an MCL (Maximum Cumulative Loss) of -52.2% compared to the CRSP index’s -58.7% MCL. But over other down-market periods, the S&P index didn’t do any better, and sometimes it did worse than the CRSP index, so it’s closer to a toss-up on the risk side. One other factor that I think is worth noting is that the companies in the S&P index are much smaller than those in the CRSP index. The median company in the S&P index is currently $3.8 bil- lion in size, while the median CRSP index company weighs in at $10.2 billion. To my way of thinking, we’re getting more mid-caps and maybe a few smaller companies in the portfolio > THOSE MASSIVE LOSSES “earned” during the financial crisis and linger- ing in our mutual funds’ portfolios are (for the most part) long gone now that we’re seven years into this bull market. Other than Precious Metals & Mining , which is sitting on realized and unreal- ized losses equal to an astounding 105% of its portfolio value (yes, really!), and a number of international stock funds that haven’t seen the massive run-ups of their domestic counterparts, most funds are sitting on unrealized gains—capital gains in stocks that haven’t been sold yet. That’s why it’s a good time to think, once again, about taxes and, more impor- tantly, the concept of tax efficiency. You see, what many investors think they know about taxes and mutual funds is, in many cases, dead wrong. Now’s the time to give this a thorough look-see and to strike down the accepted wisdom. Now that Tax Day has passed, there’s little you or I can do about what hap- pened in 2015. But as the tax reporting deadline fades, I can fully appreciate you might be wondering how to reduce or even eliminate future tax bills. But that’s not the way to think about it. Indulge me for a moment. The goal of investing isn’t to avoid taxes, but TAX EFFICIENCY After-Tax Tales

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