Tax Efficient Investing

[Jeff W]

Why would that lower returns in an index fund?

Compare the Vanguard tax-managed equities funds to their benchmarks... 3/4 have beaten their benchmarks(S&P 500, S&P 600, MSCI EAFE) since inception net expenses.

[mtgordon]

The idea was that any time you put restrictions on something (making it tax efficient adds a layer of restrictions) it can't make it better and it often makes it worse (or else the non-tax managed would be doing the same thing).

[TheMetetron]

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The idea was that any time you put restrictions on something (making it tax efficient adds a layer of restrictions) it can't make it better and it often makes it worse (or else the non-tax managed would be doing the same thing).

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It increases returns after-tax which is all that matters.

[Jeff W]

[ QUOTE ]
The idea was that any time you put restrictions on something (making it tax efficient adds a layer of restrictions) it can't make it better and it often makes it worse (or else the non-tax managed would be doing the same thing).

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The idea doesn't make any sense. You're assuming the non-tax managed funds are perfect and that any deviation from them is inefficient. Some indeces are demonstrably inefficient: S&P 500, Russell 2000 -- both have negative alpha due to index reconstitution arbitrage. Index Fund managers slavishly follow the indeces anyway to avoid tracking error. Tax managed funds that loosely track those indeces will tend to outperform them.

[mtgordon]

The idea is correct, but I should have clarified. I was talking about taking an index fund and making it a tax efficient index fund, not comparing a tax efficient fund to some other random index. Otherwise I agree that you're comparing apples to oranges.

[Jeff W]

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The idea is correct, but I should have clarified. I was talking about taking an index fund and making it a tax efficient index fund, not comparing a tax efficient fund to some other random index.

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The idea is based on a faulty premise that indeces are perfectly efficient. If anything, I'd bet that tax management adds alpha compared to the normal approach even before taxes are considered: 1. It avoids index reconstitution arbitrage that plagues major indeces like S&P 500, Russell 2000. 2. It can reduce turnover and thus transaction costs. Managers of normal index funds worry more about reducing tracking error(negative tracking error sends investors to other providers) than providing maximal returns.