Can someone explain tax advantages to owning an index fund?

[BeL0wMe]

HI,
Hey all here, I have 10k burning a hole in my pocket and wanted to start up a taxable account. The two main contenders are VTSMX, and Primecap Core, so could someone explain to me tax wise why VTSMX would be the better fund to purchase? I think primecap core would be the better large cap fund, but apparently VTSMX's tax advantages make it the better buy? Can someone help me here?

[DesertCat]

Not sure why you
a) think you need a large cap fund,
b) think that a newly started actively managed fund has any chance of beating and index fund overlong periods
c) care about the tax advantages of either, since it's total net return you really should care about.

Let's start with history. Most (something like 85-90%) of actively managed funds get their lunch handed to them by index funds over long periods. It's because an index fund has much lower costs, and fund managers have difficulty beating the market's return by enough to compensate for those costs.

In this case, PrimeCap's expense ratio is at .72% per year, while VTSMX is at .19%, so PrimeCap's managers have to beat the market by more than .53% in order to beat VTSMX over time. That's not a huge hurdle, actively managed funds can be at 1.5% or more in some cases. So that's a good point for PrimeCap.

But many new funds start with artificially low fees to lure you in, then jack them up once they've established a good performance record. I don't know if that's the case here or if it's just becase Vanguard keeps expenses low for their actively managed funds. But Primecap does have a 1% redemption fee the first year, so when you make your decision you'll want to stick it out a year.

The tax advantages of index funds are that they rarely sell stocks in their portfolios. They hold the same stocks for a year, then "rebalance", which usually involves selling the small amount of stocks that no longer qualify for the index, and buy replacements. But the VTSMX actually has a higher turnover than PrimeCap (12%-6%) over the last year.

I'm not sure if the VTSMX's turnover is usually this high (the SP500 index is at 6%). It's possible that last years rebalancing was espcially large, or that because the VTSMX is so large that it has a higher proportion of small cap stocks falling out of the index every year than a large cap index. But I doubt that PrimeCap's turnover will stay this low, they are so new it's likely they bought all the stocks they liked when they started and haven't had to change direction yet. Some actively managed funds change their stocks twice a year or more, those are the very inefficient ones. But right now both PrimeCap and VTSMX are very tax efficient.

PrimeCap's off to a great start, but my advice is that you have no way to know if they are good, or just lucky so far. You don't know if their fees will increase. The index fund choice won't beat the market, but it also won't trail the market, and offers extremely tax efficient returns in a taxable acount. Buying an actively managed fund is usually taking the worst end of a 20%-80% proposition to try to beat the market.

[NajdorfDefense]

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HI,
Hey all here, I have 10k burning a hole in my pocket and wanted to start up a taxable account. The two main contenders are VTSMX, and Primecap Core, so could someone explain to me tax wise why VTSMX would be the better fund to purchase? I think primecap core would be the better large cap fund, but apparently VTSMX's tax advantages make it the better buy? Can someone help me here?

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There are no inherent tax advantages to owning an index fund. Like poker, it all depends.

[DesertCat]

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There are no inherent tax advantages to owning an index fund. Like poker, it all depends.

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I don't know why you think this since lower turnover equals lower tax costs (esp. with long term capital gains taxed at rates substantially lower than short term capital gains), and index funds tend to have dramatically lower turnover than actively managed funds.

[NajdorfDefense]

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There are no inherent tax advantages to owning an index fund. Like poker, it all depends.

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I don't know why you think this since lower turnover equals lower tax costs ...and index funds tend to have dramatically lower turnover than actively managed funds.

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'Tend to' <> inherently advantageous. Do you see why?

There are/ I own plently of funds that have less turnover than some index funds. In past years, the SPX has turned over dozens and dozens of names a year, some indexes are worse.

[DesertCat]

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There are/ I own plently of funds that have less turnover than some index funds. In past years, the SPX has turned over dozens and dozens of names a year, some indexes are worse.

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Dozens and dozens would be 5% per year (24/500), that's very low. How many actively managed funds have less than 5% turnover a year? I don't know how to get a ranking of mutual funds by turnover percentage, but I've got to think that it's pretty rare for an actively managed fund to be less than 5%.

[Brainwalter]

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There are/ I own plently of funds that have less turnover than some index funds. In past years, the SPX has turned over dozens and dozens of names a year, some indexes are worse.

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Dozens and dozens would be 5% per year (24/500), that's very low. How many actively managed funds have less than 5% turnover a year? I don't know how to get a ranking of mutual funds by turnover percentage, but I've got to think that it's pretty rare for an actively managed fund to be less than 5%.

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To be fair, dozens and dozens is at least 48 and usually higher.

[NajdorfDefense]

I do no business with Legg Mason, other than owning Bill Miller's funds, but here is some data on the fund I spoke about above. Richie Freeman is a legend.
10 year returns
SHRAX 15.49% annual return pretax, 15.22% post-tax.
VFINX 8.83% pretax, 8.27% post-tax. The drag is literally 2x as the active fund due to additional turnover from the so-called 'passive' index.

As we all know, the SP500 is really an actively managed list of stocks, just a real big one.