Index Funds

7.4

Solutions

7.4.1 Tax-Managed Index Funds

A tax efficient or tax-managed mutual fund means that the published return and the after-tax return should be similar since there is minimal taxable distributions from the fund. Index funds can be tax-managed, in addition to the natural advantages of low turnover in the index fund. Managers of tax-managed index funds employ tax-managed trading strategies such as tax loss harvesting of stocks that large losses, while most managers of actively manage funds have high turnover of their stocks and manage the fund as if taxes were not important to their performance. Since few investors adjust their returns by the taxes they pay on the fund, the active managers prefer not to worry about taxes. However, they can have a significant impact on your returns.

Tax-Managed Index Mutual Funds

7.4.2 Reduce Taxes and Turnover Costs with Index Funds

DFA offers five tax-managed index fundsand their research demonstrates that the increase in after-tax return associated with these funds can vary from 1 to 1.5% per year. DFA has run simulations with its tax-managed U.S. Market Wide Value Fund which show that if the fund dropped 20% from its value, it could sell nearly 40% of its assets without realizing any net capital gains.

Please remember that the financial services industry wants you to trade a lot because trading is the primary source of their income. We estimate about $645 million, or about 5 cents/share for buyers and sellers per day in the U.S. for commissions, bid ask spread costs, market makers, the exchanges, etc. So it is easy to understand why trading has also been documented to be detrimental to YOUR income.

The Cost of Trading

*Trading occurs 5 days a week excluding holidays. The counter runs continuously. We've adjusted the counter to reflect this difference.

7.5

Summary

There are many silent partners eating a piece of investment returns. The best solution to this problem is to buy and hold a diversified portfolio of index funds, including tax managed funds in taxable accounts. For an example, see Portfolio 90, for Taxable Accounts.

7.6

Review Questions

Please answer the following questions before moving on to the next Step.

1. The only uncontrollable partner in investing is:

a) income tax.
b) inflation.
c) commissions.
d) margin account interest.

2. What is the difference between "realized" and "unrealized" gains?

a) taxable vs non-taxable
b) old money vs new money
c) fund based vs. investor based
d) none of the above

3. What are the advantages of low portfolio turnover?

a) lower taxes
b) fewer trading costs
c) maximum capital gain
d) all of the above

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WARNING: Past performance does not guarantee future results. Investment returns and principal value will fluctuate, so that investors' shares, when sold, may be worth more or less than their original cost. Investing in any mutual fund, index or actively managed, does not guarantee that an investor will make money, avoid losing capital, or indicate that the investment is risk-free. Actively managed funds sometimes outperform index funds. You just don't know in advance which actively managed fund will outperform the appropriate index. Just because a mutual fund is an index mutual fund, it does not guarantee a performance superior to an actively managed mutual fund. There are no absolute guarantees in investing. When reviewing any backtested performance information on this internet site, please read the Disclosure for Backtested Performance Information (click here to read the Disclosure for Backtested Performance Information.)