What makes one mutual fund more tax-efficient than another? Some relevant factors include a portfolio’s management strategy, the turnover or trading strategy, the accounting methodology used, and the activity of the fund’s investors.

Gauge tax efficiency with “tax cost”

“One way that a fund’s tax efficiency can be measured is with its ‘tax cost’,” said Scott Donaldson of Vanguard Investment Strategy Group. “Tax cost refers to the before-tax return of a fund minus its preliquidation after-tax return. It represents a very high hurdle for active fund managers to overcome, in addition to their ongoing fund management expenses.”

The illustration below shows a decisive tax advantage for index stock funds: The median tax cost for index stock funds (left side, green) was 71 basis points, whereas the median tax cost for actively managed stock funds (right side, green) was 98 basis points.

Thus, for the funds in the data set, the median tax cost of domestic actively managed stock funds was 27 basis points higher than that of domestic index stock funds.

The gap can be even larger. Note the 295 basis-point difference between the worst tax costs (shown in blue) of domestic actively managed and index stock funds. Moreover, the chart shows a much narrower range in tax cost in the index category.

U.S. stock mutual funds' tax cost 15 years ended November 30, 2015

Why index stock funds may have the upper hand

Because active managers make decisions based on a security’s potential to outperform, they can be more inclined to make specific, concentrated purchases in fewer stocks and to liquidate entire holdings more often than managers of broad-market index stock funds would. In making wholesale liquidations, active managers may be much more likely to realize capital gains because an entire position’s gain could be realized at once.

The tax efficiency of actively managed stock funds could be, therefore, much less stable, and the lack of depth and breadth of share lots in actively managed stock funds could negatively affect the funds’ future tax efficiency.

Actively managed stock funds also have the potential for manager changes, resulting in new managers completely restructuring the portfolio, which could cause realization of gains from past investment success.

Granted, some index stock funds can be tax-inefficient as well (see chart above). For example, stock funds that seek to track more narrowly focused benchmarks, such as those in the mid- and small-capitalization markets, fall into the bottom quartile in Vanguard’s tax-cost analysis.

“Much more broadly based index stock funds will typically be more tax-efficient because they change their holdings less often,” Mr. Donaldson said. “Moreover, not all ETFs or conventional index stock funds are the same. Even stock funds that seek to track the same index can have different performance. The bottom line is, while Vanguard believes it’s much more important to manage the overall allocation of assets in your portfolio than it is to manage exclusively for taxes, your portfolio’s tax efficiency is important to take into account.”

Aside from choosing stock funds that are more tax-efficient, investors can also engage in other best practices to minimize their taxes:

  • Use tax-advantaged accounts. Maximize the use of tax-advantaged accounts, such as 401(k) plans and IRAs (both traditional and Roth), and 529 college savings plans.
  • Be a tax-efficient investor. Use tax-advantaged accounts to rebalance an asset allocation or to sell appreciated positions, which may provide better after-tax returns than completing similar transactions in a taxable account.
  • Pay attention to asset location. Purchase tax-efficient investments in taxable accounts and tax-inefficient investments in tax-advantaged accounts, which can help you keep additional returns. Those incremental differences can have a powerful compounding effect over the long run.
All investing is subject to risk, including the possible loss of the money you invest.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

We recommend you consult an independent tax advisor for specific advice about your individual situation.

Prices of mid- and small-cap stocks often fluctuate more than those of large-company stocks.

There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.