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No Investment Strategy Will Perfectly Align with Your Goals

by My Journey to Millions

I read two recent articles from Registered Rep Magazine that reminded me that regardless of how well you plan, and strategize there is no perfect investment strategy.  It doesn’t matter if your investment goal is to mitigate taxes, or if the goal is to invest in all indexes because over time they “have” to beat the actively managed fund there will be examples that will interrupt any perfect planning.  It may be a bit too serious for this type of article but as the old adage goes:

We Plan and God Laughs

Three Common Strategies to Mitigate Taxes That Don’t Always Work

The first article titled, Tax Mitigation Using ETFs and Mutual Funds, provides three common techniques that most investors look for when investing in their perfect ETF or Mutual fund as it relates to minimizing taxes:

  1. Low Turnover
  2. ETFs (as opposed to Mutual Funds)

Within each of these strategies the article provides examples that are the anomalies.

Low Turnover to Minimize Taxes

Consider Franklin Rising Dividends (FRDPX), which has a tiny annual portfolio turnover rate of 6 percent, and Janus Contrarian (JSVAX), with a turnover of 104 percent. Both funds are top performers in the large blend category. During the past 10 years ending in May, Franklin returned 6.1 percent annually, outdoing 97 percent of competitors, while Janus returned 5.9 percent, according to Morningstar. But Janus was much more tax-efficient. After taxes, Janus returned 5.5 percent, compared to 4.8 percent for Franklin.

The reason was that this anomaly occurred was because of the different goals of the funds.  Specifically, Franklin was interested in Dividend Paying stocks, providing for taxes for its owners.

Index ETFs vs. Index Mutual Fund

These can be more tax-efficient than mutual funds, but it doesn’t always work out that way. Compare Vanguard 500 Index (VFINX), an S&P 500 index mutual fund, with two similar ETFs, iShares S&P 500 (IVV) and SPDR S&P 500 (SPY). During the past decade, the Vanguard fund returned 2.54 percent annually, lagging iShares, which returned 2.60 percent, and SPDR, with a return of 2.57 percent. But the Vanguard mutual fund was the most tax-efficient. After taxes, Vanguard returned 2.18 percent, compared to 2.12 percent for iShares and 2.04 percent for SPDR.

The reasoning, according to RegisteredRep, was that Mutual Funds are able to book losses (sell losing stocks) and ETFs aren’t.  I am not sure I entirely understand this reasoning – if anyone has insight I would be appreciative.

Investing in Vanguard Index Funds vs. Vanguard Active Funds

I don’t have any Vanguard accounts so I was shocked to learn that Vanguard even had active funds, nevertheless, that some of those active funds beat the index funds.

I couldn’t believe these stats:

Of Vanguard’s 21 active equity funds with 10-year tracks records, 15 have outperformed their benchmarks. Top performers include Vanguard Global Equity (VHGEX), Vanguard Prime Cap (VPMCX), and Vanguard Windsor II(VWNFX).

  •  Consider Vanguard Capital Opportunity (VHCOX), a large growth fund. During the 10 years ending in April, the fund returned 6.2 percent annually, outpacing Vanguard Growth Index (VIGRX) by 3 percentage points. 
  • Vanguard International Growth (VWIGX) returned 6.7 percent, compared to 5.3 percent for Vanguard Developed Markets Index (VDMIX).
  • By many such measures the actively managed Vanguard Equity Income (VEIPX), a large value fund, is superior to its passive equivalent, Vanguard Value Index (VIVAX). The active fund returned 4.8 percent annually over 10 years, compared to a return of 3 percent for the index portfolio.

The article titled, “At Vangaurd, Active Beats Passive – Frequently” has additional examples.

Regardless of Your Investment Plan Anomalies Exist

The point? There is nothing that always works when it comes to investing.


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JT 08/26/2011 - 11:25 am

Vanguard holds a patent on its dual-ETF/mutual fund products.

I’ll try to explain the tax benefit of an ETF as best as I can. Turnover is NOT important as a measure for ETFs and taxation.

This is very important with ETFs, because ETFs work on a creation/redemption process. To create new shares, authorized participants (major banks) give an ETF fund company a representative amount of investments for…say, 100,000 shares of the ETF.

Basically, to create a new share of SPY, the SP500 ETF, the AP sends the ETF company a proportional amount of shares of all the companies in the SP500 index.

The AP then gets the SPY shares, and the ETF trust adds the shares sent in to the trust.

Now, on redemption, tax benefits galore! Let’s say the same AP wants their stock back and redeems their 100,000 shares of the SPY ETF for the 500 securities that make up the SP 500.

The ETF company then sends the shares back to the AP with the LOWEST cost-basis, thus removing a ton of capital gains which would ordinarily be taxed.

If the AP sent in GOOG stock when it was $500, then the ETF company has a cost-basis of $500 on those shares.

However, on redemption, the ETF company can send back GOOG stock it might have received when GOOG was $300 per share.

ETF company eliminates $200 of capital gains thanks to the creation/redemption process.

Make sense?

Evan 08/29/2011 - 8:47 am

Wow, and they do all that with those low fees? I know in absolute terms we are talking REAL cash but wow.

Why would the AP take the lower basis? thus increasing their cap gains later on?

JT 08/29/2011 - 11:05 am

The lower basis doesn’t transfer to the AP.

If I buy 10,000 shares of stock for $10, and later sell them to you for $5, I lose $50,000. You don’t gain $50,000 because I lost that much.

As for the fees; operating an ETF is so much cheaper than a mutual fund. Rather than create new shares for millions of people who deposit cash, the operator only creates new shares for a few APs who give them representative securities, not cash. Really simple; really cheap. It’s all computer-driven.

Plus, ETFs love the creation/redemption process because it keeps ETF values close to their NAV.

Jeff 08/26/2011 - 3:04 pm

I’d have to say that not only does this hold true for investing, but most things. There’s not many things that will work every time, over time. Things change, people must adapt.

Evan 08/29/2011 - 8:47 am

I always say that about poker – if you are at a table full of donkeys it is YOUR responsibility to change your playing style.

Excellent point

Financial Samurai 08/30/2011 - 12:42 am

Know of any good dividend funds/etfs? I’m impressed the Janus Contra fund has done so well.

Bernard 08/31/2011 - 8:26 am

Yeah, I think one thing that I find interesting is when they want to defer taxes to the future because they bank on the idea that their income will be lower. That’s why they invest in 401k plans.

But don’t we invest to become wealthier? I mean, if we’re wealthier in the future, then we’ll be taxed more.

If we aren’t wealthier in the future, then maybe our investment didn’t do its job…

Just a thought.

Kevin 08/31/2011 - 4:55 pm

Part of the problem is that investing has different issues to deal with, and they can be mutually exclusive. You have to worry about taxes, income, growth, fees, safety. Finding a one size fits all isn’t realistic.

Retirement plans probably offer the closest thing, because they at least take out the tax monster.

Overall though, a less than perfect investment is better than having no investments for lack of ability to find the perfect scheme.


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