Tax Efficiency: Index Funds vs. Actively Managed Funds

Tax season is in full swing, which may bring up many questions and considerations about your investments. Am I saving in the most tax-efficient locations for my financial situation? Are my individual investments tax-efficient as well?

A recent article by Vanguard discusses how broadly based index funds are more tax-efficient than actively managed funds. Rockbridge has built their models strictly using index funds because of their low costs and range of securities within the funds. Their tax efficiency is just another reason why index funds make sense.

One way a fund’s tax efficiency can be measured is with its “tax cost.” Tax cost is the difference between the before-tax return of a fund and its preliquidation after-tax return. According to the article, the median tax costs for index stock funds is 27 basis points less than actively managed stock funds.

Several actively managed funds have a higher tax cost compared to index funds because they tend to change the investments within the fund more often. Since they are attempting to achieve a higher return than the market, they frequently liquidate and make new purchases in order to hold the funds their research shows will perform well. The sale of current investments for new ones causes the owners of the fund to realize capital gains (which are taxed) more often.

Although we believe it is much more important to manage the overall allocation of assets in your portfolio based on your risk tolerance than it is to manage exclusively for taxes, your portfolio’s tax efficiency is still important to take into account.