A mix of tax-managed, index, and munis should reduce the drag of taxes on all-Vanguard portfolios for accumulators.
By Christine Benz | 09-14-15 | 06:00 AM | Email Article

Given the strength of the six-plus year rally in stocks (recent weakness notwithstanding), many market prognosticators have warned investors to expect muted future returns.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

A lackluster return forecast argues for saving more, not just in tax-advantaged accounts but also in taxable accounts, and staying vigilant on the cost front. After all, direct investment and transaction costs as well as tax costs can all eat into returns.

Vanguard has much to offer the investor who aims to limit all of those costs. The firm is synonymous with budget-conscious investing, of course; its funds are usually among the cheapest, if not the cheapest, in their categories. But Vanguard's cost-consciousness extends to tax matters, too. The firm views tax costs as another line item that drags on investors' take-home returns, so it devotes research and educational efforts to matters of tax management. Many of its funds are designed with tax efficiency in mind. For example, the firm was an innovator in creating exchange-traded funds by making them share classes of already-existing index funds, a structure that enables shareholders in the firm's traditional index equity funds to enjoy tax efficiency on par with their ETF counterparts. The firm also fields a topflight lineup of tax-managed funds and, earlier this year, filed with the Securities and Exchange Commission to launch its first municipal-bond index fund and ETF.

Thus, it's easy for tax-conscious investors--that is, investors investing in taxable accounts rather than inside of a tax-deferred wrapper like an IRA--to readily build well-diversified, tax-efficient portfolios consisting exclusively of Vanguard products. In addition to a broad suite of equity index funds, the firm's tax-managed and municipal-bond lineups are also worthy building blocks.

Portfolio Basics
To cater to Vanguard investors' taxable accounts, I created three tax-efficient Vanguard saver portfolios: Aggressive, Moderate, and Conservative. I used Morningstar's Lifetime Allocation Indexes to help guide their asset allocations, and populated the portfolios with funds from  the list of Morningstar Medalist funds. I used the lowest-minimum share class available, though investors will want to take advantage of lower-expense, higher-minimum share classes if they can.

As with all of these model portfolios, investors will want to bear their own situations in mind when determining whether a given asset mix makes sense for them. While younger investors should generally hold an equity-heavy portfolio for its better long-run return potential, they should make sure they can handle the high volatility of such a portfolio first. (That's one reason asset-allocation guru Bill Bernstein has suggested that younger investors might start out with lighter equity weightings than the standard stock-heavy prescription.) On the flip side, investors who are approaching retirement and will be able to rely on a pension may want to run with a higher stock weighting than shows up in the conservative mix below. If a pension and/or Social Security will supply most of their in-retirement income needs, they don't have to hold as much in cash and low-volatility fixed-income investments as pre-retirees who expect to rely mostly on their portfolios for retirement living expenses.

Investors will also want to take a look at their tax situation when determining whether to invest their taxable portfolios' bond positions in municipal-bond funds--which I've included here--or in taxable-bond funds. Most investors who are in a position to save in a taxable account--in other words, they've already maxed out their tax-advantaged options--are in a tax bracket where they'd benefit from holding municipal bonds versus taxable, but that's not always the case.

Aggressive Tax-Efficient Saver Portfolio
Time Horizon Until Retirement: 40 Years | Risk Tolerance/Capacity: High | Target Stock/Bond Mix: 90/10

45%  Vanguard Tax-Managed Capital Appreciation
15%  Vanguard Tax-Managed Small Cap
30%:  Vanguard FTSE All-World ex-US Index
10%:  Vanguard Intermediate-Term Tax-Exempt

Geared toward a young accumulator, the Aggressive Vanguard Tax-Efficient Saver mutual fund portfolio uses the allocations of Morningstar's Lifetime Allocation 2055 Aggressive Index to guide its weightings. That index devotes more than 90% of its assets to stocks, including a healthy dose of foreign names. Thus, anyone considering such a portfolio should not only have a long time horizon but should also be able to tolerate the volatility that can accompany a very high equity allocation.

These portfolios use Vanguard's tax-managed funds for their U.S. equity exposure. I used Tax-Managed Capital Appreciation for core equity exposure, and because it's light on small caps, I augmented it with a position in the Tax-Managed Small Cap fund. I've always liked the tax-managed funds because they have a mandate to limit taxes and would likely adjust their strategies to adapt to tax-code changes; for example, if dividend-payers were again taxed at ordinary income tax rates, the funds could adjust to downplay dividend-payers, whereas index funds would not. But Vanguard's core domestic-equity index funds and ETFs would also make fine substitutes. For maximum tax efficiency, I would employ  Vanguard Total Stock Market Index for core equity exposure. Index investors could reasonably add a dash of small-cap (and especially small-cap value) index exposure.

Vanguard no longer fields a tax-managed international fund, so I used a core international-equity index fund instead. And while the Lifetime Allocation Indexes call for small commodities and TIPS stakes to provide inflation protection, neither investment type is tax-efficient and Vanguard doesn't offer a commodities fund, so I didn't include them here.

Moderate Tax-Efficient Saver Portfolio
Time Horizon Until Retirement: 20-Plus Years | Risk Tolerance/Capacity: Above Average | Target Stock/Bond Mix: 80/20

20%: Vanguard Intermediate-Term Tax-Exempt
45%: Vanguard Tax-Managed Capital Appreciation
10%: Vanguard Tax-Managed Small Cap
25%: Vanguard FTSE All-World ex-US Index

This portfolio is geared toward a slightly older investor, one who intends to retire in 2035. (Assuming a retirement at age 65, our hypothetical individual would be in his or her 40s today.) Thus, its bond stake is 10 percentage points higher than the Aggressive portfolio's. Because such a retiree still has a long time horizon, the portfolio still includes a large position in stocks, though its small-cap and foreign stakes have dropped a bit.

As with the Aggressive Saver mutual fund portfolio, I've used Morningstar's Lifetime Allocation Indexes to help set the baseline asset allocations. In this case, I used the moderate version of the 2035 index.

Conservative Tax-Efficient Saver Portfolio
Time Horizon Until Retirement: 10 Years or Less | Risk Tolerance/Capacity: Low | Target Stock/Bond Mix: 65/35

15%:  Vanguard Short-Term Tax-Exempt
20%: Vanguard Intermediate-Term Tax-Exempt
15%: Vanguard FTSE All-World ex-US Index
45%: Vanguard Tax-Managed Capital Appreciation 
5%: Vanguard Tax-Managed Small Cap

Geared toward an investor who's just 10 years from retirement, this portfolio's equity stake is naturally smaller than the Aggressive and Moderate portfolios, while its fixed-income position is larger. I've reduced both the international and small-cap holdings to make room for an allocation to short-term bonds. With retirement 10 years into the future, it's too early to start raising cash for in-retirement living expenses; at today's very low yields, the opportunity cost of doing so is simply too great. But pre-retirees might consider steering part of their fixed-income sleeves to a short-term bond fund that could be readily converted into cash. After all, having sufficient short-term assets in the portfolio can help mitigate sequencing risk--the chance that a retiree could encounter a lousy market right out of the box. Vanguard Short-Term Tax-Exempt is a particularly conservative entrant in the muni short category--it maintains a shorter duration stance than its peers. That leads to a shrimpy yield but good downside protection.

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Christine Benz has a position in the following securities mentioned above: VWITX Find out about Morningstar's editorial policies.
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