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Question For Financial Whiz Guys.....
Old 01-16-2004, 04:55 AM   #1
 
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Question For Financial Whiz Guys.....

I have decided on an asset Allocation and will have to have 1 or 2 of these funds in a Taxable Account. The rest will be in Tax Deferred Accounts.

Which of these 1 of these index funds would you put in a Taxable Account? Which fund would be your 2nd choice?

Small Cap Growth - VISGX
Small Cap Value - VISVX
INTL - VGTSX
TIPS - VIPSX
ST Corp Bond - VFSTX
REIT - VGSIX

Thanks!
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Re: Question For Financial Whiz Guys.....
Old 01-16-2004, 08:52 AM   #2
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Re: Question For Financial Whiz Guys.....

I'm not a financial whiz, but I am trying to learn more. I can give you a few thoughts to ponder, but no solid answer. Someone else will have to comment on the REIT tax implications, as I am not aware of them (and not too interested given my real estate holdings provide more than enough exposure to that area).

Tax law changes have made tax deferred accounts less attractive, IMHO. The withdrawals are taxed as ordinary income where both dividends and capital gains in taxable accounts are now taxed at a discount. Therefore I would put the highest expected return, which is the small cap's I think, in the taxable account and take advantage of the discount on taxation.

Another candidate is the INTL fund. If it passes thru foreign tax credits, then those are worthless in the IRA but are a deduction in the taxable fund. It may be that the combination of capital gain treatment and foreign tax credits are a good reason to put it in the taxable account.

It is also subject to use of your crystal ball: What will the tax structure be in 5 to 10 years? I think the current dividend taxation, while well liked, is problematic and will get some tuning. Loaned shares for short sales is one problem, and IRA's are another. I suspect that as more people draw from IRA's and realize the disadvantage of being taxed at full value on capital gains and dividends that were in the IRA, there will be some pressure from seniors and AARP to adjust the treatment. What will happen?

Wayne
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Re: Question For Financial Whiz Guys.....
Old 01-16-2004, 08:56 AM   #3
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Re: Question For Financial Whiz Guys.....

Cutthroat - Did you leave large caps completely out of your asset allocation? I don't see a total market or S&P fund there. I'm curious why if you did.

Wayne
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Re: Question For Financial Whiz Guys.....
Old 01-16-2004, 09:05 AM   #4
 
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Re: Question For Financial Whiz Guys.....

Wayne,

Couple things,

I left Large Caps out because they are already covered in my Wife's 401K plan. - VINIX Fund - Don't really have a choice to move to anything else there.

I am not really afraid of having a Tax Bill from withdrawing from IRA accounts. I am not planning on withdrawing from the Tax Deferred Accounts for 20 Years. My wife has a large enough income right now that I am looking for the least Taxes to pay for the next 10 years. So I am going for Max Capital Gains.

I look at a Large Tax Bill as I nice problem to have 20 years from now. That will mean I'm doing just fine! I am not fond of Capital Gains Losses to use as deductions
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Re: Question For Financial Whiz Guys.....
Old 01-16-2004, 09:17 AM   #5
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Re: Question For Financial Whiz Guys.....

if you are saving (not withdrawing), you want to put the funds that have high turnover ( turnover causing capital gains distributions) and the funds that pay a lot of dividends (REITs) in the Tax Sheltered account ( such as a 401k).
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Re: Question For Financial Whiz Guys.....
Old 01-16-2004, 10:54 AM   #6
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Re: Question For Financial Whiz Guys.....

To clarify Wayne's comments further, if one had a choice b/w a taxable account and a non-deductible IRA or variable annuity to hold equities, it makes more sense to hold the equities in the taxable account, especially if one is going to use a tax-efficient index fund, Tax managed fund, or ETF. I'm sure that Wayne wasn't specifically mentioning this. I think he was suggesting keeping the tax-efficient equities in the taxable, and the bonds/REITs (those assets that generate mostly dividend income or are not eligible for the new lower equity dividend tax rates) in the tax-deferred. The new lower capital gains and dividend tax rates make holding tax-efficient equities in the taxable account and bonds/REITs in the tax-deferred account more attractive than the other way around, as long as one is maxing out the tax deferred options and Roths first.

I would put the funds that are the most tax-efficient in the taxable account. I believe there are more tax-efficient funds than these metioned above. For Int'l, I'd favor either the Tax Managed Int'l, the individual Region Index funds (Europe and Pacific), or perhaps the MSCI EAFE ETF or Emerging Market ETF. They will allow foreign tax credits, but Total Int'l or Developed Markets funds (which are funds of funds) won't.

For the small caps, I'd rather not use either of the small cap value or the small cap growth. I'd also probably not use the small cap growth fund as small cap growth (as an asset class) has historically not provided the higher returns to compensate for the higher risks. Plus, small value should be a much better diversifier of the large caps in the 401(k), and the int'l large caps. I'd prefer to use either the Tax Managed Small Cap fund, or an ETF like iShares S&P 600 value (IJS ??) or Russell 2000 value . Since we can't know which asset class (int'l, large, or small) will provide the highest returns in the future, I'd go with the things we can specifically control (taxable distributions) with tax-managed funds or ETF's.

Of course, if you'll be making periodic contributions, I'd probably go with the Tax managed funds b/c of the transaction costs for the ETF's (e.g. broker fees).

- Alec
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Re: Question For Financial Whiz Guys.....
Old 01-16-2004, 12:17 PM   #7
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Re: Question For Financial Whiz Guys.....

I'd probably go with the international fund and then the short term bond fund. Both are going to produce the lowest capital gains and dividend yields of the funds provided.

TIPS inflation adjustments are taxable events, REITS throw off a lot of dividends, and small cap funds throw a lot of capital gains.

I might also suggest you look into the vanguard explorer funds rather than the small cap indexes. Small caps is one place where, unless i'm badly mistaken, managed beats indexed the vast majority of the time. Its also one place where it may be prudent to pay more in a management fee because evaluation of companies prior to investment is a lot more important in a small company than a fortune-500 company. Evaluation costs money. Plus these have higher trading costs than big company funds. A cheap managed small cap fund might just be an index in disguise.

I also went with the separate europe and japan/pac rim funds so I could set the allocation between the two of them to suit me. Right now I think the next 10 years in the pacific area beats the next 10 years in europe, but the full intl indexes heavily favor europe.

You might also consider a small holding in the emerging markets index fund. No more than 5%.
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Re: Question For Financial Whiz Guys.....
Old 01-16-2004, 12:53 PM   #8
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Re: Question For Financial Whiz Guys.....

TH,

I think you're "badly mistaken".

Two articles that say otherwise:

The Big Lie - from W. Bernstein

Problems with the Manager Data Universe - from SSGA

As the SSGA article points out nicely, there is much more survivorship bias in small caps. It is certainly correct that small caps have much higher transaction costs than large caps. Hence you would want an index. Same deal with Int'l stocks, especially emerging markets stocks.

If you take a small cap fund (with the same manager for the whole time), like Ariel, and do a three factor regression (for market risk, small cap risk, and value risk), and still find that there is a statistically significant alpha, then you can actually say that this manager has skill. Plus, small caps funds are notorious for style drift (holding a lot of mid caps plus small caps).

Though, if I was going to use a managed fund for small caps, I'd definitely use Vanguard's explorer b/c of the low expense ratio, and fairly low turnover. Could be a closet index fund.

- Alec
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Re: Question For Financial Whiz Guys.....
Old 01-16-2004, 01:28 PM   #9
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Re: Question For Financial Whiz Guys.....

That leaves me a little confused. If I look at vanguards explorer vs the overall small cap index, explorer beats the small cap index for 5 and 10 years (albeit by a small margin), even with the fund costs factored in. If I look at explorer vs the small cap growth index, which is a closer match, I dont have data further than 5 years but explorer whomps the small cap growth index during that 5 year period 10.40% vs 7.86%.

Granted I'm just looking at the small universe of vanguard funds, and for a relatively "short" 5 and 10 year periods.

So what am I missing?

Outside of the microcosm of vanguard funds, it appears (admittedly without hours of examination), that managed micro/small cap funds that arent managing a tremendous amount of money appear to handily outdo any of the vanguard small cap funds until the managers success draws more money than the manager can employ properly.
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Re: Question For Financial Whiz Guys.....
Old 01-16-2004, 01:43 PM   #10
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Re: Question For Financial Whiz Guys.....

Read more William Bernstein - and stay as far away from small cap growth as you can (lower right Morningstar box). But small cap value seems to do better. There enough 5-10 yr fund managers to muddy the picture until fund size effects start to drag performance. One can always speculate for a quick five yr. trade - maybe, just maybe successfully.
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Re: Question For Financial Whiz Guys.....
Old 01-16-2004, 02:27 PM   #11
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Re: Question For Financial Whiz Guys.....

You know, I never evaluated the individual growth vs value indexes for small caps, just the exploder vs the overall index. Small cap value does beat the exploder by a bit.

What I found interesting is that the after tax and sale of funds returns for exploder are higher than the small cap index funds. I would have expected the lesser trading index to produce better results here.

The Bernstein stuff is definitely an interesting read. However I come away feeling like I've just been exposed to an advertisement for DFA funds. I'd like to see the returns adjusted for the cost of the financial "expert" you need to hire to get access to these funds, and their after tax and sale returns vs vanguards.

One last question, regarding DFA's funds. Since they dont alwaysfollow the "traditional indexes" and instead use alternative ones, many of which (like the s&p 600) choose holdings by "committee" rather than a set of rules, doesnt that committee essentially become the fund "manager" and thence make it more a managed index than an unmanaged one? If so, then isnt the only difference between DFA funds and a managed fund are that the DFA funds only do their "management" quarterly or annually rather than daily?
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Re: Question For Financial Whiz Guys.....
Old 01-16-2004, 03:14 PM   #12
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Re: Question For Financial Whiz Guys.....

TH,

I don't think you're missing anything. The small cap funds that do beat there benchmarks (small value fund vs. small value index) over time do this through passive, NOT active, strategies. For example, look at Ariel. Very low turnover, and very little style drift from value.

As Bogle says, it's all about the fees. The lower the expense ratios, the lower the turnover (the lower the transaction costs), and the better the fund is at protecting shareholder interests (staying away from soft dollars, etc.), the better chance it has at outperforming its peers.

I'd bet that the majority of the "active" funds out there that have excellent track records are in fact very passive. Examples: Dodge and Cox, Ariel, American Funds, Vanguard's active funds.

All index or passively managed funds (like Bridgeway's funds, or DFA funds) are in a sense managed. Someone, somewhere has to decide what is small, what is value, etc. DFA's funds are more pure value and more pure small cap. Their value funds are deeper value (lower P/B) than the S&P indexes or Russell Indexes. Just like the S&P 600 is smaller than a lot of "small cap funds".

Sorry about the vague reference about the regression earlier. Basically what is says is that when we account for the value exposure of a fund, the small exposure of a fund, and the market exposure of a fund, the extra umphh (or whatever you want to call it) that a manager and his research actually adds is almost negligable (sp), and in most cases not significant enough that we can say it is not zero (or that the manager adds virtually nothing). Whenever we see return numbers compare we should ask, "which stock, fund, or asset was riskier?", and did the risk account for the excess return.

I think the main difference b/w DFA funds (index funds, Bridgeway's funds, etc.) and actively managed funds is that the former believe that security selection/stock picking is pretty much worthless and a loser's game. What matters is your exposure to risks in the market (like small and value). The actively managed funds may want us to believe that they can identify underpriced securities (which will have higher returns than the rest of the asset class), while folks like DFA will say this or that group of stocks will have higher returns b/c they are riskier.

- Alec
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Re: Question For Financial Whiz Guys.....
Old 01-16-2004, 03:15 PM   #13
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Re: Question For Financial Whiz Guys.....

Quote:
Wayne,

I am not really afraid of having a Tax Bill from withdrawing from IRA accounts. I am not planning on withdrawing from the Tax Deferred Accounts for 20 Years. My wife has a large enough income right now that I am looking for the least Taxes to pay for the next 10 years. So I am going for Max Capital Gains.

I look at a Large Tax Bill as I nice problem to have 20 years from now. That will mean I'm doing just fine! I am not fond of Capital Gains Losses to use as deductions
Thats important information. I recommend that everyone look at some of gummy's pages on tax deferral. He points out that tax deferral is important when deferring to a lower tax bracket, and may actually be costly when deferring to a higher tax bracket. I expect my tax bracket to rise when MRD time hits, so paying some tax now is an emotional negative that the logical part of my brain puts up with. It sounds like you expect a lower bracket in the future, so your circumstances and needs are different.

Alec, no I wasn't commenting on tax efficient funds, but on funds that distribute higher eligible dividend and higher expected capital gains. Even if they are not so tax efficient, I was thinking that the tax treatment would be the overriding factor. Given cutthroats tax position, I would look at tax efficiency AND eligibility of capital gains and dividends for favorable tax treatment.

I didn't see any comments on the foreign tax credit issue above. I know that in the past I have held funds that extended such credits to me. What is the concensus of holding international funds in a taxable vs tax-deferred account? Are dividends eligible? Is the tax credit significent?

Wayne
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Re: Question For Financial Whiz Guys.....
Old 01-16-2004, 03:20 PM   #14
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Re: Question For Financial Whiz Guys.....

There's a rub to using indexes. Have you noticed that the more 'tightly defined or more thinly sliced the index' the higher the portfolio turnover? - a no no to a Boglehead like me. Transaction costs count. My mini amount of VG small cap value had a 27-28% turnover last time I checked. Yahoo used to have portfolio turnover %'s for mutual funds but I don't think they track them in their 'newer format'.

Portfolio turnover is one of the things I tend to watch and think about.
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Re: Question For Financial Whiz Guys.....
Old 01-17-2004, 10:30 AM   #15
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Re: Question For Financial Whiz Guys.....

Quote:
Alec, no I wasn't commenting on tax efficient funds, but on funds that distribute higher eligible dividend and higher expected capital gains. Even if they are not so tax efficient, I was thinking that the tax treatment would be the overriding factor. Given cutthroats tax position, I would look at tax efficiency AND eligibility of capital gains and dividends for favorable tax treatment.

I didn't see any comments on the foreign tax credit issue above. I know that in the past I have held funds that extended such credits to me. What is the concensus of holding international funds in a taxable vs tax-deferred account? Are dividends eligible? Is the tax credit significent?

Wayne
Wayne,

Sorry for the mis-interpretation. I definitely agree that one should hold those assets that will distribute dividends that are eligible for the more favorable tax treatment. Equities certainly qualify for this, where bonds and REITs don't.

I'm just not sure that one would want to go seeking funds that will distribute a good amount of dividends or even distribute capital gains on a regular basis. I don't think you're advocating this at all. Even though a small cap fund will likely have the opportunity for higher returns, I think one still has to look for a fund (if going to be held in a taxable account) that will distribute very little dividends (qualifying or not) and very little capital gains.

I think we can agree that by using tax managed funds (like from Vanguard) or ETF's, and deferring almost all capital gains into the future, an investor would benefit from the compounding of that return. Where as if an investor had to pay more capital gains taxes yearly (even on a non-TM small cap fund), and pay taxes on the dividends yearly, he/she wouldn't benefit from said compounding as much.

Take DFA's tax-managed funds for example, especially the value funds. I believe that they have very low dividends, and specifically try to avoid those value stocks which pay high dividends. Hence, I don't think funds or ETF's like the new Dow Jones high dividend ETF (which is the highest dividend paying stocks in the DJ index if I'm not mistaken) would be optimal or better than a good tax-managed fund or value ETF, as the DJ ETF doesn't benefit from the tax-deferred compounding as much, since one would have to pay yearly taxes on those qualifying dividends. Though the dividends don't hurt as much, they still hurt.

As far the as foreign tax credit goes, I believe that the dividends from the Vanguard regional index funds and the TM int'l fund (not the funds of funds - Total int'l or Developed markets) are eligible for them, and they will be eligible for qualifying dividends lower tax treatment. Though, I'd call Vanguard to double check.

I think I might add TM small cap first, b/c of it's very low dividend yield, to the taxable account before TM int'l (since it has a much higher dividend yield). The TM growth and income, TSM, or TM capital appreciation do have lower dividend yields than TM int'l, but TM int'l does get foreign tax-credits.

I believe that I've seen the foreign tax credits adding perhaps 20-40 basis points (0.20%-0.40%) to return. Seems rather insignificant, but with future equity returns likely to be lower than "historicall", I'd take all the help I can get.

My vote: tax managed small cap fund (I vote for Vanguard here) or small cap ETF, and tax managed int'l or EAFE ETF.

- Alec
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Re: Question For Financial Whiz Guys.....
Old 01-17-2004, 08:19 PM   #16
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Re: Question For Financial Whiz Guys.....

Quote:

I'm just not sure that one would want to go seeking funds that will distribute a good amount of dividends or even distribute capital gains on a regular basis. I don't think you're advocating this at all. Even though a small cap fund will likely have the opportunity for higher returns, I think one still has to look for a fund (if going to be held in a taxable account) that will distribute very little dividends (qualifying or not) and very little capital gains.

- Alec
Since the ground rules weren't for overall tax minimization but short term tax minimization the issue becomes moot. But given a fund distributing 10% in qualifying dividends and LT capital gains, it turns out better to keep it in a taxable account for periods under 34 years(using a 15% tax rate). Thats taxing it at 5% yearly in the after tax, vs. a 15% tax at the end of the period in a tax deferred fund. But it does switch after 34 years, which I didn't expect. So for the very long term, I have to agree with you Alec, minimize the taxable gains in the after tax fund. However, if you are drawing money to live on from the funds, then the after tax scenerio is better. Of course the tax breaks expire in 2009, and laws can be changed anytime. However I don't think I'll do better than a 5% tax rate anytime in the future myself.

Wayne

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Re: Question For Financial Whiz Guys.....
Old 01-18-2004, 04:00 AM   #17
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Re: Question For Financial Whiz Guys.....

One general principle that this discussion illustrates is that, in deciding which assets to own and in what type of account, it is important to consider the income and investments of everyone in the family. This principle can even be extended to the assets of an elderly parent whose assets will be passed on to a person. It is not necessary, and not usually desirable, for each member of a family to have their own set of assets that is completely diversified.
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