Tax-Efficient Portfolios

Taxes and fees in your portfolio add up, quickly whittling your returns, eroding the cash you hold and harming your future. Making your investments work best for you means heading off your potential tax exposure and high management fees, and managing your portfolio to take every advantage.

Do-it-yourself investors and even some financial advisors often ignore those expenses, placing too much attention into structuring a portfolio and not enough into low-hanging opportunities, such as keeping expenses low. Portfolio tax efficiency translates into how much of your gains you keep after fees and taxes. The greater the tax efficiency, the more gains you keep – like the difference between gross pre-tax earnings and net earnings after taxes on your paycheck.

For example, one avenue of exposure to the equity markets is a Standard & Poor’s 500 Index mutual fund. While its low fees are important, the tax efficiency of the index affects your after-tax returns more. The S&P 500 Index has low turnover, less than 5% of the listed companies per year on average.

This means the index adds or removes about 5% of the total value of S&P 500 companies yearly – in stark contrast to how most money managers invest.

On average, U.S. equity managers turn over their complete portfolio once every two years. This buying and selling of securities creates taxable gains on your holdings.

You can take several steps to improve the tax efficiency of your portfolio.

Indexing. Do you want to keep 11.3% or 9.6% of your returns? That’s the after-tax difference between the Vanguard S&P 500 Index (VSPVX) and the average U.S. large-cap equity fund over the past three years. What accounts for the difference?

Fees and tax efficiency: The annual index fund fee is 0.17%, the average U.S. equity manager fee 1.03%. More important, the turnover of stocks in active manager portfolios was 10 times greater than that of the index. All that trading erodes returns.

Note: I don’t advocate putting every investment in an index fund. Our firm certainly uses managed funds in many areas of portfolios where those funds make sense. Instead, I suggest that, in certain asset categories, you index for efficiency and use active managers for other segments of the markets.

Tax-efficient managers. Where active management can improve tax efficiency, such as in global equities or emerging market portfolios, choose a manager with low turnover, longer holding periods and low fees. The lower the turnover, the greater the tax efficiency. The lower the fees, the less annual drag on performance. offers free information on fees, turnover percentages and tax-cost efficiency for every mutual fund manager. Even better, Morningstar calculates tax-adjusted returns showing historically just how much of the returns, net of taxes, you keep.

Portfolio structure. Your portfolio needs a strategic framework with reasonable bounds on how much you expect to own in stocks, bonds and other assets. Then decide whether to index certain investments and where to hold these investments.

Proper asset allocation cuts your taxes. Generally, hold your most tax-efficient investments in taxable accounts and your least tax-efficient in tax-deferred accounts such as a 401(k) or an individual retirement account.

Harvesting tax losses. Periodically, markets decline in concert, like in 2002 and 2008. Other times, only certain segments of the market decline, like emerging markets did in 2013. Such years provide opportunities to harvest tax losses.

If your investment takes a tax loss, you can sell it, capture the tax loss and move into an investment with similar characteristics. You can do this with a swap of mutual funds or with a swap of stock into an exchange-traded fund (or vice versa).

This changes nothing about the structure of investments in the portfolio, but does capture losses to offset future gains in the portfolio when markets recover.

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Nathan Sonnenberg, CFA, CAIA, is chief investment officer of Glassman Wealth Services, a fee-only investment management, financial planning and wealth management firm in McLean, Va. His vast experience includes the unique perspective of having directed the outsourced research efforts for over 90 high-net worth wealth management firms and wealthy families, in addition to managing the investment research , portfolio construction and development of asset allocation strategies for clients. The firm’s website is

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