Small value in a taxable account

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Kevinm1986
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Small value in a taxable account

Post by Kevinm1986 »

I know that small value isn't terribly tax efficient, and it's best in tax-deferred accounts, if possible. But I had never seen anything quite as cut and dry as Laura's comment in the "questions for the experts" thread:
In my opinion it is not worth holding small value in taxable. You can go for the small tilt with Tax Managed Small Cap but skip the value part unless you can hold it in a tax advantaged account.
Taylor Larimore then said that he agreed with Laura's opinion about small value, although he suggested Total Stock Market in lieu of either Small Value or TM Small Cap (VTMSX). I figured I'd start a new thread rather than clutter that one up.

It seems pretty clear to me that the general Diehard consensus (including Laura and Taylor Larimore) is that there are both size and value premia, and that one can expect to acheive greater return (and risk) by tilting to small value.

However, this raises problems of tax efficiency. Value stocks tend to have higher dividend yields, and VISVX--Vanguard's Small Value Index (where I invest my small value dollars)--has a large amount of REITs which are ineligble for the qualified dividend rate. Small stocks also tend to migrate up and out of the small-cap region, forcing managers to either realize capital gains or hold the stocks and reduce the fund's expected returns (since the size premium is lessened).

So the question is whether the expected returns of Small Value compared to TSM or Small Blend trump the tax problems. I looked at the distributions for VISVX and VTMSX. $10k invested in VISVX right at the time of each distribution last year would have resulted in $182.83 of income (ignoring reinvesting dividends, capital appreciation, etc.). The corresponding amount for VTMSX would be $74.76. Given my tax brackets (4% state and 15% federal--though I might even end up in the 10% bracket this year), that's only $20 difference in taxes paid. In other words, VISVX only needs to beat VTMSX by more than 20 basis points to come out ahead.

So will it? As the saying goes, "Past results are no guarantee of future performance," but looking at the backtesting spreadsheet shows that small value has averaged 146 bp better than small blend since 1972 (small value has also been less volatile). Also, as for the SV vs. TSM question, SV has outperformed by more than 4% a year bp on average, so I doubt any tax-efficiency problems would erase that gap.

In short, it seems almost impossible for the small/value premia to exist but be so tiny they aren't worth pursuing. I am sure there are arguments against a small/value tilt, but surely, if a premium exists, it must be more than few hundredths of a percent.

Any thoughts?
livesoft
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Post by livesoft »

Here's my take: The yield on the small value etf VBR is reported to be 2.05%. The yield on the total stock market etf VTI is reported to be 1.7%

So if small value isn't terribly tax efficient, then neither is total stock market.
xenial
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Post by xenial »

livesoft wrote:Here's my take: The yield on the small value etf VBR is reported to be 2.05%. The yield on the total stock market etf VTI is reported to be 1.7%

So if small value isn't terribly tax efficient, then neither is total stock market.
There is another factor which contributes to potential tax inefficiency: Stocks leaving the index. Stocks won't generally leave VTI. Stocks will leave VBR if they appreciate in price enough so that they're no longer "small" or no longer "value." Sale of these stocks could trigger capital gains.

Best wishes,
Ken
sterjs
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Post by sterjs »

The tax inefficiency of Smallcap Value is overblown in the ETF age, IMO. IWN and IJS have not been substantially more tax inefficient than Vanguard Total Stock Market since their inception.
SteveB3005
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Post by SteveB3005 »

Kevin,

An excellent discussion of this topic back in January on the old forum by some sharp numbers people. [ conversation 56953 ]


Dolan had this data set and comment.

For 1963 to 2000

Pre / After tax annualized returns / stdev:

_______Pre_____After___STDEV
TSM____12.04___10.65___16.40
6-10___13.36___10.46___25.22
LV_____14.67___10.57___17.62
SV_____16.01___11.91___25.59

If you chose a mix and also rebalance annualy the turnover that you produce will cost you an additional 0.5% to 1% in taxes depending on mix.
It's hard to beat TSM in taxable IMO even harder to have superior risk adjusted returns.
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alvinsch
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Post by alvinsch »

I don't agree with the advice to never put SV in taxable but VBR is probably not the most tax efficient SV ETF. Vanguard shows VBR with a 2.05% yield and 67% QDI, but the ishares IJS has only a 1.10% yield according to M* and had about 94% qualified last year.

Since the total market ETF, VTI has a 1.70% dividend yield with 100% QDI, if one assumes that VTI and IJS have roughly the same probability of avoiding CG's then IJS would be more tax efficient than VTI.

- Al
stebul
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Post by stebul »

Most ETFs have been started during a very long bull market with lots of cash inflows. What will happen in a prolonged bear market with substantial cash outflows? What will happen if the tax treatment of ETFs is changed? Should you buy the Vanguard mutual fund with an ETF share class, or a higher ER "pure" ETF from someone other than Vanguard? Will the "pure" ETF from iShares or SSga (with a higher ER) be more tax efficient than the ETF share class from Vanguard?

No one knows the answers to these questions as they depend on the future performance of the market and whims of the taxing authorities. If you are planning to buy and hold in taxable for a very long time, Total Market looks like the safest bet. If you decide you still want SV in taxable, some would say go with the lowest ER (Vanguard). Others would say go with something like iShares S&P600 Value so you get the full benefit of the ETF tax efficiencies. Does anyone have a coin to toss?
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Kevinm1986
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Post by Kevinm1986 »

FWIW I'm in the non-ETF Vanguard Small Value, but even then I don't think I'm losing enough in tax efficiency to erase the value premium.
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AzRunner
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Post by AzRunner »

Kevinm1986 wrote:FWIW I'm in the non-ETF Vanguard Small Value, but even then I don't think I'm losing enough in tax efficiency to erase the value premium.
So far, so good, but VISVX has been chewing through its long term capital losses that it built up from 2000-2. If the bull market continues there is a good chance it will declare a capital gain this year. The Vanguard site has this data for VISVX:

Realized Capital Gain/Loss –$0.25
Realized Capital Gain/Loss as a % of NAV –1.41%
Unrealized Appreciation/Depreciation $3.21
Unrealized Appreciation/Depreciation as a % of NAV 18.15%

My own thinking is that VISVX belongs in a tax advantaged account. It is not a slam dunk in a taxable account as the 1963-2000 data illustrates.

Norm
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stratton
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Post by stratton »

Another option might be Bridgeway Small Cap Value BRSVX, but it has an ER of 0.77 and it appears to be migrating towards a small blend looking at M* xray. But, boy is it a hot fund right now up 10.95% YTD. :shock:

Paul
sterjs
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Post by sterjs »

stratton wrote:Another option might be Bridgeway Small Cap Value BRSVX, but it has an ER of 0.77 and it appears to be migrating towards a small blend looking at M* xray. But, boy is it a hot fund right now up 10.95% YTD. :shock:

Paul
I ignore the Morningstar X-Ray, but the Price/Book for BRSVX is higher than the Vanguard Small Cap blend. BRSVX looks more like a GARP(Growth-At-Reasonable-Price) fund than Small "Value" right now.
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Kenster1
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Post by Kenster1 »

Note also that a few people on the M* MF forum had given up on BRSVX--Bridgeway SCV Fund because of its volatility. Over the past year it had exhibited a fair amount of volatility, more so than most Smallcap Funds.
larryswedroe
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Post by larryswedroe »

IMO that advice is wrong

The only equities that belong in tax advantaged accounts as preference are REITS---

There are TM SV funds (DFA) and you now have as noted ETFs for small value.

Holding SV in tax advantaged accounts loses these benefits
a) converts capital gains into ordinary income
b) loss of ability to harvest losses--and not only is this valuable, the more volatile an asset class the more valuable it becomes, and SV is high volatility asset class
c) cannot donate appreciated shares to charity
d) lose potential for stepped up basis for heirs, a very valuable benefit

And if it was int'l sv you would also lose the benefit of the foreign tax credits.
edge
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Too volatile?

Post by edge »

Those MF forum members invest in a SCV fund and want low volatility?


....


I get the feeling that those guys are the proverbial lemmings in the stock market.
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Kenster1
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Post by Kenster1 »

Edge,

It's all relative.

In fact, I've noticed myself that BRSVX can be pretty volatile -- more volatile than other SCV indexes or funds I've seen. As others have noted, the fund seems more like a GARP fund -- perhaps it also uses some type of momentum screens like it does in their other funds which are also quite volatile.
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