Tax-managed fund comparison

Vanguard offers three mutual funds which are explicitly tax-managed. However, index funds and exchange-traded funds (ETFs) are inherently tax-efficient, and are sometimes less expensive; therefore, the tax-managed mutual funds may not always be the best options even for taxable investors.

General recommendations
Vanguard Tax-Managed Small-Cap Fund and Vanguard Tax-Managed Capital Appreciation Fund are worth holding if your taxable account needs a separate large-and-mid cap or small cap fund (and, in the case of TM Capital Appreciation, you don't mind its slight growth bias, say because you have a value bias in your IRA.) Except in the top tax bracket, TM Capital Appreciation is probably not worthwhile as a substitute for a large-cap-only fund; use 500 Index.

Total Stock Market is still better than a combination of tax-managed funds, except in the top tax bracket, and even then it is just as good.

Vanguard Tax-Managed Balanced Fund has no tax advantage but a small cost advantage over the individual funds, in addition to the simplicity. However, you may lose that to extra tax costs if you have to sell the fund.

Vanguard also used to have a Tax-Managed International Fund; the Developed Markets Index fund is being merged into this fund. Post merger, the current Developed Market Index fund will cease to exist, and the revamped Tax-Managed International fund will be renamed Developed Market Index Fund. If you previously had TM International, you should keep these shares rather than selling for a capital gain because the additional cost is trivial, but Total International is better as the core of a taxable international portfolio.

Comparisons
These comparisons are based on the total costs, including both taxes and expenses. Calculations will be done with three tax assumptions: 15%/25%/top tax brackets. In the 15% tax bracket, qualified dividends and long-term gains are taxed at 0%. In the 25% tax bracket, qualified dividends and long-term gains are taxed at 15%. In the top tax bracket, investment income is taxed at 43.4% (including the 3.8% Affordable Care Act surcharge) and qualified dividends and long-term gains are taxed at 23.8% (including the surcharge).

Your actual tax cost will be higher if you owe state taxes (add your state tax rate on the dividend yield, reduced by your federal tax rate if you itemize deductions) or are in the phase-out range for some tax benefit such as the child tax credit (add 5% to all tax rates) or the personal exemption phase-out for the Alternative Minimum Tax (add 7% to all tax rates, but your overall tax on non-qualified dividends is 28%).

All calculations assume Admiral or ETF shares of the alternative funds; given the $10,000 minimum for the tax-managed funds, you should have Admiral shares, and for multiple-fund combinations, the cost of waiting for Admiral shares is trivial. Expense ratios are adjusted for the acquired fund fees and expenses from business development companies; the SEC requires these fees to be included in the reported ratio but they are misleading in a comparison of indexes.

Tax-Managed Small-Cap
TM Small-Cap tracks the same index as the S&P 600 ETF. Currently, TM Small-Cap has 0.03% lower expenses, but the S&P 600 ETF may reduce its expenses as it gets larger. The reported yields are almost equal, and neither fund is likely to distribute a capital gain. The advantage of TM Small-Cap is from its 100% qualified dividends, versus 75% assumed for the S&P 600, and the current lower cost.

If you do not use ETFs, Small-Cap Index has an expense ratio 0.02% less than TM Small-Cap, but a higher cap range, so you need more of Small-Cap Index to get the same small-cap exposure. In addition, it has a 0.20% higher yield, which causes dividend taxes to cancel out the cost savings.

Tax-Managed Capital Appreciation
TM Capital Appreciation tracks the Russell 1000 index, with equal expenses to the ETF but a lower yield because it selects stocks to reduce dividend yields. Both funds should have 100% qualified dividends and avoid all capital gains; the tax-managed fund benefits from the lower yield.

Large-Cap Index is an alternative fund, and the alternative you would use if you do not use ETFs. It is a similar index with 0.02% lower expenses. 500 Index misses most of the mid-caps, but if you don't need mid-caps, it may be an even better deal than the tax-managed fund with 0.07% lower expenses. 500 Index has a slightly higher yield because large-cap stocks have higher yields than mid-cap stocks.

Tax-managed funds versus Total Stock Market
80% TM Capital Appreciation and 20% TM Small-Cap approximates the allocation of Total Stock Market. However, Total Stock Market saves 0.07% in expenses, has almost 100% qualified dividends (98% assumed, as the 94% in 2013 was the first year without 100%), should never distribute a capital gain, and eliminates your own potential capital gains from rebalancing the large-cap and small-cap funds. Total Stock Market thus comes out ahead of the TM combination except in the top tax bracket, and even there, you might lose the advantage of two basis points to capital gains from rebalancing.

Tax-Managed Balanced
TM Balanced is essentially the same as 49% TM Capital Appreciation and 51% Intermediate-Term Tax-Exempt. The expenses are 0.10% for the balanced funds, versus 0.12% for the individual funds (assuming Admiral shares of the municipal-bond fund with a $50,000 minimum; the expense difference is 0.06% if you have Investor shares), so the balanced fund has a slight cost advantage over the two separate funds. However, it isn't really suitable for a single-fund portfolio because it lacks international stocks. In addition, it has the usual disadvantage of a balanced fund in a taxable account: you cannot sell bonds without paying a capital gain on your stock sales. In particular, if you move to a high-tax state, you may want to sell your national municipal-bond fund and buy a fund for that state, but you will have to pay a capital-gains tax if your municipal bonds are in a balanced fund.

Total international
After the scheduled April 4, 2014 reorganization and merger of the Vanguard Developed Markets index fund into the TM International fund, the combined fund will be renamed the Vanguard Developed Markets Index Fund. To get the same allocation as Total International (which includes small-caps and emerging markets), you need 70% Developed Market (nee TM International), 15% Emerging Markets, 15% FTSE All-World Ex-US Small-Cap. The FTSE Small-Cap fund should be held as an ETF because it has no Admiral shares and the ETF is much less expensive; the others can be held as Admiral shares or ETF. The three-fund combination has 0.12% expenses, compared to 0.14% for Total International.

Even if the expense ratio on Total International doesn't decrease to eliminate the 0.23% difference, you are likely to lose that 0.02% to tax costs. You will have your own tax costs from rebalancing the three-fund combination, and even if you overweight small-cap or emerging markets so that you need three funds, using Total International as the core holding will reduce the amount you need in the small-cap and emerging markets funds and thus the amount of rebalancing. The three-fund combination may have a disadvantage on qualified dividends if a stock moves to a different index before the 61-day holding period for qualified dividends. FTSE Small-Cap may distribute some capital gains; it distributed capital gains in 2009 and 2010 but not in 2011-2013. And as a non-tax cost, you will lose a bit to transaction costs buying and selling FTSE Small-Cap, which trades at a large spread.