Tax Efficiency of Index Funds...instant return

Long-term; a properly diversified portfolio of index funds will deliver a superior return than conventional actively managed mutual funds. There are several reasons for this, some more important than others. Today, I’ll talk about the first major factor, which is the tax efficiency of index funds. By their nature, they have a very low turnover rate, which means that index funds distribute very little capital gains (which is taxed) to shareholders. For instance, there are many index funds that are benchmarked to the S&P 500 index, which only had a turnover rate of about 6 percent per year over the last 10 years according to the S&P 500 Directory. Most of this very low turnover was triggered by mergers and acquisitions. Most actively managed mutual funds fail to meet or beat their respective benchmark index funds on a pre-tax basis. On an after tax basis, the index funds beat the actively managed funds by an even wider margin. When we look at the turnover rate of some of Vanguard’s actively managed Large Cap mutual funds, we see turnover rates between 7% and 357% in any given year. However, I must emphasize that the average turnover rate for active funds in general is significantly higher than that of index funds.