Article, .COM Example

The Short Answer

How Tax-Efficient Is This Fund?

Question: I am looking for funds for a taxable account. How can I tell if a fund is tax-efficient?

Answer: Morningstar.com's fund quote pages contain many useful data points for evaluating a fund's tax efficiency. We'll run through them, and give a brief explainer on how to use each one.

It also pays to remember, though, that past isn't prologue. Funds that have been tax-efficient in the past may not necessarily be great choices for taxable investors going forward. For that reason, investors in a taxable account may want to take stock of which kinds of funds are more likely to be tax-efficient choices simply due to their structure or the type of securities they invest in.

Tax-Efficient by Nature

It also pays to remember, though, that past isn't prologue. Funds that have been tax-efficient in the past may not necessarily be great choices for taxable investors going forward. For that reason, investors in a taxable account may want to take stock of which kinds of funds are more likely to be tax-efficient choices simply due to their structure or the type of securities they invest in.

Before getting into the nitty-gritty of tax evaluation metrics, it's important to point out that there are certain types of funds that are more tax-efficient than others. Many index funds, especially large-cap index funds or total-market index funds that are weighted by market cap, have fairly low turnover and tend not to pay out big distributions. But you can't assume that just because it's an index fund it earns high marks for tax-efficiency: Sometimes stocks get booted out of indexes with market-cap constraints or factor exposures when the stocks no longer meet the indexes' criteria for inclusion.

Exchange-traded funds tend to be tax-efficient because of their ability to exchange securities in-kind (which doesn't result in a tax liability as a sale of the asset would). However, certain types of ETFs are more likely to make distributions (such as currency-hedged funds that employ derivatives contracts).

On the other end of the spectrum, actively managed funds that tend to have high turnover strategies, funds focusing on real-estate investment trusts, or high-yield bond funds are often a poor choice for taxable accounts because they frequently pay out income and capital gains distributions.

Most bond funds are also best kept in a tax-deferred account type, with the exception of municipal bond funds , whose income is tax-advantaged: In the vast majority of cases, the income they provide is not taxed at the federal level and, in some instances, it's not taxed at the state or local level, either. (Some muni bonds could be subject to alternative minimum tax, however.)

Aftertax Returns

Most bond funds are also best kept in a tax-deferred account type, with the exception of municipal bond funds , whose income is tax-advantaged: In the vast majority of cases, the income they provide is not taxed at the federal level and, in some instances, it's not taxed at the state or local level, either. (Some muni bonds could be subject to alternative minimum tax, however.)

In addition, because traditional measures of tax efficiency are calculated by taking expenses out of income, funds with higher expense ratios can end up looking more tax-efficient, even though their aftertax return may lag that of a cheaper fund.

By clicking on a fund's tax tab on its fund quote page, you can compare a fund's aftertax return to its pretax return. We'll use Vanguard Dividend Growth (VDIGX) as an example, because it tends to be a highly requested fund quote by Morningstar.com users.

Vanguard Dividend Growth does not implicitly set out to limit investors' tax exposure, as a so-called tax-managed fund aims to do. Its prospectus states that it seeks to provide a growing stream of income over time as well as long-term capital appreciation and current income. That said, you may expect that it's not a highly tax-efficient strategy.

But you can see that it has been pretty tax-efficient nonetheless: By comparing the fund's pretax returns with its aftertax returns, you can see that there isn't a large gap. (To facilitate the comparison I created the table below using information on the performance tab—the pretax return and pretax rank in category—and the tax tab—the aftertax return, aftertax rank in category, and tax-cost ratio—of Vanguard Dividend Growth's fund quote page.)

Tax Analysis of Vanguard Dividend Growth Inv

Here is where we want an accurate description about the data displayed and/or the table's intent
1 Year
3 Years (Annualized)
5 Years (Annualized)
10 Years (Annualized)
Pretax Return 16.27 14.70 12.09 11.22
Pretax Return Rank in Category 49% 67% 57% 46%
Aftertax Return 14.51 13.34 10.76 10.37
Aftertax Return Rank in Category 45% 56% 47% 39%
Tax-Cost Ratio 1.51 1.19 1.19 0.77
Data as of Sept. 30, 2018. Morningstar uses the highest federal tax rate when dealing with short-term cap gains, interest, and nonqualified dividends.

Also, the fund's return “% rank in category” is higher for the fund's aftertax return that its pretax return over all trailing periods. (A rank in category of 1 is most desirable and means that the fund's return is at the top of the category, while 100 means it's at the bottom.)

One way the fund achieves this is by keeping its annual turnover low—over the past 10 years it's been in the range of 11% to 27%, which in many years is well below the average of actively managed peers in the category. Also, fund manager Donald Kilbride's focus on quality leads him to stocks that have the potential to grow their dividends over time rather than those with the highest current yields.

Tax-Cost Ratio

Another evaluation metric investors can use is the tax-cost ratio. Also found on a fund quote's tax tab, this metric measures how much a fund's annualized return is reduced by taxes investors pay on distributions.

The way it's expressed is much like an expense ratio: The lower it is, the less money the investor has surrendered to taxes. A tax-cost ratio of zero means that the fund didn't pay out any taxable distributions for the period. (Of course, that's not to say that you should buy a fund just because its tax-cost ratio is low or zero. You should also consider a fund's management, strategy, record, and fees.)

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

Note that the tax-cost ratio is not simply the difference between the pretax return and the aftertax return. This is the formula to calculate it:

Tax-Cost Ratio = [ 1 - ( (1+Tax-adjusted Return) / (1+Pretax Return) ) ] x 100

Plugging in the five-year returns for Vanguard Dividend Growth:

Pretax Return = 12.09%
Tax-adjusted Return = 10.76%
= [ 1 - ( (1+0.1076) / (1+0.1209) ) ] x 100
= [ 1 - ( 1.1076 / 1.1209 ) ] x 100
= (1 - 0.9881) x 100
= 0.0119 x 100
= 1.19%

Potential Capital Gains Exposure

Aftertax returns and tax-cost ratio tell you about how tax-efficient a fund has been in the past, but neither guarantees anything about how tax-efficient a fund will be going forward.

One helpful data point that can help you size up a fund's potential for a tax hit is its potential capital gains exposure, which can also be found on the fund's tax tab. From a tax perspective, you can think of a high positive potential capital gains estimate as “a worst-case scenario.” The PCGE percentage measures all of the gains that have not yet been distributed to shareholders or taxed but could be in the event that the entire portfolio were turned over.

A positive PCGE indicates that the fund's holdings have generally increased in value, while a negative PCGE indicates that the fund has some tax losses on its books that it can carry forward to offset gains. With markets near record highs, however, most stock funds won't find themselves in this position.

The word “potential” is key here, though; a high PCGE figure doesn't always result in a big payout. If the fund doesn't sell the appreciated securities, the gain will not be realized during the calendar year—or anytime soon, for that matter. Funds with low-turnover strategies such as those that follow an index-tracking strategy are less likely to experience events that trigger high turnover, but they aren't immune from them.

Vanguard Dividend Growth's PCGE is 40.35%, indicating that about two-fifths of its holdings consist of appreciated securities that, if sold, could result in capital gains. The fund has been very tax-efficient and has had fairly low turnover in recent years, but it's not an impossibility that it could experience a manager change or be hit by large outflows—two major catalysts that can lead to increased selling and subsequent distributions.

All told, if you're an investor in a taxable account, it pays to take time to investigate and understand the strategy. Using the tax-efficiency metrics on Morningstar.com can help you make some reasonable inferences about how tax-efficient a fund has been and whether it is likely to remain so even in the worst of circumstances.

Karen Wallace does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.

Article, .COM Example

The Short Answer

How Tax-Efficient Is This Fund?

Question: I am looking for funds for a taxable account. How can I tell if a fund is tax-efficient?

Answer: Morningstar.com's fund quote pages contain many useful data points for evaluating a fund's tax efficiency. We'll run through them, and give a brief explainer on how to use each one.

It also pays to remember, though, that past isn't prologue. Funds that have been tax-efficient in the past may not necessarily be great choices for taxable investors going forward. For that reason, investors in a taxable account may want to take stock of which kinds of funds are more likely to be tax-efficient choices simply due to their structure or the type of securities they invest in.

Tax-Efficient by Nature

It also pays to remember, though, that past isn't prologue. Funds that have been tax-efficient in the past may not necessarily be great choices for taxable investors going forward. For that reason, investors in a taxable account may want to take stock of which kinds of funds are more likely to be tax-efficient choices simply due to their structure or the type of securities they invest in.

Before getting into the nitty-gritty of tax evaluation metrics, it's important to point out that there are certain types of funds that are more tax-efficient than others. Many index funds, especially large-cap index funds or total-market index funds that are weighted by market cap, have fairly low turnover and tend not to pay out big distributions. But you can't assume that just because it's an index fund it earns high marks for tax-efficiency: Sometimes stocks get booted out of indexes with market-cap constraints or factor exposures when the stocks no longer meet the indexes' criteria for inclusion.

Exchange-traded funds tend to be tax-efficient because of their ability to exchange securities in-kind (which doesn't result in a tax liability as a sale of the asset would). However, certain types of ETFs are more likely to make distributions (such as currency-hedged funds that employ derivatives contracts).

On the other end of the spectrum, actively managed funds that tend to have high turnover strategies, funds focusing on real-estate investment trusts, or high-yield bond funds are often a poor choice for taxable accounts because they frequently pay out income and capital gains distributions.

Most bond funds are also best kept in a tax-deferred account type, with the exception of municipal bond funds , whose income is tax-advantaged: In the vast majority of cases, the income they provide is not taxed at the federal level and, in some instances, it's not taxed at the state or local level, either. (Some muni bonds could be subject to alternative minimum tax, however.)

Aftertax Returns

Most bond funds are also best kept in a tax-deferred account type, with the exception of municipal bond funds , whose income is tax-advantaged: In the vast majority of cases, the income they provide is not taxed at the federal level and, in some instances, it's not taxed at the state or local level, either. (Some muni bonds could be subject to alternative minimum tax, however.)

In addition, because traditional measures of tax efficiency are calculated by taking expenses out of income, funds with higher expense ratios can end up looking more tax-efficient, even though their aftertax return may lag that of a cheaper fund.

By clicking on a fund's tax tab on its fund quote page, you can compare a fund's aftertax return to its pretax return. We'll use Vanguard Dividend Growth (VDIGX) as an example, because it tends to be a highly requested fund quote by Morningstar.com users.

Vanguard Dividend Growth does not implicitly set out to limit investors' tax exposure, as a so-called tax-managed fund aims to do. Its prospectus states that it seeks to provide a growing stream of income over time as well as long-term capital appreciation and current income. That said, you may expect that it's not a highly tax-efficient strategy.

But you can see that it has been pretty tax-efficient nonetheless: By comparing the fund's pretax returns with its aftertax returns, you can see that there isn't a large gap. (To facilitate the comparison I created the table below using information on the performance tab—the pretax return and pretax rank in category—and the tax tab—the aftertax return, aftertax rank in category, and tax-cost ratio—of Vanguard Dividend Growth's fund quote page.)

Tax Analysis of Vanguard Dividend Growth Inv

Here is where we want an accurate description about the data displayed and/or the table's intent
1 Year
3 Years (Annualized)
5 Years (Annualized)
10 Years (Annualized)
Pretax Return 16.27 14.70 12.09 11.22
Pretax Return Rank in Category 49% 67% 57% 46%
Aftertax Return 14.51 13.34 10.76 10.37
Aftertax Return Rank in Category 45% 56% 47% 39%
Tax-Cost Ratio 1.51 1.19 1.19 0.77
Data as of Sept. 30, 2018. Morningstar uses the highest federal tax rate when dealing with short-term cap gains, interest, and nonqualified dividends.

Also, the fund's return “% rank in category” is higher for the fund's aftertax return that its pretax return over all trailing periods. (A rank in category of 1 is most desirable and means that the fund's return is at the top of the category, while 100 means it's at the bottom.)

One way the fund achieves this is by keeping its annual turnover low—over the past 10 years it's been in the range of 11% to 27%, which in many years is well below the average of actively managed peers in the category. Also, fund manager Donald Kilbride's focus on quality leads him to stocks that have the potential to grow their dividends over time rather than those with the highest current yields.

Tax-Cost Ratio

Another evaluation metric investors can use is the tax-cost ratio. Also found on a fund quote's tax tab, this metric measures how much a fund's annualized return is reduced by taxes investors pay on distributions.

The way it's expressed is much like an expense ratio: The lower it is, the less money the investor has surrendered to taxes. A tax-cost ratio of zero means that the fund didn't pay out any taxable distributions for the period. (Of course, that's not to say that you should buy a fund just because its tax-cost ratio is low or zero. You should also consider a fund's management, strategy, record, and fees.)

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

Note that the tax-cost ratio is not simply the difference between the pretax return and the aftertax return. This is the formula to calculate it:

Tax-Cost Ratio = [ 1 - ( (1+Tax-adjusted Return) / (1+Pretax Return) ) ] x 100

Plugging in the five-year returns for Vanguard Dividend Growth:

Pretax Return = 12.09%
Tax-adjusted Return = 10.76%
= [ 1 - ( (1+0.1076) / (1+0.1209) ) ] x 100
= [ 1 - ( 1.1076 / 1.1209 ) ] x 100
= (1 - 0.9881) x 100
= 0.0119 x 100
= 1.19%

Potential Capital Gains Exposure

Aftertax returns and tax-cost ratio tell you about how tax-efficient a fund has been in the past, but neither guarantees anything about how tax-efficient a fund will be going forward.

One helpful data point that can help you size up a fund's potential for a tax hit is its potential capital gains exposure, which can also be found on the fund's tax tab. From a tax perspective, you can think of a high positive potential capital gains estimate as “a worst-case scenario.” The PCGE percentage measures all of the gains that have not yet been distributed to shareholders or taxed but could be in the event that the entire portfolio were turned over.

A positive PCGE indicates that the fund's holdings have generally increased in value, while a negative PCGE indicates that the fund has some tax losses on its books that it can carry forward to offset gains. With markets near record highs, however, most stock funds won't find themselves in this position.

The word “potential” is key here, though; a high PCGE figure doesn't always result in a big payout. If the fund doesn't sell the appreciated securities, the gain will not be realized during the calendar year—or anytime soon, for that matter. Funds with low-turnover strategies such as those that follow an index-tracking strategy are less likely to experience events that trigger high turnover, but they aren't immune from them.

Vanguard Dividend Growth's PCGE is 40.35%, indicating that about two-fifths of its holdings consist of appreciated securities that, if sold, could result in capital gains. The fund has been very tax-efficient and has had fairly low turnover in recent years, but it's not an impossibility that it could experience a manager change or be hit by large outflows—two major catalysts that can lead to increased selling and subsequent distributions.

All told, if you're an investor in a taxable account, it pays to take time to investigate and understand the strategy. Using the tax-efficiency metrics on Morningstar.com can help you make some reasonable inferences about how tax-efficient a fund has been and whether it is likely to remain so even in the worst of circumstances.

Karen Wallace does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.

Article, .COM Example

The Short Answer

How Tax-Efficient Is This Fund?

Question: I am looking for funds for a taxable account. How can I tell if a fund is tax-efficient?

Answer: Morningstar.com's fund quote pages contain many useful data points for evaluating a fund's tax efficiency. We'll run through them, and give a brief explainer on how to use each one.

It also pays to remember, though, that past isn't prologue. Funds that have been tax-efficient in the past may not necessarily be great choices for taxable investors going forward. For that reason, investors in a taxable account may want to take stock of which kinds of funds are more likely to be tax-efficient choices simply due to their structure or the type of securities they invest in.

Tax-Efficient by Nature

It also pays to remember, though, that past isn't prologue. Funds that have been tax-efficient in the past may not necessarily be great choices for taxable investors going forward. For that reason, investors in a taxable account may want to take stock of which kinds of funds are more likely to be tax-efficient choices simply due to their structure or the type of securities they invest in.

Before getting into the nitty-gritty of tax evaluation metrics, it's important to point out that there are certain types of funds that are more tax-efficient than others. Many index funds, especially large-cap index funds or total-market index funds that are weighted by market cap, have fairly low turnover and tend not to pay out big distributions. But you can't assume that just because it's an index fund it earns high marks for tax-efficiency: Sometimes stocks get booted out of indexes with market-cap constraints or factor exposures when the stocks no longer meet the indexes' criteria for inclusion.

Exchange-traded funds tend to be tax-efficient because of their ability to exchange securities in-kind (which doesn't result in a tax liability as a sale of the asset would). However, certain types of ETFs are more likely to make distributions (such as currency-hedged funds that employ derivatives contracts).

On the other end of the spectrum, actively managed funds that tend to have high turnover strategies, funds focusing on real-estate investment trusts, or high-yield bond funds are often a poor choice for taxable accounts because they frequently pay out income and capital gains distributions.

Most bond funds are also best kept in a tax-deferred account type, with the exception of municipal bond funds , whose income is tax-advantaged: In the vast majority of cases, the income they provide is not taxed at the federal level and, in some instances, it's not taxed at the state or local level, either. (Some muni bonds could be subject to alternative minimum tax, however.)

Aftertax Returns

Most bond funds are also best kept in a tax-deferred account type, with the exception of municipal bond funds , whose income is tax-advantaged: In the vast majority of cases, the income they provide is not taxed at the federal level and, in some instances, it's not taxed at the state or local level, either. (Some muni bonds could be subject to alternative minimum tax, however.)

In addition, because traditional measures of tax efficiency are calculated by taking expenses out of income, funds with higher expense ratios can end up looking more tax-efficient, even though their aftertax return may lag that of a cheaper fund.

By clicking on a fund's tax tab on its fund quote page, you can compare a fund's aftertax return to its pretax return. We'll use Vanguard Dividend Growth (VDIGX) as an example, because it tends to be a highly requested fund quote by Morningstar.com users.

Vanguard Dividend Growth does not implicitly set out to limit investors' tax exposure, as a so-called tax-managed fund aims to do. Its prospectus states that it seeks to provide a growing stream of income over time as well as long-term capital appreciation and current income. That said, you may expect that it's not a highly tax-efficient strategy.

But you can see that it has been pretty tax-efficient nonetheless: By comparing the fund's pretax returns with its aftertax returns, you can see that there isn't a large gap. (To facilitate the comparison I created the table below using information on the performance tab—the pretax return and pretax rank in category—and the tax tab—the aftertax return, aftertax rank in category, and tax-cost ratio—of Vanguard Dividend Growth's fund quote page.)

Tax Analysis of Vanguard Dividend Growth Inv

Here is where we want an accurate description about the data displayed and/or the table's intent
1 Year
3 Years (Annualized)
5 Years (Annualized)
10 Years (Annualized)
Pretax Return 16.27 14.70 12.09 11.22
Pretax Return Rank in Category 49% 67% 57% 46%
Aftertax Return 14.51 13.34 10.76 10.37
Aftertax Return Rank in Category 45% 56% 47% 39%
Tax-Cost Ratio 1.51 1.19 1.19 0.77
Data as of Sept. 30, 2018. Morningstar uses the highest federal tax rate when dealing with short-term cap gains, interest, and nonqualified dividends.

Also, the fund's return “% rank in category” is higher for the fund's aftertax return that its pretax return over all trailing periods. (A rank in category of 1 is most desirable and means that the fund's return is at the top of the category, while 100 means it's at the bottom.)

One way the fund achieves this is by keeping its annual turnover low—over the past 10 years it's been in the range of 11% to 27%, which in many years is well below the average of actively managed peers in the category. Also, fund manager Donald Kilbride's focus on quality leads him to stocks that have the potential to grow their dividends over time rather than those with the highest current yields.

Tax-Cost Ratio

Another evaluation metric investors can use is the tax-cost ratio. Also found on a fund quote's tax tab, this metric measures how much a fund's annualized return is reduced by taxes investors pay on distributions.

The way it's expressed is much like an expense ratio: The lower it is, the less money the investor has surrendered to taxes. A tax-cost ratio of zero means that the fund didn't pay out any taxable distributions for the period. (Of course, that's not to say that you should buy a fund just because its tax-cost ratio is low or zero. You should also consider a fund's management, strategy, record, and fees.)

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

Note that the tax-cost ratio is not simply the difference between the pretax return and the aftertax return. This is the formula to calculate it:

Tax-Cost Ratio = [ 1 - ( (1+Tax-adjusted Return) / (1+Pretax Return) ) ] x 100

Plugging in the five-year returns for Vanguard Dividend Growth:

Pretax Return = 12.09%
Tax-adjusted Return = 10.76%
= [ 1 - ( (1+0.1076) / (1+0.1209) ) ] x 100
= [ 1 - ( 1.1076 / 1.1209 ) ] x 100
= (1 - 0.9881) x 100
= 0.0119 x 100
= 1.19%

Potential Capital Gains Exposure

Aftertax returns and tax-cost ratio tell you about how tax-efficient a fund has been in the past, but neither guarantees anything about how tax-efficient a fund will be going forward.

One helpful data point that can help you size up a fund's potential for a tax hit is its potential capital gains exposure, which can also be found on the fund's tax tab. From a tax perspective, you can think of a high positive potential capital gains estimate as “a worst-case scenario.” The PCGE percentage measures all of the gains that have not yet been distributed to shareholders or taxed but could be in the event that the entire portfolio were turned over.

A positive PCGE indicates that the fund's holdings have generally increased in value, while a negative PCGE indicates that the fund has some tax losses on its books that it can carry forward to offset gains. With markets near record highs, however, most stock funds won't find themselves in this position.

The word “potential” is key here, though; a high PCGE figure doesn't always result in a big payout. If the fund doesn't sell the appreciated securities, the gain will not be realized during the calendar year—or anytime soon, for that matter. Funds with low-turnover strategies such as those that follow an index-tracking strategy are less likely to experience events that trigger high turnover, but they aren't immune from them.

Vanguard Dividend Growth's PCGE is 40.35%, indicating that about two-fifths of its holdings consist of appreciated securities that, if sold, could result in capital gains. The fund has been very tax-efficient and has had fairly low turnover in recent years, but it's not an impossibility that it could experience a manager change or be hit by large outflows—two major catalysts that can lead to increased selling and subsequent distributions.

All told, if you're an investor in a taxable account, it pays to take time to investigate and understand the strategy. Using the tax-efficiency metrics on Morningstar.com can help you make some reasonable inferences about how tax-efficient a fund has been and whether it is likely to remain so even in the worst of circumstances.

Karen Wallace does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.

Article, .COM Example

The Short Answer

How Tax-Efficient Is This Fund?

Question: I am looking for funds for a taxable account. How can I tell if a fund is tax-efficient?

Answer: Morningstar.com's fund quote pages contain many useful data points for evaluating a fund's tax efficiency. We'll run through them, and give a brief explainer on how to use each one.

It also pays to remember, though, that past isn't prologue. Funds that have been tax-efficient in the past may not necessarily be great choices for taxable investors going forward. For that reason, investors in a taxable account may want to take stock of which kinds of funds are more likely to be tax-efficient choices simply due to their structure or the type of securities they invest in.

Tax-Efficient by Nature

It also pays to remember, though, that past isn't prologue. Funds that have been tax-efficient in the past may not necessarily be great choices for taxable investors going forward. For that reason, investors in a taxable account may want to take stock of which kinds of funds are more likely to be tax-efficient choices simply due to their structure or the type of securities they invest in.

Before getting into the nitty-gritty of tax evaluation metrics, it's important to point out that there are certain types of funds that are more tax-efficient than others. Many index funds, especially large-cap index funds or total-market index funds that are weighted by market cap, have fairly low turnover and tend not to pay out big distributions. But you can't assume that just because it's an index fund it earns high marks for tax-efficiency: Sometimes stocks get booted out of indexes with market-cap constraints or factor exposures when the stocks no longer meet the indexes' criteria for inclusion.

Exchange-traded funds tend to be tax-efficient because of their ability to exchange securities in-kind (which doesn't result in a tax liability as a sale of the asset would). However, certain types of ETFs are more likely to make distributions (such as currency-hedged funds that employ derivatives contracts).

On the other end of the spectrum, actively managed funds that tend to have high turnover strategies, funds focusing on real-estate investment trusts, or high-yield bond funds are often a poor choice for taxable accounts because they frequently pay out income and capital gains distributions.

Most bond funds are also best kept in a tax-deferred account type, with the exception of municipal bond funds , whose income is tax-advantaged: In the vast majority of cases, the income they provide is not taxed at the federal level and, in some instances, it's not taxed at the state or local level, either. (Some muni bonds could be subject to alternative minimum tax, however.)

Aftertax Returns

Most bond funds are also best kept in a tax-deferred account type, with the exception of municipal bond funds , whose income is tax-advantaged: In the vast majority of cases, the income they provide is not taxed at the federal level and, in some instances, it's not taxed at the state or local level, either. (Some muni bonds could be subject to alternative minimum tax, however.)

In addition, because traditional measures of tax efficiency are calculated by taking expenses out of income, funds with higher expense ratios can end up looking more tax-efficient, even though their aftertax return may lag that of a cheaper fund.

By clicking on a fund's tax tab on its fund quote page, you can compare a fund's aftertax return to its pretax return. We'll use Vanguard Dividend Growth (VDIGX) as an example, because it tends to be a highly requested fund quote by Morningstar.com users.

Vanguard Dividend Growth does not implicitly set out to limit investors' tax exposure, as a so-called tax-managed fund aims to do. Its prospectus states that it seeks to provide a growing stream of income over time as well as long-term capital appreciation and current income. That said, you may expect that it's not a highly tax-efficient strategy.

But you can see that it has been pretty tax-efficient nonetheless: By comparing the fund's pretax returns with its aftertax returns, you can see that there isn't a large gap. (To facilitate the comparison I created the table below using information on the performance tab—the pretax return and pretax rank in category—and the tax tab—the aftertax return, aftertax rank in category, and tax-cost ratio—of Vanguard Dividend Growth's fund quote page.)

Tax Analysis of Vanguard Dividend Growth Inv

Here is where we want an accurate description about the data displayed and/or the table's intent
1 Year
3 Years (Annualized)
5 Years (Annualized)
10 Years (Annualized)
Pretax Return 16.27 14.70 12.09 11.22
Pretax Return Rank in Category 49% 67% 57% 46%
Aftertax Return 14.51 13.34 10.76 10.37
Aftertax Return Rank in Category 45% 56% 47% 39%
Tax-Cost Ratio 1.51 1.19 1.19 0.77
Data as of Sept. 30, 2018. Morningstar uses the highest federal tax rate when dealing with short-term cap gains, interest, and nonqualified dividends.

Also, the fund's return “% rank in category” is higher for the fund's aftertax return that its pretax return over all trailing periods. (A rank in category of 1 is most desirable and means that the fund's return is at the top of the category, while 100 means it's at the bottom.)

One way the fund achieves this is by keeping its annual turnover low—over the past 10 years it's been in the range of 11% to 27%, which in many years is well below the average of actively managed peers in the category. Also, fund manager Donald Kilbride's focus on quality leads him to stocks that have the potential to grow their dividends over time rather than those with the highest current yields.

Tax-Cost Ratio

Another evaluation metric investors can use is the tax-cost ratio. Also found on a fund quote's tax tab, this metric measures how much a fund's annualized return is reduced by taxes investors pay on distributions.

The way it's expressed is much like an expense ratio: The lower it is, the less money the investor has surrendered to taxes. A tax-cost ratio of zero means that the fund didn't pay out any taxable distributions for the period. (Of course, that's not to say that you should buy a fund just because its tax-cost ratio is low or zero. You should also consider a fund's management, strategy, record, and fees.)

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

Note that the tax-cost ratio is not simply the difference between the pretax return and the aftertax return. This is the formula to calculate it:

Tax-Cost Ratio = [ 1 - ( (1+Tax-adjusted Return) / (1+Pretax Return) ) ] x 100

Plugging in the five-year returns for Vanguard Dividend Growth:

Pretax Return = 12.09%
Tax-adjusted Return = 10.76%
= [ 1 - ( (1+0.1076) / (1+0.1209) ) ] x 100
= [ 1 - ( 1.1076 / 1.1209 ) ] x 100
= (1 - 0.9881) x 100
= 0.0119 x 100
= 1.19%

Potential Capital Gains Exposure

Aftertax returns and tax-cost ratio tell you about how tax-efficient a fund has been in the past, but neither guarantees anything about how tax-efficient a fund will be going forward.

One helpful data point that can help you size up a fund's potential for a tax hit is its potential capital gains exposure, which can also be found on the fund's tax tab. From a tax perspective, you can think of a high positive potential capital gains estimate as “a worst-case scenario.” The PCGE percentage measures all of the gains that have not yet been distributed to shareholders or taxed but could be in the event that the entire portfolio were turned over.

A positive PCGE indicates that the fund's holdings have generally increased in value, while a negative PCGE indicates that the fund has some tax losses on its books that it can carry forward to offset gains. With markets near record highs, however, most stock funds won't find themselves in this position.

The word “potential” is key here, though; a high PCGE figure doesn't always result in a big payout. If the fund doesn't sell the appreciated securities, the gain will not be realized during the calendar year—or anytime soon, for that matter. Funds with low-turnover strategies such as those that follow an index-tracking strategy are less likely to experience events that trigger high turnover, but they aren't immune from them.

Vanguard Dividend Growth's PCGE is 40.35%, indicating that about two-fifths of its holdings consist of appreciated securities that, if sold, could result in capital gains. The fund has been very tax-efficient and has had fairly low turnover in recent years, but it's not an impossibility that it could experience a manager change or be hit by large outflows—two major catalysts that can lead to increased selling and subsequent distributions.

All told, if you're an investor in a taxable account, it pays to take time to investigate and understand the strategy. Using the tax-efficiency metrics on Morningstar.com can help you make some reasonable inferences about how tax-efficient a fund has been and whether it is likely to remain so even in the worst of circumstances.

Karen Wallace does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.

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The Short Answer

How Tax-Efficient Is This Fund?

Question: I am looking for funds for a taxable account. How can I tell if a fund is tax-efficient?

Answer: Morningstar.com's fund quote pages contain many useful data points for evaluating a fund's tax efficiency. We'll run through them, and give a brief explainer on how to use each one.

It also pays to remember, though, that past isn't prologue. Funds that have been tax-efficient in the past may not necessarily be great choices for taxable investors going forward. For that reason, investors in a taxable account may want to take stock of which kinds of funds are more likely to be tax-efficient choices simply due to their structure or the type of securities they invest in.

Tax-Efficient by Nature

It also pays to remember, though, that past isn't prologue. Funds that have been tax-efficient in the past may not necessarily be great choices for taxable investors going forward. For that reason, investors in a taxable account may want to take stock of which kinds of funds are more likely to be tax-efficient choices simply due to their structure or the type of securities they invest in.

Before getting into the nitty-gritty of tax evaluation metrics, it's important to point out that there are certain types of funds that are more tax-efficient than others. Many index funds, especially large-cap index funds or total-market index funds that are weighted by market cap, have fairly low turnover and tend not to pay out big distributions. But you can't assume that just because it's an index fund it earns high marks for tax-efficiency: Sometimes stocks get booted out of indexes with market-cap constraints or factor exposures when the stocks no longer meet the indexes' criteria for inclusion.

Exchange-traded funds tend to be tax-efficient because of their ability to exchange securities in-kind (which doesn't result in a tax liability as a sale of the asset would). However, certain types of ETFs are more likely to make distributions (such as currency-hedged funds that employ derivatives contracts).

On the other end of the spectrum, actively managed funds that tend to have high turnover strategies, funds focusing on real-estate investment trusts, or high-yield bond funds are often a poor choice for taxable accounts because they frequently pay out income and capital gains distributions.

Most bond funds are also best kept in a tax-deferred account type, with the exception of municipal bond funds , whose income is tax-advantaged: In the vast majority of cases, the income they provide is not taxed at the federal level and, in some instances, it's not taxed at the state or local level, either. (Some muni bonds could be subject to alternative minimum tax, however.)

Aftertax Returns

Most bond funds are also best kept in a tax-deferred account type, with the exception of municipal bond funds , whose income is tax-advantaged: In the vast majority of cases, the income they provide is not taxed at the federal level and, in some instances, it's not taxed at the state or local level, either. (Some muni bonds could be subject to alternative minimum tax, however.)

In addition, because traditional measures of tax efficiency are calculated by taking expenses out of income, funds with higher expense ratios can end up looking more tax-efficient, even though their aftertax return may lag that of a cheaper fund.

By clicking on a fund's tax tab on its fund quote page, you can compare a fund's aftertax return to its pretax return. We'll use Vanguard Dividend Growth (VDIGX) as an example, because it tends to be a highly requested fund quote by Morningstar.com users.

Vanguard Dividend Growth does not implicitly set out to limit investors' tax exposure, as a so-called tax-managed fund aims to do. Its prospectus states that it seeks to provide a growing stream of income over time as well as long-term capital appreciation and current income. That said, you may expect that it's not a highly tax-efficient strategy.

But you can see that it has been pretty tax-efficient nonetheless: By comparing the fund's pretax returns with its aftertax returns, you can see that there isn't a large gap. (To facilitate the comparison I created the table below using information on the performance tab—the pretax return and pretax rank in category—and the tax tab—the aftertax return, aftertax rank in category, and tax-cost ratio—of Vanguard Dividend Growth's fund quote page.)

Tax Analysis of Vanguard Dividend Growth Inv

Here is where we want an accurate description about the data displayed and/or the table's intent
1 Year
3 Years (Annualized)
5 Years (Annualized)
10 Years (Annualized)
Pretax Return 16.27 14.70 12.09 11.22
Pretax Return Rank in Category 49% 67% 57% 46%
Aftertax Return 14.51 13.34 10.76 10.37
Aftertax Return Rank in Category 45% 56% 47% 39%
Tax-Cost Ratio 1.51 1.19 1.19 0.77
Data as of Sept. 30, 2018. Morningstar uses the highest federal tax rate when dealing with short-term cap gains, interest, and nonqualified dividends.

Also, the fund's return “% rank in category” is higher for the fund's aftertax return that its pretax return over all trailing periods. (A rank in category of 1 is most desirable and means that the fund's return is at the top of the category, while 100 means it's at the bottom.)

One way the fund achieves this is by keeping its annual turnover low—over the past 10 years it's been in the range of 11% to 27%, which in many years is well below the average of actively managed peers in the category. Also, fund manager Donald Kilbride's focus on quality leads him to stocks that have the potential to grow their dividends over time rather than those with the highest current yields.

Tax-Cost Ratio

Another evaluation metric investors can use is the tax-cost ratio. Also found on a fund quote's tax tab, this metric measures how much a fund's annualized return is reduced by taxes investors pay on distributions.

The way it's expressed is much like an expense ratio: The lower it is, the less money the investor has surrendered to taxes. A tax-cost ratio of zero means that the fund didn't pay out any taxable distributions for the period. (Of course, that's not to say that you should buy a fund just because its tax-cost ratio is low or zero. You should also consider a fund's management, strategy, record, and fees.)

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

For instance, Vanguard Dividend Growth Fund's tax-cost ratio is 1.19% over the annualized five-year period. This means investors in the fund gave up 1.19% of their assets in the fund (per year) to taxes over this period.

Note that the tax-cost ratio is not simply the difference between the pretax return and the aftertax return. This is the formula to calculate it:

Tax-Cost Ratio = [ 1 - ( (1+Tax-adjusted Return) / (1+Pretax Return) ) ] x 100

Plugging in the five-year returns for Vanguard Dividend Growth:

Pretax Return = 12.09%
Tax-adjusted Return = 10.76%
= [ 1 - ( (1+0.1076) / (1+0.1209) ) ] x 100
= [ 1 - ( 1.1076 / 1.1209 ) ] x 100
= (1 - 0.9881) x 100
= 0.0119 x 100
= 1.19%

Potential Capital Gains Exposure

Aftertax returns and tax-cost ratio tell you about how tax-efficient a fund has been in the past, but neither guarantees anything about how tax-efficient a fund will be going forward.

One helpful data point that can help you size up a fund's potential for a tax hit is its potential capital gains exposure, which can also be found on the fund's tax tab. From a tax perspective, you can think of a high positive potential capital gains estimate as “a worst-case scenario.” The PCGE percentage measures all of the gains that have not yet been distributed to shareholders or taxed but could be in the event that the entire portfolio were turned over.

A positive PCGE indicates that the fund's holdings have generally increased in value, while a negative PCGE indicates that the fund has some tax losses on its books that it can carry forward to offset gains. With markets near record highs, however, most stock funds won't find themselves in this position.

The word “potential” is key here, though; a high PCGE figure doesn't always result in a big payout. If the fund doesn't sell the appreciated securities, the gain will not be realized during the calendar year—or anytime soon, for that matter. Funds with low-turnover strategies such as those that follow an index-tracking strategy are less likely to experience events that trigger high turnover, but they aren't immune from them.

Vanguard Dividend Growth's PCGE is 40.35%, indicating that about two-fifths of its holdings consist of appreciated securities that, if sold, could result in capital gains. The fund has been very tax-efficient and has had fairly low turnover in recent years, but it's not an impossibility that it could experience a manager change or be hit by large outflows—two major catalysts that can lead to increased selling and subsequent distributions.

All told, if you're an investor in a taxable account, it pays to take time to investigate and understand the strategy. Using the tax-efficiency metrics on Morningstar.com can help you make some reasonable inferences about how tax-efficient a fund has been and whether it is likely to remain so even in the worst of circumstances.

Karen Wallace does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.

Article, Blog Example

Investing Trends

How Much Carbon Risk Do Morningstar Medalists Carry?

What we found when we analyzed the carbon risk in our medalists funds

Investors are increasingly aware that climate change poses risks to their investment portfolios and are looking to manage these risks. To this end, Morningstar recently launched a series of carbon risk metrics. We also introduced the Morningstar® Low Carbon Designation™ to help investors identify those funds that are in general alignment with the transition away from a fossil-fuel intensive economy to a low-carbon economy.

Analyzing carbon risk in Morningstar Medalists

Investors concerned about transition risk can incorporate the Low Carbon designation into their selection process, in combination with the Morningstar Analyst Rating™ of Gold, Silver and Bronze.

We did just that in a recent analysis. We found that of all 3,801 medalist funds—funds that Morningstar analysts believe will outperform their peers going forward—only 412, or 11%, have received the Low Carbon designation. We also found that the choices are not spread evenly across investment categories because carbon risk is related to style and, especially, sector exposures.

Carbon risk in growth funds

Looking at 10 diversified investment categories (above), we found that close to two thirds of the low-carbon Morningstar Medalists are growth funds. Why? Because growth funds tend not to invest in companies in the three sectors with the most carbon risk (energy, utilities, and materials), while having significant investments in technology companies, which carry very little carbon risk. Among the U.S. and Europe large-growth funds, it’s very easy to find a good low-carbon fund as 88% and 92% of the medalists in these categories, respectively, receive the Low Carbon designation.

Carbon risk in value funds

It’s significantly harder, however, to find a good low-carbon fund on the value side, especially in the Europe large-value category where no Morningstar Medalists receive the Low Carbon designation. In the U.S. and global large-value categories, only 11% and 5% of the medalists, respectively, receive the Low Carbon designation.

Europe large-value funds, on average, devote nearly 22% of assets to companies in the higher-carbon-risk energy, utilities, and materials sectors and only less than 5% to tech companies. U.S. and global large-value funds, on average, are more balanced in terms of how much they allocate to higher-carbon-risk and lower-carbon-risk sectors.

Emerging markets and carbon risk

Fewer emerging-markets funds (6%) receive the Low Carbon designation. Emerging-markets managers generally must choose among companies with higher carbon risk compared with developed-markets managers. In the automobile industry, for example, emerging-markets firms have an average Morningstar® Portfolio Carbon Risk Score™ of 41.2, in the High risk range, while developed-markets firms have a much lower average score of 26.3, in the Medium risk range.

When to use the Carbon Risk Score

To find additional lower-carbon options in the large-value and emerging-markets categories, investors should use the Carbon Risk Score rather than the Low Carbon designation and search for funds with scores in the category’s lowest quartile. That’s a weaker screen than the Low Carbon designation, because it doesn’t include an explicit fossil-fuel exposure component, but the Carbon Risk Score can be compared with other funds.

This blog post is adapted from research that was originally published in Research Portal in Morningstar Direct™. If you’re a user, you have access. If not, take a free trial

Article, Blog Example

Investing Trends

How Much Carbon Risk Do Morningstar Medalists Carry?

What we found when we analyzed the carbon risk in our medalists funds

Investors are increasingly aware that climate change poses risks to their investment portfolios and are looking to manage these risks. To this end, Morningstar recently launched a series of carbon risk metrics. We also introduced the Morningstar® Low Carbon Designation™ to help investors identify those funds that are in general alignment with the transition away from a fossil-fuel intensive economy to a low-carbon economy.

Analyzing carbon risk in Morningstar Medalists

Investors concerned about transition risk can incorporate the Low Carbon designation into their selection process, in combination with the Morningstar Analyst Rating™ of Gold, Silver and Bronze.

We did just that in a recent analysis. We found that of all 3,801 medalist funds—funds that Morningstar analysts believe will outperform their peers going forward—only 412, or 11%, have received the Low Carbon designation. We also found that the choices are not spread evenly across investment categories because carbon risk is related to style and, especially, sector exposures.

Carbon risk in growth funds

Looking at 10 diversified investment categories (above), we found that close to two thirds of the low-carbon Morningstar Medalists are growth funds. Why? Because growth funds tend not to invest in companies in the three sectors with the most carbon risk (energy, utilities, and materials), while having significant investments in technology companies, which carry very little carbon risk. Among the U.S. and Europe large-growth funds, it’s very easy to find a good low-carbon fund as 88% and 92% of the medalists in these categories, respectively, receive the Low Carbon designation.

Carbon risk in value funds

It’s significantly harder, however, to find a good low-carbon fund on the value side, especially in the Europe large-value category where no Morningstar Medalists receive the Low Carbon designation. In the U.S. and global large-value categories, only 11% and 5% of the medalists, respectively, receive the Low Carbon designation.

Europe large-value funds, on average, devote nearly 22% of assets to companies in the higher-carbon-risk energy, utilities, and materials sectors and only less than 5% to tech companies. U.S. and global large-value funds, on average, are more balanced in terms of how much they allocate to higher-carbon-risk and lower-carbon-risk sectors.

Emerging markets and carbon risk

Fewer emerging-markets funds (6%) receive the Low Carbon designation. Emerging-markets managers generally must choose among companies with higher carbon risk compared with developed-markets managers. In the automobile industry, for example, emerging-markets firms have an average Morningstar® Portfolio Carbon Risk Score™ of 41.2, in the High risk range, while developed-markets firms have a much lower average score of 26.3, in the Medium risk range.

When to use the Carbon Risk Score

To find additional lower-carbon options in the large-value and emerging-markets categories, investors should use the Carbon Risk Score rather than the Low Carbon designation and search for funds with scores in the category’s lowest quartile. That’s a weaker screen than the Low Carbon designation, because it doesn’t include an explicit fossil-fuel exposure component, but the Carbon Risk Score can be compared with other funds.

This blog post is adapted from research that was originally published in Research Portal in Morningstar Direct™. If you’re a user, you have access. If not, take a free trial

Article, Blog Example

Investing Trends

How Much Carbon Risk Do Morningstar Medalists Carry?

What we found when we analyzed the carbon risk in our medalists funds

Investors are increasingly aware that climate change poses risks to their investment portfolios and are looking to manage these risks. To this end, Morningstar recently launched a series of carbon risk metrics. We also introduced the Morningstar® Low Carbon Designation™ to help investors identify those funds that are in general alignment with the transition away from a fossil-fuel intensive economy to a low-carbon economy.

Analyzing carbon risk in Morningstar Medalists

Investors concerned about transition risk can incorporate the Low Carbon designation into their selection process, in combination with the Morningstar Analyst Rating™ of Gold, Silver and Bronze.

We did just that in a recent analysis. We found that of all 3,801 medalist funds—funds that Morningstar analysts believe will outperform their peers going forward—only 412, or 11%, have received the Low Carbon designation. We also found that the choices are not spread evenly across investment categories because carbon risk is related to style and, especially, sector exposures.

Carbon risk in growth funds

Looking at 10 diversified investment categories (above), we found that close to two thirds of the low-carbon Morningstar Medalists are growth funds. Why? Because growth funds tend not to invest in companies in the three sectors with the most carbon risk (energy, utilities, and materials), while having significant investments in technology companies, which carry very little carbon risk. Among the U.S. and Europe large-growth funds, it’s very easy to find a good low-carbon fund as 88% and 92% of the medalists in these categories, respectively, receive the Low Carbon designation.

Carbon risk in value funds

It’s significantly harder, however, to find a good low-carbon fund on the value side, especially in the Europe large-value category where no Morningstar Medalists receive the Low Carbon designation. In the U.S. and global large-value categories, only 11% and 5% of the medalists, respectively, receive the Low Carbon designation.

Europe large-value funds, on average, devote nearly 22% of assets to companies in the higher-carbon-risk energy, utilities, and materials sectors and only less than 5% to tech companies. U.S. and global large-value funds, on average, are more balanced in terms of how much they allocate to higher-carbon-risk and lower-carbon-risk sectors.

Emerging markets and carbon risk

Fewer emerging-markets funds (6%) receive the Low Carbon designation. Emerging-markets managers generally must choose among companies with higher carbon risk compared with developed-markets managers. In the automobile industry, for example, emerging-markets firms have an average Morningstar® Portfolio Carbon Risk Score™ of 41.2, in the High risk range, while developed-markets firms have a much lower average score of 26.3, in the Medium risk range.

When to use the Carbon Risk Score

To find additional lower-carbon options in the large-value and emerging-markets categories, investors should use the Carbon Risk Score rather than the Low Carbon designation and search for funds with scores in the category’s lowest quartile. That’s a weaker screen than the Low Carbon designation, because it doesn’t include an explicit fossil-fuel exposure component, but the Carbon Risk Score can be compared with other funds.

This blog post is adapted from research that was originally published in Research Portal in Morningstar Direct™. If you’re a user, you have access. If not, take a free trial

Article, Blog Example

Investing Trends

How Much Carbon Risk Do Morningstar Medalists Carry?

What we found when we analyzed the carbon risk in our medalists funds

Investors are increasingly aware that climate change poses risks to their investment portfolios and are looking to manage these risks. To this end, Morningstar recently launched a series of carbon risk metrics. We also introduced the Morningstar® Low Carbon Designation™ to help investors identify those funds that are in general alignment with the transition away from a fossil-fuel intensive economy to a low-carbon economy.

Analyzing carbon risk in Morningstar Medalists

Investors concerned about transition risk can incorporate the Low Carbon designation into their selection process, in combination with the Morningstar Analyst Rating™ of Gold, Silver and Bronze.

We did just that in a recent analysis. We found that of all 3,801 medalist funds—funds that Morningstar analysts believe will outperform their peers going forward—only 412, or 11%, have received the Low Carbon designation. We also found that the choices are not spread evenly across investment categories because carbon risk is related to style and, especially, sector exposures.

Carbon risk in growth funds

Looking at 10 diversified investment categories (above), we found that close to two thirds of the low-carbon Morningstar Medalists are growth funds. Why? Because growth funds tend not to invest in companies in the three sectors with the most carbon risk (energy, utilities, and materials), while having significant investments in technology companies, which carry very little carbon risk. Among the U.S. and Europe large-growth funds, it’s very easy to find a good low-carbon fund as 88% and 92% of the medalists in these categories, respectively, receive the Low Carbon designation.

Carbon risk in value funds

It’s significantly harder, however, to find a good low-carbon fund on the value side, especially in the Europe large-value category where no Morningstar Medalists receive the Low Carbon designation. In the U.S. and global large-value categories, only 11% and 5% of the medalists, respectively, receive the Low Carbon designation.

Europe large-value funds, on average, devote nearly 22% of assets to companies in the higher-carbon-risk energy, utilities, and materials sectors and only less than 5% to tech companies. U.S. and global large-value funds, on average, are more balanced in terms of how much they allocate to higher-carbon-risk and lower-carbon-risk sectors.

Emerging markets and carbon risk

Fewer emerging-markets funds (6%) receive the Low Carbon designation. Emerging-markets managers generally must choose among companies with higher carbon risk compared with developed-markets managers. In the automobile industry, for example, emerging-markets firms have an average Morningstar® Portfolio Carbon Risk Score™ of 41.2, in the High risk range, while developed-markets firms have a much lower average score of 26.3, in the Medium risk range.

When to use the Carbon Risk Score

To find additional lower-carbon options in the large-value and emerging-markets categories, investors should use the Carbon Risk Score rather than the Low Carbon designation and search for funds with scores in the category’s lowest quartile. That’s a weaker screen than the Low Carbon designation, because it doesn’t include an explicit fossil-fuel exposure component, but the Carbon Risk Score can be compared with other funds.

This blog post is adapted from research that was originally published in Research Portal in Morningstar Direct™. If you’re a user, you have access. If not, take a free trial

Article, Blog Example

Investing Trends

How Much Carbon Risk Do Morningstar Medalists Carry?

What we found when we analyzed the carbon risk in our medalists funds

Investors are increasingly aware that climate change poses risks to their investment portfolios and are looking to manage these risks. To this end, Morningstar recently launched a series of carbon risk metrics. We also introduced the Morningstar® Low Carbon Designation™ to help investors identify those funds that are in general alignment with the transition away from a fossil-fuel intensive economy to a low-carbon economy.

Analyzing carbon risk in Morningstar Medalists

Investors concerned about transition risk can incorporate the Low Carbon designation into their selection process, in combination with the Morningstar Analyst Rating™ of Gold, Silver and Bronze.

We did just that in a recent analysis. We found that of all 3,801 medalist funds—funds that Morningstar analysts believe will outperform their peers going forward—only 412, or 11%, have received the Low Carbon designation. We also found that the choices are not spread evenly across investment categories because carbon risk is related to style and, especially, sector exposures.

Carbon risk in growth funds

Looking at 10 diversified investment categories (above), we found that close to two thirds of the low-carbon Morningstar Medalists are growth funds. Why? Because growth funds tend not to invest in companies in the three sectors with the most carbon risk (energy, utilities, and materials), while having significant investments in technology companies, which carry very little carbon risk. Among the U.S. and Europe large-growth funds, it’s very easy to find a good low-carbon fund as 88% and 92% of the medalists in these categories, respectively, receive the Low Carbon designation.

Carbon risk in value funds

It’s significantly harder, however, to find a good low-carbon fund on the value side, especially in the Europe large-value category where no Morningstar Medalists receive the Low Carbon designation. In the U.S. and global large-value categories, only 11% and 5% of the medalists, respectively, receive the Low Carbon designation.

Europe large-value funds, on average, devote nearly 22% of assets to companies in the higher-carbon-risk energy, utilities, and materials sectors and only less than 5% to tech companies. U.S. and global large-value funds, on average, are more balanced in terms of how much they allocate to higher-carbon-risk and lower-carbon-risk sectors.

Emerging markets and carbon risk

Fewer emerging-markets funds (6%) receive the Low Carbon designation. Emerging-markets managers generally must choose among companies with higher carbon risk compared with developed-markets managers. In the automobile industry, for example, emerging-markets firms have an average Morningstar® Portfolio Carbon Risk Score™ of 41.2, in the High risk range, while developed-markets firms have a much lower average score of 26.3, in the Medium risk range.

When to use the Carbon Risk Score

To find additional lower-carbon options in the large-value and emerging-markets categories, investors should use the Carbon Risk Score rather than the Low Carbon designation and search for funds with scores in the category’s lowest quartile. That’s a weaker screen than the Low Carbon designation, because it doesn’t include an explicit fossil-fuel exposure component, but the Carbon Risk Score can be compared with other funds.

This blog post is adapted from research that was originally published in Research Portal in Morningstar Direct™. If you’re a user, you have access. If not, take a free trial