Executive Summary: Most active funds don’t outperform index funds—and that’s before taxes. Add in capital gains distributions, and the average active fund falls even further behind. Vanguard’s index funds have a strong track record of tax efficiency. Vanguard’s best managers can earn their place in the performance derby, but overall, for taxable accounts, indexing remains the smarter, simpler choice for most investors.
It’s becoming dogma on Wall Street: Most investors should stick with low-cost index funds. And those who prefer actively managed funds should do so only within tax-sheltered accounts.
Is this prevailing wisdom right? The ultra-short answer is yes.
If you aim to keep things simple and minimize capital gains distributions, then using index funds in your taxable account remains a solid, no-fuss strategy. Why? Because after taxes, most active funds can’t beat their low-cost index counterparts.
But that’s hardly the end of the story. Our investment goal is to maximize after-tax returns—not simply to minimize our tax bills. Plus, I’ve never given a blanket endorsement to either indexing or active management. I choose active managers very carefully, and apply the same scrutiny to the index funds and ETFs I consider worthy of my investment dollars—and yours.
So, while I’ve said the conventional wisdom is pretty much on the mark, let’s question it by scrutinizing the after-tax returns of active and indexed funds.
Next week, I’ll analyze specific funds that may be worth owning even if they hand you a higher tax bill. I’ll also provide some simple tweaks to the IVA Portfolios for tax-sensitive investors to consider.
Key Points
- The average active fund trails a low-cost index fund before and after taxes.
- Vanguard’s index funds are consistently tax-friendly, while their active funds' tax efficiency varies over time.
Active Management’s Uphill Climb
Most active funds lose the performance race to low-cost index funds—even before taxes. Costs play a role in this equation, since expense ratios directly detract from returns.
But the real reason is grounded in simple math.
Active investors are the market. They are the ones buying and selling all the stocks, and their combined results—before costs—add up to the market’s total return. Add in costs, and active funds, as a group, lag the market.
Flip that logic around, and it’s clear: If you can match the market and pay less in fees, as Vanguard’s index funds do, you’re already ahead of the curve.
Even at Vanguard, where the fee headwind is not as strong, it’s no easy feat for their hand-picked active managers to beat their benchmarks or the market.
The math just doesn’t let up—it only gets tougher when taxes enter the equation.
The table below shows the 10-year returns through the end of the first quarter for Vanguard’s actively managed, diversified U.S. stock funds. Only three outpaced Total Stock Market Index (VTSAX) before taxes.
Over a full market cycle, index funds tend to be more tax-friendly—they usually distribute fewer capital gains than active funds. So, if the average active fund already lags behind a low-cost index fund before taxes, it’s almost guaranteed to fall further behind once taxes are factored in.
Unsurprisingly, Vanguard’s total market fund, already a top performer, moves up the ranks after taxes are considered. Only one active fund—U.S. Growth (VWUSX)—beat Total Stock Market Index over the last decade after taxes.
| 10-Year Before-Tax Return | 10-Year After-Tax Return | ||
| U.S. Growth | 12.9% | U.S. Growth | 11.7% |
| Growth & Income | 12.1% | Total Stock Market Index | 11.3% |
| PRIMECAP | 12.1% | PRIMECAP | 10.5% |
| Total Stock Market Index | 11.7% | Growth & Income | 10.1% |
| Capital Opportunity | 11.3% | Capital Opportunity | 9.8% |
| PRIMECAP Core | 11.1% | PRIMECAP Core | 9.7% |
| Diversified Equity | 11.1% | Diversified Equity | 9.4% |
| Dividend Growth | 10.4% | Dividend Growth | 9.2% |
| Windsor II | 10.3% | Equity Income | 8.8% |
| Equity Income | 10.3% | Windsor II | 8.5% |
| Windsor | 9.4% | Windsor | 7.2% |
| Strategic Equity | 8.8% | Strategic Equity | 6.9% |
| Selected Value | 8.5% | Explorer | 6.6% |
| Explorer | 8.4% | Selected Value | 6.6% |
| Strategic SmallCap Equity | 7.8% | Strategic SmallCap Equity | 6.3% |
| MidCap Growth | 7.1% | Explorer Value | 5.7% |
| Explorer Value | 6.8% | MidCap Growth | 5.4% |
| Note: Total returns 3/2015 through 3/2025. Source: Vanguard and The IVA. | |||
See here for a look at how all of Vanguard’s funds fared before and after taxes over the last decade.
Of course, this is just one 10-year stretch—and shifting the timeframe can change the story, at least somewhat. This particular decade was marked by the dominance of large U.S. stocks, which influenced the outcome.
Additionally, while I’ve narrowed this list down to “diversified U.S. stock funds,” I’m still not necessarily comparing apples to apples.
Take Explorer (VEXPX), for example. It trailed the broad index fund after taxes, but that had more to do with being a small-cap fund than being an active small-cap growth fund. SmallCap Index (VSMAX) also trailed 500 Index (VFIAX), 7.8% to 12.5% over the past decade. So, while taxes took a bite out of Explorer’s returns, the larger headwind, relative to the total stock benchmark, was its focus on smaller stocks.
I’m not trying to dispel the notion that the average active fund trails the indexes, but we have to exercise caution when drawing conclusions from point-in-time returns. So, let’s examine fuller data on tax efficiency over time.
When Tax Efficiency Fades
Let’s examine my claim that index funds are more tax-friendly than active funds over time.