Question: 
I have read that Vanguard's Total Stock Market Index Fund is much more tax efficient than the Vanguard 500 Index Fund that you have recommend. And they seem to have virtually identical returns. Why don't you recommend the Total Stock Market fund for its tax efficiency? Also, I am impressed with Vanguard Primecap and Vanguard Health Care funds. What is your opinion of them?

Answer:
I think you are misinformed about the tax efficiency of these two funds, both of which are extremely tax-efficient. According to Morningstar, for the past five years the Index 500 fund has a tax efficiency ratio of 92.96 percent; the Total Stock Market fund's corresponding ratio is 91.06 percent. That gives the advantage to the 500 Index fund.

It's true that the returns of the two funds are very similar. For the past year, the Total Stock Market fund lost 14.2 percent while the 500 Index Fund lost 14.6 percent. Over longer periods, the returns diverge more meaningfully. Over the past five years, according to Morningstar, the Total Stock Market fund's annualized return was 9.4 percent, compared with 10.4 percent for the Index 500 fund. That is a significant difference. An initial investment of $10,000 at that rate would have grown to $15,656 in the Total Stock Market fund or $16,407 in the Index 500 fund.

Using the five-year tax efficiency ratio figures, that means an investor would be left with $806 more in the Index 500 fund. As a percentage of the initial $10,000 investment, that's a difference of about 8 percent - and nothing to sneeze at, in my opinion.

We use and recommend Vanguard Index 500 because it zeroes in on one asset class - U.S. large-cap stocks - that makes up an important part of the broadly diversified portfolio we think will do best for investors. By contrast, the Total Stock Market Index Fund tries to cover the whole waterfront. If you want maximum tax efficiency, consider the Vanguard Tax Managed Growth & Income Fund, which has virtually identical returns to the Index 500. The tax-managed fund, which has never declared a capital gains distribution, requires an initial minimum investment of $10,000.

Vanguard Primecap and Health Care are both excellent funds with low expense ratios, lots of diversification and no sales loads. However, each of them requires a $25,000 minimum initial investment; that requirement will put them out of reach of many investors.

I think index funds will deliver better performance over time than actively managed funds like Primecap. But if you are seeking an actively managed alternative to Index 500 and you can meet the $25,000 minimum, Primecap is a good candidate.

Vanguard Health Care is a sector fund, concentrated in a single area of the economy. That sector looks very promising right now, just as technology and wireless stocks did two years ago. But no sector has ever remained dominant permanently, and if you invest heavily in health care, you could live to regret it - just as so many of 1999's technology-heavy investors did in 2000 and 2001.

If you really want to invest in a sector fund, I suggest you do it with only a small part of your portfolio - less than 10 percent. And if you're committed to it for the long run, then check that fund once a year. If you committed 5 percent of your portfolio to that sector and it has grown to more than 5 percent, sell enough to reduce it to 5 percent once again. If it has fallen to less than 5 percent, buy enough to bring it up to 5 percent. This will seem counter-intuitive, but it will force you to methodically buy low and sell high. And that's the recipe for long-term investing success.