At risk of sounding self-serving since I am a DFA-approved advisor, I’d like to discuss DFA’s core fund idea.

Let me use this as an example, an investor allocates some money to a small cap fund, some to a large cap funds. When a stock graduate from small cap to large cap, the investor still own the same stock but it is sold by the small cap fund and bought by the large cap fund, thereby triggering capital gain taxes.

Now if an investor has 9 funds (corresponding to Moringstar style boxes,) migrations of stocks would trigger many unnecessary capital gain taxes and transaction costs on the fund level. That’s where the core fund comes in. It covers all capitalization and styles, so the aforementioned capital gain tax event would not happen.

Michael Zhuang

As much I’m not a fan of trying to pick stocks to beat the market, there’s no debating that buying and holding a diversified portfolio of individual stocks can be an extremely low-cost, tax-efficient way to invest. The trick is the “diversified portfolio” bit!

I don’t have any special insight on the matter though. I can’t think of anything that would be more reliable than historical default rate data. It would seem reasonable to expect higher municipal default rates in the next few years due to all the budget crises occurring across the country. That said, your guess is as good as mine as to how much higher default rates will be.

RR: Thanks for the article suggestion. And I agree: The commenters around here do tend to have some excellent insights.

It astounds me that I can ask a question like this and get this professional level and quality of analysis and information in just a couple days’ time–FOR FREE!!!

And the comments are often as good as the original content. Amazing.

Thanks Mike.

Another thing to compare would be the relative safety of municipal bonds versus Treasury or a mix of gov’t/credit (corporate?) bonds. This might be a bigger factor going forward if states start to have more budget problems. Or maybe it won’t – what are your thoughts, Mike?

Steve: Honestly, that surprised me as well. Your question spurred me to check Morningstar’s data against Vanguard’s data. Vanguard’s info is much closer to what I would have expected:

VB’s 5-year after-tax returns are 0.37% lower than before-tax.
NAESX’s 5-year after-tax returns are 0.34% lower than before-tax.

Interestingly, according to Vanguard, the 5-year after-tax returns of VTMSX are 0.22% less than the 5-year before-tax returns.

The end result is that the difference in tax-cost ratios between NAESX and VTMSX is 0.12% whether we use Vanguard’s data or Morningstar’s. VB, however, looks a great deal better when we use Vanguard’s data.

I wonder if any other readers can provide information as to the reason for the discrepancies.

I don’t profess to be an investment guy, but it seems that there’s some necessity for holding at least some investments outside a retirement portfolio. Even though investments may grow more freely in a tax sheltered account, accessing those funds comes with stiff costs.

You never know when you might need to get your hands on your money, and if most or all of it is tied up in tax sheltered plans things can get messy.