Should you always do the most ‘efficient’ thing? You’ll probably be surprised to hear this from me, but… no, you shouldn’t.

Consider the case of car fuel efficiency. Automatic, a company that helps drivers measure their own fuel efficiency, has found that speeds between 40 and 60 miles per hour is the ‘sweet spot’ of fuel economy for most cars. Does that mean you should always drive at 40 to 60 miles per hour? Of course not. Sometimes it’s safer to drive slower, and sometimes it’s important to drive faster. Fuel efficiency is just one factor to consider when deciding how fast to drive.

Now, let’s think about efficiency as it applies to investments. In financial marketing lingo, ‘tax efficiency’ is often bantered about as a great selling point for ETFs and fund products. The trouble is that while more efficient is usually better than less efficient, some financial marketers out there sometimes forget to tell you the whole story.

There are three types of tax efficiency an investor should know about before buying any fund, and they’re entirely different.

### The Tax Efficiency Ratio

The first one is called the tax efficiency ratio. It’s a simple equation—pre-tax return divided by after-tax return—that just shows how much of the pre-tax return an investor keeps after paying taxes.

The reason why this can get a bit dubious is that, rather than learning the tax efficiency ratio, an investor really should just want to know the after-tax return, what goes in his or her pocket.

Sometimes, when that number is not as favorable as it should be, usually because of high management fees, talking about the tax efficiency ratio can be a good way to distract an investor from asking the right question: What are the management expenses?

In the following hypothetical example, two ETFs are shown, side-by-side. The first is a lower-expense ETF and the second is a higher-expense ETF. Both generated an average return of 8.5%, but the first had a management expense of 0.25% and the second had 0.50%.

The pre-tax return of the lower expense ETF was 8.25%, minus a 1.24% tax cost, equivalent to a 15% tax rate, giving the investor a net after-tax return of 7.01%.

The pre-tax return of the higher expense ETF was 8.0%, minus a 1.20% tax cost, also equivalent to a 15% tax rate, giving the investor a net after-tax return of 6.80%.

Yes, the first ETF has a ‘tax cost’ of 1.24% which is higher than the second ETF’s 1.20%, but the important number—the after-tax return—is also higher.

Interestingly, in both cases, the tax efficiency ratio—pre-tax return / after-tax return—is 85%. But, it’s the fund with lower expenses that offers a greater total return to the investor.

For many years, financial marketing actually focused on pre-tax returns because most money managers catered to the pension fund industry, which is tax-exempt. Managers who also focus on 401(k) plans that many employers offer for retirement also never worried about tax implications as those assets are also tax exempt, until withdrawal.

But today’s investors should pay attention to taxes—that is, after-tax returns.

#### Side-By-Side Comparison of Hypothetical Investments

ETF A ETF B
Return Before Expenses 8.50% 8.50%
Management Expense 0.25% 0.50%
Return After Expenses (Pre-Tax) 8.25% 8.00%
Tax (15%) 1.24% 1.20%
Net Investor Return (After-Tax) 7.01% 6.80%
Tax Cost¹ 1.24% 1.20%
Tax Efficiency Ratio 85% 85%
Investor Return Ratio 83% 80%

### A “Tax-Efficient” Structure

The second time an investor might hear about tax efficiency is within the structure of a fund, mutual funds, especially. The example case here is that an active portfolio manager is aiming for the highest possible return for all of the participants, not looking out for any individual investors and their tax status, and often trades without regard for the tax implications. Every time a mutual fund sells a component for a gain, it books a tax expense. The more profitable trading, the more potential tax expense.

Since most active managers underperform after fees and expenses, we don’t use funds that churn their holdings. In fact, we do the opposite. We tax loss harvest. Betterment’s Tax Loss Harvesting+ is part of our algorithm that sells positions with losses that offset the tax implications of external gains.