How the Tax Efficiencies of Vanguard ETFs Differ from Others

The tax efficiency of Vanguard exchange traded funds (ETFs) may be different than other ETFs. That’s because they are actually a special share class of Vanguard’s Index Mutual Funds, as Preet Banerjee notes on his wheredoesallmymoneygo.com blog.

According to Preet, index funds face the risk of having to sell shares to meet redemption requests, which could trigger capital gains that are distributed to unitholders (and become taxable in their hands). ETFs don’t face this same risk because they “can simply redeem ETF units on an in-kind basis to fund the request.”

The table below, from Sigma Investing, might be interesting to consider in this context. It shows the capital gains distributed by the Vanguard 500 Index and SPDR S&P 500 (SPY) from 1993 to 2006. The bottom of the table shows that the Vanguard 500 distributions are, on average, higher than SPY. But this is due to the early years. For the seven most recent years of the period, there are no distributions.

The SPY has capital distributions because it has to update its holdings whenever its index changes. So do the Vanguard index funds, I believe. The latter have ways to offset capital gains, which Preet mentioned. ETFs also have ways to offset capital gains.

The Sigma Investing website has some tables containing “average tax drag” for a number of Vanguard index funds. The Vanguard Total Market Index Fund (VTI), for example, is reported to have an “average tax drag” of 0.33%. The site doesn’t say what period the data covers or provide the data source, etc. I sent them an email and hope to get this info.

Capital Gains Distributed by Vanguard 500 Index and SPY

Update:

As mentioned above, there is a possibility that redemptions in the Vanguard index funds may have adverse tax consequences for Vanguard ETFs (which are special share classes of the index funds). Vanguard says this is only a hypothetical situation that has yet to materialize.

Vanguard notes:

Out of our 39 ETFs, only our REIT ETF paid a small capital gains (in 2004, 2005, and 2006), and our Consumer Staples ETF paid a small gain in 2004. Not one of our large, broadly diversified ETFs, like VTI or VWO, has ever paid a gain.

Vanguard also says the share-class structure of Vanguard ETFs

gives Vanguard additional ways to maximize after-tax ETF returns relative to competitors.

All ETFs minimize capital gains by distributing their lowest-cost shares to meet redemption requests for creation units and Vanguard ETFs are no exception. However, as cash flows into the funds’ conventional shares, they purchase stocks in various tax lots, and when investors redeem shares of the conventional funds (or when there are index changes that require sale of a security),

we sell the highest cost lots first, typically resulting in the realization of capital losses.

These losses are then stored up in the fund to offset capital gains that could be realized in the future.

Moreover, if there was a large enough transaction that might cause a capital gain, an open-ended fund could do an in-kind redemption of securities instead of cash. It’s rarely utilized … and in our case, rarely necessary. In fact, our index funds are so large, and take in such steady cash flow, that we can typically ‘cross’ incoming cash with outgoing redemptions, thereby avoiding the need to buy or sell stocks altogether.

So the risk of capital-gains distributions is quite low in the case of Vanguard ETFs, especially for a fund with a large asset base that has steady cash flows and in-kind redemptions. For a fund with a small asset base without steady cash flows and the option of in-kind redemptions, the risks are somewhat higher.

Vanguard also says its ETFs have an edge in avoiding distributions when index changes occur.

Stand-alone ETFs may have to sell securities in order to purchase new index entrants and weight their portfolios appropriately because all of their cash flows are paid in kind, not with real cash.

Vanguard ETFs (i.e. their underlying index funds), on the other hand, will have cash flows that can be used to buy new additions to the index.

Lastly, as a special share class of the Vanguard index funds, the Vanguard ETFs have lower start-up costs and can leverage the economies of scale of an existing large pool of assets to minimize ongoing operating and trading costs – which means some of the lowest MERs around.

Comments

[TJ Schoenlein:]

The closer one looks at the Vanguard ETFs the better they look.
No surprise here.. good information for those who are looking for low cost top notch ETFs.

Sep 30 02:24 AM