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Herb Morgan submits: I must admit that I recently became excited about the waxing competition in the ETF manufacturing business, writes Herb Morgan, President and Chief Investment Officer of Efficient Market Advisors, LLC. Barclays still has the lion’s share of the market for sure, but Vanguard has recently caught my eye. After all, Vanguard has a reputation for doing things right: low fees, honesty, and generally serving as a watchdog in a historically slick industry. But from what I can tell, it looks like the good guys are trying to pull one over on us this time.

As a money manager, I am constantly looking at data trying to find statistical relevance for asset classes which could justify their inclusion in my managed portfolios. While looking at Emerging Markets (which did not make the portfolio) I came across some information on the Vanguard VIPERs that surprised me. Vanguard decided to make their ETFs a share class of their existing open end index funds.

Why would they do this rather than file for a new fund?

The open end Vanguard Emerging Markets Stock Index Fund (MUTF:VEIEX), with about $4.5 billion in assets, has unrealized capital gains of $4.41 per share on a $16.91 share price. This equates to an untapped capital gain of $1.2 billion dollars. Along comes the new share class Vanguard Emerging Markets VIPERs (NYSEARCA:VWO) which have raised just under $200 million in assets. Guess what? Anybody buying Vanguard ETFs may be buying a tax liability they had not planned on. The end result is a redistribution of not-yet-realized tax liability from open end fund holders to ETF holders. This may be one reason the Vanguard ETF’s have not seen as much success as some of the other players.

To be fair, index funds have a long tradition of having positive cash inflows into the funds, which serves to dilute capital gains to the remaining investors. Turnover is also very low, which means they probably won’t voluntarily expose investors to these gains. However, Vanguard has no control over flows into and out of their funds and anything can and does happen from time to time. If VEIEX were to experience significant net redemptions, the fund would be forced to sell securities and realize capital gains. ETF investors would get their share of these gains along with the traditional open end fund shareholders. What’s more, these gains would accrete to the remaining shareholders at the end of the year. While not highly likely, if the open end fund experiences substantial redemptions the remaining shareholders could well be stuck with a liability even greater than the $4.41 per share.

ETFs have multiple advantages over open end funds, one of which is the tax advantage gained by the funds unique creation and redemption process. Vanguard should have left well enough alone and stuck with the traditional ETF format.

Herb Morgan is President and Chief Investment Officer of Efficient Market Advisors, LLC, a Registered Investment Advisor located in San Diego, California.Prior to founding EMA Mr. Morgan was Sr. Vice President of Advisory Services for LPL Financial, the nation’s largest independent broker dealer where he was responsible for the firms $25 Billion dollar investment advisory business. Mr. Morgan spent time as a Senior Vice President with Pilgrim Funds (Now ING), and Dreyfus Funds. He also held positions with J&W Seligman and Dean Witter Reynolds. (Now Morgan Stanley) Mr. Morgan is one of the nation’s premier experts in the investment and brokerage industry. He can be reached at herb [at] efficient-portfolios.com.

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Source: The Problem With Vanguard VIPERs ETFs