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ETF providers promote many benefits of their products: convenience, liquidity, and tax-efficiency, among others. This analysis focuses on some of the mechanics behind tax efficiency, and a unique twist which Vanguard brings to the table with their ETF structure.

Tax-deferral synergies from bringing together mutual fund and ETF investors

Of course, tax efficiency matters when an investor is subject to capital gains taxes. Investors in ETFs can realize capital gains and losses in multiple ways. Buying and selling on the exchanges triggers taxable gains and losses. Like mutual funds, ETFs must distribute any net capital gains realized at the end of the their fiscal year. For a small subset of investors, an in-kind redemption, where an investor exchanges ETF shares for a proportionate number of shares in every stock the ETF holds, can lead to a taxable event for the investor ... but not for the ETF. (Hereafter, we will focus on equity ETFs, not fixed income, commodity, or swap-based ETNs.)

Tax-efficiency can be maximized as long as investors continue purchasing an ETF in sufficient volumes (by way of creation units) while redemptions do not spike for a prolonged period. ETF managers strive to reduce capital gains distributions by trading underlying securities in a manner which offsets realized capital gains with capital losses. The mechanics are no different than with any individual taxable account, in which one tries to harvest losses at opportune times. Ideally, within its underlying securities, an ETF would continue realizing and rolling over net capital losses which can offset any future capital gains.

For Vanguard, the scope of tax-efficiency goes beyond the ETF. Among those Vanguard funds which offer an ETF, the ETF investors and mutual fund investors belong to the same fund. Every investor owns a pro rata share of the same basket of stocks, including all of the associated tax lots. The difference in ownership is signified by the share class. An excerpt from a Vanguard brochure nicely summarizes the benefit to ETF investors: (Click to enlarge)


The more tax lots available, the better a portfolio manager can minimize taxable distributions to all shareholders. This rule applies regardless of whether a fund is a traditional mutual fund or ETF. Thus, when structuring their funds, Vanguard decided to combine the strengths of both the mutual fund and the ETF to maximize tax efficiency.

A historical comparison of two leading Vanguard index funds demonstrates the impact of having mutual fund and ETF investors share the same underlying portfolio. On May 24, 2000, Vanguard launched the ETF share class for the Vanguard Total Stock Market Index Fund (NYSEARCA:VTI). At the time, Vanguard's 500 Index Fund (NYSEARCA:VOO) was larger and had existed for a much longer time. However, the ETF share class did not get launched until over ten years later, on September 7, 2010. Did the "patented share-class system" give the Total Stock Market Index Fund advantages which the 500 Index Fund may only be starting to realize?

The annual and semi-annual financial reports for the Vanguard funds provide some very useful details on potential capital gains tax liabilities and the impact of in-kind redemptions ("IKRs"). The following data points, collected from the financial reports, were utilized in this analysis:

1. Realized Net Capital Gains and Losses on securities
2. Realized Net Capital Gains and Losses resulting from in-kind redemptions
3. Purchases and Redemptions by share class.
4. Cumulative Paid-In Capital

Items 1 and 2 directly pertain to the potential capital gains tax liability. Item 3 will help demonstrate the relationship between IKRs and all institutional-size redemptions. Finally, item 4 has a less clear impact, if any, on the potential capital gains tax liability of a mutual fund or ETF. The following excerpt from the latest Vanguard 500 Index Fund semi-annual report helps to explain the relevance of paid-in capital:

During the six months ended June 30, 2010, the fund realized $131,817,000 of net capital gains resulting from in-kind redemptions—in which shareholders exchanged fund shares for securities held by the fund rather than for cash. Because such gains are not taxable to the fund, and are not distributed to shareholders, they have been reclassified from accumulated net realized losses to paid-in capital.

This disclosure is quite common for Vanguard ETFs, as well as ETFs from other sponsors. In fact, Vanguard's index funds disclosed capital gains realized from IKRs even before the ETF class existed. Such disclosures clearly show how good a job the sponsor does at removing share lots of underlying securities with the largest capital gains (without incurring any immediate tax liability). When capital gains are realized from IKRs, the fund simply reclassifies them as paid-in capital. (More specifically, these capital gains are added to paid-in capital instead of increasing Accumulated Net Realized Gains or offsetting Accumulated Net Realized Losses.)

In terms of tax efficiency, how has the tax profile of the 500 Index Fund fared over the last ten years? The following graph shows the two sources of paid-in capital — new investments (green bars) and capital gains resulting from IKRs (yellow bars) — and compares them to the taxable realized capital losses (red bars).

Click to enlarge:


As the fund AUM [assets under management) grows over time due to new investments (rising green bars), so does the cumulative balance of IKR capital gains classified as paid-in capital (yellow bars). In fact, those capital gains resulting from IKRs are almost as large as the accumulated net realized capital losses (red bars). If the yellow bars did not exist, how would the tax profile have fared over the same period?

Click to enlarge:


For tax years 2001 and 2009, the 500 Index Fund would have been forced to make capital gain distributions to all classes of shareholders, proportionate to the value of shares allocated to each class and shareholder. The tax-deferral benefit from IKRs (presumably from institutional investors who have positions large enough to warrant accepting the underlying 500 securities instead of cash) accrues to all classes of shareholders.

We can assume that retail investors accessed this fund through the Investors share class. The other classes (Admiral and Signal) have lower expense ratios but much higher minimum account size requirements. Hence they are more appropriate for institutional investors. How does the redemption activity of institutional investors compare to that of individual investors?

Click to enlarge:

In most years, the value of institutional shares redeemed for cash or in-kind (red bars) is a fraction of the equivalent amount for retail shares (green bars). Furthermore, the capital gains classified as paid-in capital represent an even smaller fraction of these redemptions.

The following graphs convey the same data for the Total Stock Market ("TSM") Index Fund, which launched its ETF share class on May 24, 2000. (Remember, the 500 Index Fund did not have an ETF share class until after its latest published financial report.)

Click to enlarge:


First, the AUM growth rate for the TSM Index Fund (depicted by the increasing green bars over time) is much higher than that of the 500 Index Fund. Normally, such a large and consistent inflow of new investments would give the portfolio manager ample flexibility to minimize capital gain distributions to shareholders. In fact, the magnitude of tax-deferral is impressive as the portfolio manager realized only net capital losses (red bars) since 2000. These capital losses are more than offset by the paid-in capital resulting from IKRs (yellow bars).

However, excluding the impact of IKRs, the tax profile changes significantly.

Click to enlarge:


In every tax year, the fund likely would have made capital gain distributions to shareholders. Thanks to IKRs, the portfolio manager was able to avoid a series of capital gain distributions and retain more AUM (from which the manager's fees are computed).

The following graph shows historical redemption activity for retail and institutional investors. For the TSM Index Fund, institutional investors are deemed to have utilized the Institutional and ETF share classes, both of which do not exist in the 500 Index Fund. The Vanguard Institutional Index Fund, which also holds approximately 500 stocks, offers institutional share classes, but its financial and tax books are entirely separate from those of the 500 Index Fund. Perhaps differences in legal opinion explain the separation.

Click to enlarge:


Here one can observe that the amount of capital gains resulting from IKRs (yellow bars) fluctuates consistently with the amount of institutional and ETF shares redeemed (red bars). (ETF redemptions are presumed to always be in-kind redemptions since the other means of liquidating an ETF position — via the seconday market — is not a redemption from the fund's perspective.) As long as IKRs keep occurring, the portfolio manager should be able to continue realizing net capital losses every tax year. Of course, if the market rallies strongly and steadily, the manager may run out of tax lots with embedded capital losses. (One could think of worse challenges to have.)

On the surface, everyone appears to have benefitted. The portfolio manager removes the largest capital gain tax lots from the fund, reducing the likelihood of realizing net capital gains in future tax years. If the fund continues to realize only net capital losses every tax year, a capital gain distribution should not occur, thus avoiding a taxable event for investors in non-qualified accounts. However, by avoiding a capital gains distribution, the AUM of the fund does not decrease either, increasing the management fee incrementally. Only when an investor eventually sells shares, either back to the mutual fund or in the ETF's secondary market, a capital gains tax liability could be incurred. Essentially, those net capital gains resulting from IKRs, including any unrealized net capital gains, are accumulated within the fund's NAV and become taxable when an investor redeems shares. Whether the capital gains are classified as long-term or short-term depends on the holding period of the fund investor, not the fund's holding period at the underlying security level.

Long-term investors benefit the most. Not only do they avoid receiving taxable distributions until redeeming fund shares, their profits should be mostly (or entirely, depending on investor-specific holding periods) taxed at the lower long-term capital gains tax rate. Short-term investors should benefit, but not necessarily in all cases. If a short-term investor (who holds a position under one year) realizes a capital gain, the entire gain would presumeably be taxed as current income (subject to the investor's specific circumstances, of course). If instead the investor had received a capital gain distribution from the fund (which likely could have happened if not for the IKRs), part of the distribution may have been classified as long-term capital gains (pursuant to the portfolio manager's choice of which security-level tax lots to sell). Since Vanguard promotes long-term investment horizons, one can understand the focus on benefiting long-term investors.

This brief analysis does not draw any new conclusions. Rather, the comparison between two leading Vanguard funds, one with and one without an ETF class, demonstrates the importance of in-kind redemptions on tax efficiency. Investors in the Vanguard 500 Index Fund should look forward to greater tax efficiency in the future. What about the investors in the Vanguard Institutional Index Fund, which does not offer an ETF class? Could a very large fund merger be on the horizon?

Disclosure: No positions

Source: Exploring Tax Efficiency With Vanguard ETFs