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By Paul Justice, CFA | 07-09-2010 11:49 AM

Sauter: ETFs Aren't Automatically More Tax Efficient

Traditional index mutual funds can offer similar tax advantages to ETFs says Vanguard's Chief Investment Officer Gus Sauter.

Paul Justice: Hi, there. I'm Paul Justice, Director of ETF Research for Morningstar, and today I'm here to talk about the tax efficiency of Exchange Traded Funds, and I'm joined by Gus Sauter, Chief Investment Officer at the Vanguard Group.

Gus, thank you for joining me.

Gus Sauter: Thank you, Paul. Glad to be here.

Justice: With Vanguard's product structure your ETFs operate as a separate share class of the mutual fund, so you really have the same assets in two different product wrappers, and I'd like to talk about kind of how that helps out both the Fund and the ETF. How do they operate differently as far as a tax efficiency standpoint?

Sauter: Sure. Yeah. Well, first of all, as you point out, it really is one index mutual fund, one portfolio that we manage and just make sure that that tracks the index. The portfolio then is distributed in two different channels, one is the direct index mutual fund channel, the conventional index mutual fund, and the other is through the ETF share class structure. So, as an investor, you can choose to invest in this same fund either directly through us as a conventional mutual fund or through a broker buying it on the exchange, either way you're going to get exactly the same fund, it's just a matter of convenience for the investor.

Justice: Okay. Now with the Exchange Traded Fund, it has a process called an in-kind creation and redemption process that can often times reduce the tax liability for the ETF holders making it more tax efficient than a mutual fund. Is this necessarily the case with Vanguard and since you do have separate share class, the ETF is a separate share class of the mutual fund. Are those benefits shifted from one product to the other, are they shared or even perhaps do they create some synergies in between the two?

Sauter: A lot of investors are familiar with the in-kind redemption process that occurs in ETFs and it does lend tax efficiency to ETFs. However, I think, many investors misunderstand that that's not a tax regime that is solely available to ETFs. In fact, it's available to any mutual fund, any regulated investment company as all mutual funds are.

So, our regular mutual fund can take advantage of the same in-kind process and gain tax efficiency from that. If we have a large redemption, instead of paying the redeeming investor out with cash, we might give them securities. In other words that's an in-kind redemption in securities, and that turns out to be a very tax efficient way to do distribution. And so, that tax efficiency isn't just available to ETFs, it's available to all mutual funds, really, any regulated investment company.

Justice: Okay. Now is it common practice with any of your mutual funds to act in the in-kind process or is it more a function of the ETF in general terms?

Sauter: From a practical standpoint, a mutual fund won't redeem a small investor out in-kind. If you are, redeeming let's say $10,000 or even $100,000 likely the mutual fund is going to give you cash. However, if you're redeeming a large amount out, $10 million, $20 million, $50 million, which happens with institutional investors, then it's very common that the investor might get securities instead, in other words an in-kind distribution. So, we do take advantage of that opportunity, and in say something like our 500 Index Fund over the last 20 years, we've distributed billions of dollars, in fact tens of billions of dollars in the form of in-kind distributions. So it is a process that occurs naturally in ETFs, but it's not entirely uncommon in a conventional mutual fund as well.

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