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.
Justice: Okay. So we realize, ETFs are not always more efficient than the mutual fund structure from a tax standpoint. In June, you guys launched 20 new Exchange Traded Funds and one of those was a real headliner the Vanguard 500 ETF following the S&P 500 and is also now a separate share class of the Vanguard 500 mutual fund. Now as far as S&P 500 funds go, there are two very large ETFs already available on the market, the SPDR with ticker SPY and the iShares, IVV, that follow the S&P 500. But your Vanguard 500 mutual fund has actually demonstrated over the last decade a better tax cost ratio than the Exchange Traded Funds. Can you tell us how you manage to do so?
Sauter: Yeah, there seems to be a great American myth that ETFs are automatically more tax efficient than a mutual fund. I guess, I would point out first of all most ETFs are index mutual funds. And really the majority of tax efficiency comes from the index concept. Indexing being largely a buy and hold strategy. So ETFs and index mutual funds are going to be tax efficient by their very nature.
In addition to that, in a conventional index mutual fund, we have some tools and some opportunities to really increase the tax efficiency that may not be available to a standard ETF. For instance, if we do have someone redeeming money out of the fund and we have to sell stocks on any given day to fund that redemption, we're going to sell the highest cost lots that we own of a stock. So that we might have purchased a stock a month ago before the decline in the market and we're selling it today at a lower price. In other words, we're going to be realizing a capital loss, not a capital gain. That capital loss will then sit in the portfolio as kind of a contingent asset, if you will, available to offset any future realized capital gains. So it will sit there for eight years until we ultimately use it.
So the funds – index funds in general can be very tax efficient through using this process, and I would note that an ETF really doesn't get that particular tax advantage because ETFs almost always fund redemptions in kind. So ETFs really aren't selling off stock to fund redemption. They're not able to sell their highest cost lots to fund redemption and store up those capital losses for the future. So, over time, as you note, our 500 portfolio has been very tax efficient, and in many cases even more tax efficient than an ETF counterpart.
Justice: It's often said that the first mover advantage in the ETF space is paramount. We know the SPDR was the first ETF that was launched back in 1993, but people should remember, like you said, it's an index fund and the first index fund was launched by the Vanguard Group in 1974, the Vanguard 500 fund. Can you talk about why you came out with the ETF structure now and will it help this Vanguard 500 fund become even more tax efficient at all, or is it merely a way for people to access the market differently?
Sauter: Well, we've been working with Standard & Poor's, the owner of the S&P 500 Index for many years now, working to get to this day, where we can actually launch the ETF share class off of the 500 portfolio. So, we're excited to be able to do that and really our excitement is around our ability now to offer the 500 portfolio in two different flavors.
You can invest in it in a conventional share class as you've always been able to do and in the future you'll be able to invest in it through the ETF share class as well. So really, it's just providing more choice for investors, what's their preferred way to invest in the fund. So we're excited about having that opportunity.
At the same time, the two different share classes combined create a synergy that's not available to either share class separately, either a standalone conventional index mutual fund or a standalone ETF and that's because they both offer some tax efficiencies and so they can really complement each other.
As we've discussed, ETFs do have this natural in-kind process and that works to the tax efficiency of the overall fund. At the same time, when we have cash redemptions that we might have to fund and sell stocks on the conventional share class side that has the tax efficiency. So they really work together to complement each other.
They work in other ways as well. Many people might not realize how much blocking and tackling there is in an index mutual fund. In fact, they think that it's kind of a buy and hold sort of thing; you set it up one day and walk away and it will take care of itself.
In fact, index investing has to occur almost on a daily basis. Indexes are constantly changing and you need to rebalance a portfolio to make sure that it's always in line with the index as it moves. So, if you don't have cash flow coming in, it would mean you might have to sell off one stock to buy another one as the index itself is changing.
Having the conventional share class as a part of this offering gives us a natural cash inflow into the fund in the form of true cash and we can divert that cash to rebalance the portfolio. We don't necessarily have to sell off securities to rebalance the portfolio. Just direct the cash in the appropriate direction. And so, that's an additional portfolio management synergy that the conventional share class adds to the overall pie.
At the same time, they are both adding efficiency from the standpoint of economies of scale as they both contribute assets to this one pool of assets, so the fund is getting larger and that certainly is an advantage when managing an index fund. The larger index fund is easier to manage and easier to track the benchmark than a smaller one.
Justice: Really interesting. You are bringing out so many new product choices for investors so they have additional vehicles to go through, which will also increase your operating efficiency and as always, probably bringing down the cost of the overall industry like Vanguard has done for a few decades on hand. So, thank you for joining me in discussing these points Gus.
Sauter: Okay. Well, thank you, Paul.