Should You Worry About the Tax Efficiency of Vanguard ETFs?

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Vanguard's equity exchange traded funds have managed to be very tax-efficient so far, but will they always be? Joining me to discuss some research on this topic is Ben Johnson, he's director of global ETF research for Morningstar.

Ben, thank you so much for being here.

Ben Johnson: Thanks for having me Christine.

Benz: Ben, before we get into Vanguard specifically and its lineup of ETFs. I'd like to talk about equity exchange traded funds, why the broad market index trackers tend to be pretty tax-efficient investment vehicles.

Johnson: Generally speaking ETFs have two sources that drive their tax advantages. The first is not unique to the ETF structure, and it has to do with the fact that most ETFs track broad-based market-capitalization-weighted indexes. These indexes will have, say for example in the case of a U.S. Total Stock Market Index, a run rate of turnover around 3% to 5% per year. This low rate of turnover within the portfolio is really the bedrock of their tax efficiency, relative to actively managed mutual funds that might turnover 50%, 60%, 70% a year.

The other source of their tax advantage has to do with the ETF structure. The fact that as ETF shares are created, as ETF shares are redeemed, they take securities from a special breed of market-maker called an authorized participant and take into the portfolio say the stocks that make up the S&P 500 on an in-kind basis. When those shares are no longer needed in the market place and are ultimately destroyed, those shares are sent back out to that same authorized participant and then sold on the marketplace.

So, by virtue of purging the portfolio of those shares on an in-kind basis--which I should stress is a feature that's not unique to ETFs it's just far more commonplace relative to the same practice in traditional mutual funds--you are not unlocking any embedded capital gains that might be present in those securities. Strategy as represented by broad-based market-cap-weighted passive exposure to the market or a slice thereof, and the structural advantage of that in-kind creation to redemption underpin ETFs' tax efficiency.

Benz: That structural setup that you just referenced that stands in contrast to how it works if I have a traditional mutual fund and I want to sell some shares, maybe I am a big investor in that fund. The fund has to send me my cash and they may have to sell stuff in order to raise the cash to pay me back, right?

Johnson: That's absolutely right. So more often than not when a mutual fund faces redemptions they'll follow exactly those steps by liquidating a portion of the portfolio to meet redemptions. And as has been the case, as we've seen over the course of recent years, is there have been large outflows from many funds. There have been mass liquidations and the unlocking and what has been, generally speaking, an upward trending market of sizable capital gains that have been distributed to those fund shareholders.

Benz: And we should say before we go any further. If I'm in an IRA or a 401(k) this discussion doesn't matter to me.

Johnson: It means nothing to you. This means something and is very meaningful to investors in a taxable setting.

Benz: Let's talk about Vanguard's setup for its exchange traded funds, they are share classes of its index funds. Let's talk about that structure and also the implications for tax management of those funds.

Johnson: Vanguard's ETF structure is unique and that, as you alluded to, it's a separate share class of their mutual funds. This has certain benefits to the extent that when the ETFs that are indeed structured in that manner were first launched, they had the benefit of the scale of the existing mutual fund, which was expressed chiefly in a very competitive price tag. They benefit from lower trading cost, given that the overall heft of the portfolio creates greater efficiencies with respect to trading in the securities and just the day-to-day portfolio management function.

Now that said, because they are just a separate sleeve, a separate share class of the fund, they will, in the event of any taxable capital gains, take their fair share of those taxable capital gains distributions, which is a risk that is unique to this particular structure that isn't present in the case of standalone ETFs.

Benz: Let's walk through that, say it's a big index fund, a big Vanguard index fund, and for whatever reason investors begin to redeem heavily the traditional index fund. You are saying because of that setup even though if I am situated over here in the ETF share class that could still affect me.

Johnson: That could negatively affect ETF shareholders, the bad behavior, say a mass exodus from the admiral or the investor share class of a Vanguard mutual fund that also has an ETF share class--any gains that are unlocked by that behavior, that selling on behalf of shareholders of the mutual fund share classes will be shared pro rata with investors in the ETF share class.

Benz: You did an article on this topic for ETFInvestor. Let's talk about how realistic such a scenario is. Should this be something that Vanguard ETF investor should be worried about?

Johnson: It's something where I will say that, in the grand scheme of things, the probability of this risk manifesting is probably quite low. And the magnitude of any negative tax consequences, at least based on many Vanguard funds' historical track record, I would say is quite small. What would result in such a scenario is really the most important question. The circumstances that would have to sort of transpire would be large scale selling in a favorable market environment, such as we are in today. Why are we even talking about this, because there are some index funds that we've seen over the course of recent years that have seen their asset bases cut in half by such a mass exodus, by huge outflows in the midst of a bull market. The portfolio managers can try to do everything in their power to try to shield shareholders, ongoing shareholders from realizing taxable capital gains, but when your asset base is cut in half there is only so much you can do.

What is the probability of something similar happening in Vanguard funds? I would say it's really quite low, to be honest. Generally speaking what we've seen is that Vanguard investors tend to be somewhat better behaved than investors in other fund families. You also have to consider the channels via which their funds are distributed and take into account that in many cases these are funds that are a component of a target date portfolio, where we have documented very good behavior on behalf of investors largely because these portfolios--be they target date portfolios or the individual a la carte index mutual funds--are made available to investors through a defined contribution platform, where, generally speaking, we see better behavior than investors in other settings and other channels. The odds of a mass exodus among mutual fund shareholders I would argue are probably very low. Thus, I would say that potential for nasty tax surprises for ETF shareholders of those same funds is equally low.

Benz: Ben, you mentioned the in-kind redemption process that's available for ETFs. Does that help mitigate this problem potentially for Vanguard funds, for the ETF share class as well as potentially the traditional index funds?

Johnson: It absolutely does. Absolutely in the case of the ETF share class, but also as I mentioned before, important to keep in mind, that mutual funds can redeem in-kind as well. Vanguard retains the right and has executed the right historically in the case of potentially disruptive redemptions from the mutual fund share classes to meet those redemption requests on an in-kind basis, thus forgoing liquidation which would potentially unlock capital gains, and thus protecting ongoing shareholders from the negative tax consequences of any such liquidation. If you take, for example, the case of the Vanguard 500 Index ETF and go all the way back to 1999, which is the last time that that particular fund distributed a taxable capital gain, Vanguard exercised that right, did not completely shield shareholders from taxable capital gains but certainly mitigated the magnitude of that particular distribution which amounted to less than 1% of the fund's net asset value.

Benz: To take a step back say I am a taxable investor, and I am really concerned with limiting tax efficiency in my portfolio. How do I make smart choices here in terms of trying to find the investment that's going to do the best job of limiting these taxable capital gains distributions to me?

Johnson: A lot of it has to do with focusing on the traits that we discussed earlier: looking at turnover and looking at structure. The ETF structure is really quite powerful, and I think it's power to shield investors from negative tax events is actually best demonstrated by the fact that there are a number of ETFs that have had median turnover in excess of 100% now for five years running, that have yet to distribute a taxable capital gain to investors. That is the structural advantage of that format on display. Now if you want to mitigate the risk that's present and unique to the Vanguard structure or at least just reduce the likelihood of such tax consequences. You can consider an ETF that's a standalone ETF that isn't structured--and all non-Vanguard ETFs are structured--as standalone ETFs that sit on their own, that haven't been bolted on to an existing fund. But again, I would stress that both the probability and the magnitude of negative tax consequences for investors in Vanguard ETFs is really quite low.

Benz: A related issue is that if someone is watching this and maybe inclined to say, I am a little spooked by my Vanguard ETFs, you probably have an embedded gain in that holding anyway. Before you switch into something else, be careful there.

Johnson: That's absolutely right. I would stress too, and we've had conversations about this in the past, is that as this field becomes increasingly competitive, these fears are more often than not being fanned by Vanguard's competitors that are trying to poke holes in their product because their products are so substantially similar in so many different ways, that they are splitting hairs that have already been split two or three times.

Benz: Great insight, Ben. Thank you so much for being here.

Johnson: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.