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ETFs: Are Vanguard's VIPERs Flawed?

VIPER ETFs' tax efficiency called into question.

Vanguard recently launched 14 new exchange-traded funds, called VIPERs, making it a major player in the ETF arena. At first glance, there's much to like about the Vanguard offerings--low costs, inherent tax efficiency, and trading flexibility. But one prominent ETF guru isn't so sure.

Gastineau Takes Aim
In a recent article for the Journal of Indexes, Gary Gastineau (an early architect of ETFs and founder and principal of ETF Consultants) argues that Vanguard's VIPER ETFs are inferior choices for tax-sensitive investors compared with other ETFs. Gastineau's argument centers around the unique structure used by the VIPERs: Whereas all other ETFs are stand-alone funds, Vanguard created its VIPERs as additional share classes of conventional mutual funds.

Before we delve deeper into Gastineau's argument, let's quickly review how tax inefficiency can arise in an ETF or conventional index fund. Namely, when such funds realize capital gains, those gains are taxed at either ordinary income or long-term capital gains rates (depending on how long the underlying securities have been held). Capital gains have three primary sources: 1) portfolio managers can be forced to sell lower-cost-basis shares of stocks held by the fund to meet redemptions, 2) the use of index futures can result in capital gains being realized (most index funds, including ETFs, need to use futures to track their indexes properly), and 3) a stock in which the fund has unrealized gains can get dropped from the index, forcing the manager to liquidate the position.

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