Vanguard's Unique ETF Structure Presents Unique Tax Risks
It is important investors be aware of this risk, but it isn't worth losing sleep over.
It is important investors be aware of this risk, but it isn't worth losing sleep over.
A version of this article previously appeared in the December issue of Morningstar ETFInvestor. Click here to download a copy.
Exchange-traded funds' structural advantages make them more tax-efficient than traditional open-end mutual funds. But not all ETFs are built alike. Most of Vanguard's ETFs were established as separate share classes of the firm's mutual funds. There are pros and cons to this setup, which I'll outline here. I'll focus on the unique tax risk faced by investors in the ETF share class of Vanguard's funds, steps the funds' managers can take to mitigate this risk, and whether it is a risk worth taking.
Part Mutual Fund, Part ETF
Vanguard holds a patent on a unique fund structure, a mutual fund/ETF hybrid. Most of its ETFs were bolted onto existing mutual funds. This is distinct from its competitors' ETFs, which stand on their own. Vanguard's ETF-as-a-share-class structure has some key advantages over a stand-alone ETF:
But there is a potential drawback to this structure. Shareholders of the mutual fund and ETF share classes share everything--good and bad. This means that ETF shareholders could receive taxable capital gains distributions that result from the actions of investors in the mutual fund share classes of the same fund.
An untimely mass exodus on the part of mutual fund shareholders could unlock capital gains for everyone left holding the fund, ETF investors included. There has been one notable instance where this stung Vanguard ETF shareholders in the past. Specifically, in 2009, the Vanguard Extended Duration Treasury Index fund distributed a capital gain of $11.11 per ETF share. This amounted to 10.7% of the fund's average daily net asset value per share for the year. The distribution was spurred by a combination of a brief spike in Treasury prices that began in late 2008 and significant outflows from the Institutional share class of the fund during the first six months of the year, which equaled one fourth of its end-December 2018 assets. The ETF share class (which represented 17% of fund assets as of the end of 2018) saw modest inflows during this period. This risk isn't present in ETFs that aren't linked to a mutual fund.
Don't Fret
This tax risk, which is unique to Vanguard's patented structure, will always be present. That said, I don't think it is something investors in Vanguard ETFs should fret over. Here's why:
How Can Investors in Vanguard ETFs Assess This Risk?
There are a few things investors can do to assess the potential tax risk faced by their Vanguard ETFs. As discussed above, one of the determinants of the level of risk is the size of the ETF share class relative to the mutual fund share classes. The greater the portion of assets invested in the ETF, the lower the risk is likely to be. That said, it is also important to understand the nature of the mutual fund share classes' investor base. For example, investors in Vanguard Total Stock Market Index may be less flighty than those in one of the firm's sector funds. The former tends to be a core holding, the latter a satellite position. Also, the former features prominently in the firm's target-date series and retirement plan menus--channels where turnover is relatively low. Exhibit 1 features data for Vanguard's 20 largest funds with ETF share classes. As of October 2019, the ETF share class held the majority of fund assets for eight of these funds. The ETF share class' share of total assets increased for 16 of the 20 funds over the past five years.
Key Takeaways
[1] Clark, J.W., Utkus, S.P., & Young, J.A. 2019. "Understanding Household Trading Behavior 2011–2018." Vanguard Research. https://personal.vanguard.com/pdf/ understanding-trading-behavior.pdf
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Ben Johnson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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