Vanguard ETFs have Different Tax Considerations Than Other ETFs
A little known fact (it seems) is that the Vanguard lineup of ETFs are not stand-alone products to the same extent as other ETF manufacturers’ ETFs. Rather, Vanguard ETFs are simply a special share class of Vanguard’s Index Mutual Fund lineup. While on the surface this might not sound like an important distinction, it is important to note the implications.
There are certain tax advantages of the ETF structure over and above the mutual fund open-ended trust structure. All other things being equal, suppose we have an index fund which has had a strong performance since inception. Further, let us assume a large investor redeems half the fund. An open-ended mutual fund trust will be forced to sell stocks at a realized gain in order to fund the redemption request. This creates a taxable event in which all the remaining unit-holders are subject to. A traditional ETF, on the other hand, can simply redeem ETF units on an in-kind basis to fund the request, thereby potentially sparing the remaining unit holders from any capital gains distributions.
So, it is important to note that Vanguard funds do not offer this one advantage of other ETFs from a tax efficiency perspective since they are, again, just a separate share class of the open-ended mutual fund trust index funds. If there were large redemptions causing realized capital gains, these could flow through to the Vanguard ETF holders.
However, it is also important to note open-ended mutual fund trusts have one advantage over traditional ETFs in that they can harvest capital losses to offset future capital gains. In this case, Vanguard ETFs have an advantage over other ETFs because they participate in the benefits of tax loss harvesting that is normally reserved for the mutual fund structure.
So at the end of the day, are Vanguard ETFs better or worse from a taxation perspective compared to other ETFs? Long term it’s close enough to a wash for me that it wouldn’t impact my decision to purchase Vanguard ETFs on a retail basis.
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Comment by Michael James on 15 September 2009:
As always, you’re right on top of fine distinctions that matter. I had no idea that Vanguard’s ETFs had this different structure.
Comment by Jordan on 16 September 2009:
It might also be good to point out that some of Vanguard’s funds are huge. Take the Total Stock Market Index, it is one of the largest funds in the world with 100 billion in net assets.
With such a large fund I imagine it would require more then a few institutional investors to liquidate all their holdings to see a noticeable impact. (I thought I once saw a list of top unit holders in the prospectus but can’t find it right now.)
Comment by Henry on 16 September 2009:
Is there anyway to find out the amount of capital gain or loss that is within a Vanguard ETF? I would imagine that 2008 resulted in some capital losses.
I hold VWO so I am particularly interested in this issue.
Comment by Preet on 16 September 2009:
@Henry – yes, just look up the fund in question on Vanguard’s site and select the distributions tab. VWO carries an unrealized gain of $2.38/unit, which is 10.74% of the NAV, for a total of over $2 billion.
Comment by brian on 17 September 2009:
I’ve always had trouble understanding tax efficiency of different investments. This post might be a little over my head.
Anyone know of some useful links/resources that would help me understand?
Pingback by Tax Efficiency of Vanguard ETFs Follow Up : WhereDoesAllMyMoneyGo.com on 21 September 2009:
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Comment by D on 26 September 2009:
Keep in mind though that being an index fund, they really can’t harvest losses or their tracking error will widen; i.e. if they move sideways from investment A to B to lock in the loss, they are out of line with the index for the time they are out of investment A (31 days min.). Therefore, you get the potential distribution problem, but doubtfully would get the tax loss sekking advantage. all-in-all though, it probably won’t amount to a big deal as they have such large inflows of capital they can probably fund most redemptions with a cash component. Larger players are probably in a true ETF.