Blogs & Comment

Tax efficiency of Vanguard ETFs (II)

As mentioned in the previous post(and Preet Banerjees postto which it links), there is a possibility that redemptions in the Vanguard index funds may have adverse tax consequences for Vanguard ETFs (which are special share classes of the index funds). Vanguard says this is only a hypothetical situation that has yet to materialize.
Out of our 39 ETFs, only our REIT ETF paid a small capital gains (in 2004, 2005, and 2006), and our Consumer Staples ETF paid a small gain in 2004. Not one of our large, broadly diversified ETFs, like VTIor VWO, has ever paid a gain, Vanguard notes.
Vanguard also says theshare-class structure of Vanguard ETFs “gives Vanguard additional ways to maximize after-tax ETF returns relative to competitors.” All ETFsminimize capital gains by distributing their lowest-cost shares to meet redemption requests for creation units andVanguard ETFs are no exception.However,as cash flows into the funds conventional shares, theypurchase stocks in various tax lots, and when investors redeem shares of the conventional funds (or when there are index changes that require sale of a security), “we sell the highest cost lots first, typically resulting in the realization of capital losses.” These losses are then stored up in the fundtooffset capital gains that could be realized in the future.
Moreover, if there was a large enough transaction that might cause a capital gain, an open-ended fund could do an in-kind redemption of securities instead of cash. It’s rarely utilized and in our case, rarely necessary. In fact, our index funds are so large, and take in such steady cash flow, that we can typically cross incoming cash with outgoing redemptions, thereby avoiding the need to buy or sell stocks altogether.
So the risk of capital-gains distributions is quite low in the case of Vanguard ETFs, especially for a fund with a large asset base that has steady cash flows and in-kind redemptions. For a fund with a small asset base without steady cash flows and the option of in-kind redemptions, the risks are somewhat higher.
Vanguard also says its ETFs have an edge in avoiding distributions when index changes occur. Stand-alone ETFs may have to sell securities in order to purchase new index entrants and weight their portfolios appropriately because all of their cash flows are paid in kind, not with real cash. Vanguard ETFs (i.e. their underlying index funds), on the other hand, will have cash flows that can be used to buy new additions to the index.
Lastly, as a special share class of the Vanguard index funds, the Vanguard ETFs have lower start-up costs and can leverage the economies of scale of an existing large pool of assets to minimize ongoing operating and trading costs which means some of the lowest MERs around.