Index funds incur capital gains which are distributed to shareholders when one of two events occurs:
Change to Index Composition: The stocks within an index change and the fund is forced to sell the departing stocks which may have an unrealized capital gain. This gain is realized and distributed to the shareholders of the fund.
Redemptions: There are net redemptions which require the fund to sell some underlying stock to pay for the redemptions. At the point of the sale, the sold stock may have an unrealized capital gain. If so, then the capital gain must be taxed accordingly and the tax will be spread over all shareholders.
ETF managers are able to pay for sales of the ETF creation units (to market makers) with the underlying securities (instead of needing to redeem shares of stocks). Thus, they can off-load the lower cost basis shares to the market makers. This should allow the ETF to avoid realizing a capital gain and to reduce the unrealized capital gains in the portfolio when redemptions occur.
Thus, they should be protected against both instances where a capital gain would be passed on to a shareholder.
Change to Index Composition: The ETF manager does need to sell the stock which is leaving the index. However, when the index changes, the ETF should have a high cost basis for the stock leaving the portfolio which will help minimize the capital gain.
Redemptions: The redemptions are funded with stock (rather than having the need to sell stock and realize capital gains). The fund manager can use the lowest cost basis shares to pay for this redemption. Thus, this potential tax situation should be completely avoided.
To determine where this tax advantage may lead to significant cost savings for ETFs vs. index funds, one should consider the following characteristics of an index fund:
Turnover of the underlying index: A high turnover can result in capital gain distributions.
Unrealized capital gains: The current unrealized capital gains for the index fund may need to be distributed to the existing shareholders in the future if there is a major net redemption. Managers can actually reduce current capital gains by selling higher cost basis shares when shareholders redeem (or the index changes). This will reduce the capital gains realized in the current period but will increase the unrealized capital gains which may need to be paid off in the future.
High redemptions or potential for high redemptions: The unrealized capital gains may need to be paid if there is a significant level of redemptions where the manager is forced to sell some lower cost basis shares to fund the redemptions.
Good ETF Candidates
Emerging market (medium turnover, high unrealized, potential for high redemptions)
Value (medium turnover, medium unrealized)
Treasuries (very high turnover, low unrealized)
REIT (low turnover, high unrealized, potential for high redemptions?)
Small Cap (medium turnover, medium unrealized)
Small Cap Value (medium turnover, medium unrealized)
International developed equities (low turnover, medium unrealized)
Large Cap (low turnover, high unrealized)
On the Vanguard ETFs, we think that they provide some additional tax efficiency to the index fund since they are just a different share class. When the ETF shares are redeemed, Vanguard can send the lower cost basis shares from the entire fund to the market maker. However, the ETF is exposed to tax consequences of shareholders of the index fund redeeming shares. As mentioned above, the index manager can sell higher cost basis shares to reduce the realized capital gain in the current period. In theory, if the ETF has significant assets in relation to the assets in the index fund, the unrealized gains for the entire fund could be reduced to close to zero for all the shares.
Given all of this, it seems like the presence of the ETF makes the index fund more tax efficient but the ETF may be less tax efficient than competitors. See the article below from Morningstar.
Article from Morningstar on Vanguard's VIPERS:
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.
Gastineau argues that the share-class structure used by VIPERs prevents them from taking full advantage of the mechanism that improves ETFs’ tax efficiency relative to that of conventional funds. ETFs, unlike conventional funds, only sell their shares at NAV in large blocks (typically 50,000 shares) called creation units. Everyone else buys and sells ETF shares over an exchange at the prevailing market price. Entities dealing in creation units (usually specialists or market makers) have to execute their transactions in-kind, however. When buying a creation unit, they must deliver the stocks that make up the creation unit, and when selling a creation unit, they receive the underlying stocks held by the ETF, not cash.
This structure does two things. Because ETF managers can pay out securities to shareholders who are redeeming (rather than having to sell shares to meet redemptions), they aren’t forced to recognize capital gains due to investor trading. Moreover, the in-kind redemption process allows the portfolio manager to unload low-cost-basis shares of stock. The latter allows the manager to flush out unrealized capital gains from the portfolio on an ongoing basis, assuming there are sufficient redemptions to do so.
Gastineau argues that this mechanism is diluted in the case of the VIPERs, at least for those VIPERs where the conventional share class’ asset base is much larger than the VIPER asset base ( Vanguard Total Stock Market VTSMX is one such offering). Because the conventional fund will redeem its shares for cash, the fund as a whole loses some opportunities to hand off low-cost-basis shares of the stocks it owns.
Not the Whole Story
Although Gastineau’s point is well taken, it’s not the whole story. To get the other side, we spoke with Vanguard’s Gus Sauter, who oversees all the family’s index funds. Sauter, perhaps not surprisingly, thinks Gastineau’s argument is off the mark.
Sauter argues that there are ways in which the conventional share class can actually help the tax efficiency of VIPER shares. He notes, for example, that although ETFs redeem shares in-kind, conventional funds can sell their highest-cost shares to meet redemptions. This can have the salutary effect of realizing capital losses for the funds, which can be used to offset any gains. In fact, many Vanguard index funds are sitting on substantial realized losses at this point. In effect, ETF share classes of these funds can benefit from the losses enabled by the cash flows associated with conventional share classes. (ETFs can also do this by redeeming high-cost shares for cash to realize losses. Many did not take advantage of this at first, but Gastineau asserts in his article that most ETF managers are now doing so.)
But, if the VIPERs’ tax efficiency benefits from the capital losses enabled by the conventional shares, wouldn’t they be harmed by any gains generated by the conventional shares? The answer is yes, but you have to consider the likelihood of that happening. Even after running through their tax-loss carryforwards, which extend out eight years, the likelihood of one of Vanguard’s index funds substantially reducing its ETF share class’ tax efficiency seems low.
Sauter argues that redemptions are unlikely to pose much more of a problem for ETFs with conventional share classes than for standalone ETFs. We think he’s right.
First, as we said above, the redemptions at conventional share classes can allow the portfolio manager to realize losses that can be used to offset future gains. Further, in the 1990s bull market—when its funds were sitting on large unrealized gains—Vanguard did a study that showed that most of its index funds could suffer redemptions of 10% to 15% of their assets before being forced to pay out capital gains. Though that might not sound like much, it’s actually quite a cushion. After the crash of 1987, for example, Vanguard 500 suffered redemptions of only 7% of its asset base, according to Sauter.
As regards to capital gains resulting from the use of futures, it should be noted that ETFs have no advantage that we know of. To the extent that a standalone ETF uses futures and thereby recognizes capital gains, it will have to pass along those gains to shareholders unless it is able to offset them with losses elsewhere in the portfolio. The tax effect of futures would be the same for an ETF structured as a share class of a conventional fund.
The third source of gains is more problematic. When a company is dropped from an index, a conventional index fund or ETF must liquidate its holdings of that company’s stock. If a fund has large unrealized gains in the stock, it will realize those gains. An ETF, assuming it has had sufficient redemptions to enable its manager to dump low-cost-basis shares, should realize smaller gains on the stock than a conventional fund.
Nevertheless, as Gastineau notes, this could only be a hindrance to ETF share classes of funds where the bulk of the assets are in the conventional share class, such as Vanguard Total Stock Market. Further, such gains could well be offset by the manager’s ability to realize capital losses elsewhere in the portfolio.
Only time will tell, of course, but at this point, we see no clear evidence that ETFs structured as share classes of conventional funds should necessarily be materially less tax-efficient than stand-alone ETFs tracking the same index. As always, however, tax-sensitive investors should exercise care with regard to their choice of an index. Funds that track bogies with higher turnover rates (small-cap indexes, for example) are likely to be significantly less tax-efficient than funds with lower turnover rates.