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Index funds and the myth of the "tax trap"

July 05, 2013

With many Americans facing tax increases as a result of legislation enacted earlier this year, it's no surprise that there's heightened interest in tax-efficient investing. One concern we hear from time to time is that index mutual funds can become "tax traps" during bear markets, as the funds' managers are forced to sell holdings and realize large capital gains.

From Vanguard's perspective, however, that notion is a myth. Even in the face of higher tax rates, our analysis finds that index funds retain their high potential for tax efficiency, especially relative to actively managed funds.

The American Taxpayer Relief Act (ATRA) created a new top tax bracket of 39.6% and raised the long-term capital gains and dividend tax rates to 20%. Also, upper-income taxpayers are now subject to a 3.8% Medicare investment surtax.

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Scott DonaldsonAs explained by Scott Donaldson of the Vanguard Investment Strategy Group, "typically, an index fund in practice carries a wide dispersion of share lots in each security—that is, groups of shares purchased at different prices, both high and low—that serve as a powerful defense against the risk that such portfolios will become 'tax traps.'"

At the peak of the late-1990s equity bull market, Vanguard broad-market index funds maintained large unrealized capital gains. A similar situation exists today, as shown in the last column of the chart below. These broad-market index funds distributed no capital gains from 2001 through 2012, even considering two extreme bear markets in the early 2000s and again in 2008. The chart also shows "breakeven redemption" ratios for three hypothetical market scenarios indicating that these three funds are well-positioned to redeem substantial portions of fund assets before realizing any net capital gains—in a flat market as well as during steep market declines.

Redemptions under highest in, first out (HIFO) accounting as of March 31, 2013

 
 
 
 
Vanguard fund
Breakeven redemption*
(percentage of fund):
 
Flat market 20% market decline 30% market
decline
Unrealized gains**
Vanguard 500 Index Fund 26% 53% 78% 36%
Vanguard Total Stock Market Index Fund 42% 90% 100% 22%
Vanguard Total International Stock Index Fund 54% 100% 100% 12%

Source: Vanguard.

*Percentage of the fund's portfolio that could be redeemed before realizing capital gains.

**Includes accumulated realized losses.

Notes: The hypothetical analysis in the "Breakeven redemption" section shows the percentage of each fund's total portfolio that could be redeemed in cash before realization of net capital gains. (There are other forms of redemption, such as "in kinding" of securities, that do not trigger distributable capital gains to shareholders of the fund.) Each scenario assumes the portfolio starts with a net realized capital gain position equal to the previous month's net accumulated capital gain or loss, which is not necessarily indicative of the portfolio's actual tax status. Capital gains and losses realized by selling proportional amounts of each stock held in the portfolio are then factored into the analysis. Because the analysis assumes that highest-cost lots are sold first (consistent with the manner in which Vanguard administers each portfolio's tax-lot structure), net losses are typically realized from initial sales. Loss realization from successive sales accumulates until subsequent sales realize net capital gains. This table shows the percentage of each fund that can be sold in this fashion before realized net capital gains return to 0%. This analysis is based on each fund's then-current holdings and tax-lot structure as of the reference date of the analysis. The analysis also assumes security prices as of the reference date. Because substantial shareholder redemption activity is normally associated with poor recent performance, results from sensitivity analyses that assume security price declines of 20% and 30% are also provided.

"It's important to understand that a broad-market index fund has the ability to sell share lots that were purchased at high prices and realize losses that can then be used to offset gains elsewhere in the portfolio," said Mr. Donaldson. "Thus, a well-managed index fund can use its high-cost share lots (those purchased at high prices) to accommodate redemption requests. As a result, redemptions during a bear market can actually help a broad-market index fund remain tax efficient."

This concept is well demonstrated in the chart below, which shows that stock index funds distributed very low capital gains through the end of 2012. In fact, capital gains distributions for stock index mutual funds—expressed as percentages of their average net asset values (NAVs)—decreased during the 2000–2002 bear market, and again following the global financial crisis in 2008.

Average annual capital gains distributions for stock index funds as percentages of their NAVs, 1993–2012

Average annual capital gains

Note: Averages calculated using capital gains distributions and NAVs as of each year-end.

Sources: Lipper Inc. and Vanguard.

How the risk exposures of index and active funds differ

An index fund's return is primarily due to the risk exposure of the benchmark index it seeks to track. Ideally, an index fund's absolute return will be very close to that of its benchmark. And as such, it's unlikely that an equity index fund would experience significant negative cash flows in a rising or flat stock market.

In contrast, an actively managed fund's return is made up of the risk exposure from the overall market in which the fund participates, along with any additional results of the fund managers' efforts. Understandably, such efforts can have a major impact on an active fund's beta, whether additive or dilutive. Therefore, an actively managed fund's absolute return can deviate significantly from its relative benchmark return.

Because investors often have a propensity to chase past performance (as shown by research at Vanguard and elsewhere), an actively managed fund is much more likely to experience significant negative cash flows based on past performance, even if its current absolute performance is positive. In such an environment, a fund's track record of high tax efficiency can quickly break down, producing significant capital gains distributions. As a result, Vanguard believes that an actively managed fund's historical tax efficiency is of little value as a forward-looking indicator, while broad index funds' tax efficiency has been an enduring characteristic and is expected to remain so.

Adopting a tax efficient posture

Sarah HammerIf you're concerned about rising tax rates, Sarah Hammer of the Vanguard Investment Strategy Group says there are several steps you can take to improve your portfolio's tax efficiency.

"For example, consider using tax-advantaged accounts and maximizing the use of accounts such as traditional and Roth 401(k)s, IRAs, and 529 college savings plans," Ms. Hammer said. "Give serious thought to using tax-advantaged accounts to rebalance your asset allocation or to sell appreciated positions. And pay attention to the asset location of your investments, purchasing tax-efficient investments in your taxable accounts and tax-inefficient investments in tax-advantaged accounts. These practices may help you earn extra returns and can have a powerful compounding effect over the long term," she said.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
  • We recommend you consult an independent tax advisor for specific advice about your individual situation.
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