Markets & Economy
ETFs and tax efficiency
May 15, 2014
Amy Chain: Another live question came in from Liz. Liz says, "What is the difference in potential capital gains on ETFs versus index funds?" Liz, I'm so glad you asked this question. We love this question. Who wants to take it?
Joel Dickson: So, this often gets to this question about ETFs talked about in the form of potentially better tax- efficiency. And again, a lot of this, we think, comes from the index strategy, especially when you talk about broad-based equity and exposures, that you get the tax efficiency from the lack of portfolio management that needs to be done in terms of maintaining relative to a broad-based index, and so, therefore, less capital gains.
But the "ETF versus fund" issue often gets talked about in the context of this concept. And it's a little bit of the—we'll go into the 201 concept here. With ETFs—not you as an investor—but underneath in this mechanism by which the net asset value and the market price, as I mentioned before, sort of stay relatively in-line, there's something called "ETF creation" and "ETF redemption" that are done by large institutional purchasers interacting with the fund.
When they transact, they do so with securities—what's called an "in-kind" transaction. So, with the S&P 500, they'll give us 500 stocks, we'll give them shares of the ETF or vice versa if it goes the other way.
And when transactions are done in-kind out of the portfolio— that is we give one of these large institutional players a portfolio of securities—you don't have to realize the gain that otherwise would have been realized from selling those securities at the fund level, and therefore it doesn't have to be distributed.
Amy Chain: You sort of net some things out from the fund level.
Joel Dickson: Yes, exactly. Now, that said, in the traditional mutual fund, we actually also try to manage those portfolios in a very tax-efficient way, which is when we get a redemption in a traditional mutual fund, which is, in that case, funded by selling securities at the fund level and paying in cash.
If a gain were realized there, you would have to distribute it to all shareholders in the fund. We often try to minimize that gain by selling what's called "highest-cost-lot securities," which is to try to minimize the taxes on any sales in the portfolio. So, you can sort of use both.
And we've talked about how with the ETF and the fund, they're the same underlying portfolio. The way that we manage that is we actually try to tax-optimize across these different share classes, realizing losses to the extent that we can when there's a redemption from the mutual fund and trying to sort of get rid of the highest-tax issues when we're doing the in-kind redemption.
Amy Chain: If I could just reiterate with a point that you opened with, I think that it’s really what you sort of said, when you read in the newspapers, ETFs are really tax efficient, try subbing that out and indexing is really tax-efficient. So it’s more of the strategy than the vehicle of that of the tax strategy.
Joel Dickson: The indexing strategy gets you a long way there. Some of the ETF structure can help, but I think as Vanguard has shown with our own index funds, we have not distributed a lot of capital gains on the equity side over the last decade, and that's not just because of the ETF mechanism. It's because of the market environment, the way that we manage portfolios, and the indexing approach.
James Rowley: And maybe just to add, let's not lose sight of what we would define tax efficiency to be, right? Don't go down the path of whether or not a fund pays a capital gain or it doesn't. What's more important is how much do you keep? So if you're invested in an index fund, what you really care about is, "How well does that fund track the index, and after I account for expenses and/or any taxes I've paid, how well am I tracking the index?" Because if you're in a fund that severely lags its index, and you say, "Oh, I paid no capital gain" well clearly I'm better off being with the product that maybe it paid a little gain with smaller expenses but that, when all that is said and done, I still tracked my index better.
Joel Dickson: And I think that it is important to highlight, even though we've highlighted some of the differences, the tax rules that ETFs, at least those structured as open-end funds as we've talked about, and mutual funds have, are exactly the same. To the extent that you have dividends or interest income that is received or capital gains that are realized, they have to be distributed to investors. There's no difference in the tax rules between ETFs and funds, at least, again, those structured as open-end funds.
All investing is subject to risk, including the possible loss of the money you invest.
For more information about Vanguard ETF Shares, visit vanguard.com, call 800-992-8327, or contact your broker to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
This webcast is for educational purposes only. We recommend that you consult a financial or tax advisor about your individual situation.
© 2014 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.
The indexing approach can make a difference
Not all indexes are created the same and those differences often can be found in ETFs. Vanguard's Joel Dickson explains that ETFs often are the doorway into alternative indexing methods.
Other highlights from this webcast:
- All investing is subject to risk, including the possible loss of the money you invest.
- For more information about Vanguard ETF Shares, visit vanguard.com, call 800-992-8327, or contact your broker to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.
- Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.
- This webcast is for educational purposes only. We recommend that you consult a financial or tax advisor about your individual situation.