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An interesting article comparing the tax efficiency of ETFs and 'conventional funds'.
The Anatomy of Tax Efficiency
Some extracts from the article
"...it is clear that there is a substantially greater likelihood of a capital gain distribution in most conventional funds than comparable ETFs."
"Dependable long-term capital gains tax deferral in taxable accounts is much more likely if you own equity ETFs than if you own conventional equity funds."
“...a mature ETF can grow in tax efficiency over time.” my underline i.e. it can accumulate capital losses rather than gains (as I understand).
"The portfolio and tax management processes in a conventional fund are likely to become more and more constrained over time as low cost basis positions reduce a portfolio manager's flexibility."
"Any investor who is concerned about tax efficiency should look carefully at a fund's capital gain overhang."
"Capital gains overhang is far more useful than the SEC after-tax return calculation in predicting a fund's long-term tax efficiency."
Robert
Edited to add a few additional extracts from the article which may be of interest.
The Anatomy of Tax Efficiency
The Anatomy of Tax Efficiency
Last edited by Robert T on Tue Jun 17, 2008 6:47 am, edited 1 time in total.
Great article. As indicated, for long-term tax management you can do better than Index 500 in a taxable account. However, the article does not address Large Cap Index (VV/VLACX), which would have been quite small and new when this was published.
Based on the issues described, Large Cap Index appears tp be a terrific choice, because it has both very low expenses (7 bp for the ETF) and 2/3 of fund assets are now in the ETF share class ($1.6 billion out of $2.4 billion), which should make it very tax-efficient in the future. This is a much larger percentage in the ETF share class than Total Stock Market (VTI/VTSMX). Large Cap Index may never accrue as many losses as SPY, but it appears to derive enough advantage from its ETF share class to avoid taxable distributions (or so it appears to my untrained eye). If held at Vanguard brokerage, it also counts as a Vanguard asset toward Flagship (and, I presume, Voyager) status, which SPY of course does not.
Based on the issues described, Large Cap Index appears tp be a terrific choice, because it has both very low expenses (7 bp for the ETF) and 2/3 of fund assets are now in the ETF share class ($1.6 billion out of $2.4 billion), which should make it very tax-efficient in the future. This is a much larger percentage in the ETF share class than Total Stock Market (VTI/VTSMX). Large Cap Index may never accrue as many losses as SPY, but it appears to derive enough advantage from its ETF share class to avoid taxable distributions (or so it appears to my untrained eye). If held at Vanguard brokerage, it also counts as a Vanguard asset toward Flagship (and, I presume, Voyager) status, which SPY of course does not.
Value-based allocation.
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FWIW – I just checked up on two midcap funds - an ETF and a ‘conventional fund’. The ETF has accumulated capital losses of -15% (even though it has been open longer than the comparator conventional fund), while the ‘conventional fund’ accumulated capital gains of +15%.
Obviously just one observation.
It’s interesting that some of the ETFs have matched recent tax-efficiency of conventional tax-managed funds without the ‘sampling’ (and associated sampling risk) used by these tax-managed funds, and without a large build up in (unrealized) capital gains.
For example the table below shows fairly similar tax efficiency of the Vanguard TM Small Cap fund and iShares S&P600 fund (both tracking the same index), but a significantly larger capital gain for the Vanguard fund (28% versus -6%). Interestingly the 0.14 pre-tax return difference is close to the expense ratio difference.
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Dave
You may be right in that the ETF structure may not benefit TSM type funds as much if the additional accumulated losses (possible in a SPY type ETF structure) are not needed to avoid taxable distributions due to the low turnover etc. of the underlying index. It seems it may make more of a difference over the long-term with higher turnover funds. Time will tell…
Robert
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FWIW – I just checked up on two midcap funds - an ETF and a ‘conventional fund’. The ETF has accumulated capital losses of -15% (even though it has been open longer than the comparator conventional fund), while the ‘conventional fund’ accumulated capital gains of +15%.
Code: Select all
Accumulated
Inception Capital Gain (Loss)
S&P MidCap 400 SPDR (MYD) 05/04/95 (15%)
Vanguard MidCap Index (VIMSX) 05/21/98 15%
Source: M* data
It’s interesting that some of the ETFs have matched recent tax-efficiency of conventional tax-managed funds without the ‘sampling’ (and associated sampling risk) used by these tax-managed funds, and without a large build up in (unrealized) capital gains.
For example the table below shows fairly similar tax efficiency of the Vanguard TM Small Cap fund and iShares S&P600 fund (both tracking the same index), but a significantly larger capital gain for the Vanguard fund (28% versus -6%). Interestingly the 0.14 pre-tax return difference is close to the expense ratio difference.
Code: Select all
5 YEAR TAX EFFICIENCY as at 5/31/2008
Vanguard TM* iShares**
Small Cap S&P600
Pretax Return 13.93 13.79
Tax-adjusted Return 13.80 13.61
Tax Cost Ratio 0.11 0.16
Potential Cap Gains Exposure % 28 -6
*Inception 3/25/1999
**Inception 5/22/2000
Dave
You may be right in that the ETF structure may not benefit TSM type funds as much if the additional accumulated losses (possible in a SPY type ETF structure) are not needed to avoid taxable distributions due to the low turnover etc. of the underlying index. It seems it may make more of a difference over the long-term with higher turnover funds. Time will tell…
Robert
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