Exchange Traded Funds: Conceptual and Practical Investment Approaches
Edited By A. Seddik Meziani, Professor of Economics and Finance at Montclair State University, Department of Economics and Finance.
Chapter 6: Understanding ETF Structures Important in Building Portfolios
Gus Sauter - Vanguard
Writing on the subject of tax-efficiency using the the share-class of Vanguard ETFs as opposed to standalone ETFs:
I believe this is the first time that Gus or anyone from Vanguard has put in writing their belief that the proprietary Vanguard ETF share-class structure has been at least as tax-efficient as standalone ETFs, and that cash creation and redemptions from conventional shareholders help the tax-efficiency of the ETF share class, not hurt it."As mentioned earlier, some posit that share-class ETFs are less tax-efficient than standalone ETFs (including those with both the UIT and open-end structure). The argument focuses on the gains realized from the sales of portfolio securities in the event of net redemption requests from holders of conventional shares. In theory, a large market decline might trigger large-scale redemptions of the conventional shares, forcing the managers to sell portfolio securities and realize gains. Because any capital gains would be allocated pro rata across all share classes, the ETF holder would receive an unwanted taxable distribution.
This hypothesis has never materialized, however. In fact the opposite has been true, as conventional index funds have generally enjoyed net cash inflows even during the declining market of 2000-2, and more recently 2007-8. In addition any sales that resulted from relatives modest redemptions led to realized losses, not gains, that can be carried forward to enhance the tax efficiency in future years.
Interestingly, share-class ETFs have an additional tax management tool at their arsenal. The conventional share classes of such funds typically receive actual cash that can he used to rebalance the fund to changes in the underlying benchmark. Over time, the fund accumulates a large number of share lots, with a distribution of low-cost lots and high-cost lots. Should securities need to be sold from the fund in order to meet redemptions, the manager can sell the highest-cost lots potentially at a loss, thereby realizing capital losses that may be used to offset any gains. Capital losses can be used to offset subsequent realized gains of a fund for up to eight years after the loss are realized, providing a cushion if it would ever be necessary.”
Rick Ferri