VTMSX (TM SCap) - CG distributions to come?

[alvinsch]

Looking at the latest fund distribution updates on Vanguard.com (1/31/07), I see the tax managed small cap fund is showing positive realized gains for 2007. Ok they are currently small (0.31%) and they have 11 months to find stocks to sell at a loss. However, combined with the 37% in unrealized gains, at what point do you think this unrealized overhang becomes too big a burden to work around and they either distribute CG's or avoiding them costs them in performance (i.e. excessive trading for loss harvesting, not selling stocks that get too big, etc.).

Now in theory I assume one could keep this up forever if they had enough in kind distributions and sufficient in flows of new money to continuously dilute the unrealized gain. However, my understanding is that the in kind distributions are quite small (anyone have real numbers for this fund). I also worry that with the increasing popularity of reasonably tax efficient ETF's that net cash flows into this fund will be slowing which further limits their ability to avoid CG's.

The fact that DFA's tax managed small value has had near 10% CG distributions for the last two years, just adds more fuel to the fire that VTMSX's ability to avoid CG's is going to end.

So I have several questions:
- Anybody know their history of in-kind distributions?
- Anybody know their history of net cash flows into the fund? Is it slowing?
- How long do you think they can keep this up?

- Al

[yobria]

Hi Al,

Excel tells me things don't look good going forward. The problem is inflows as a percent of assets decline over time, but cap gains don't. Consider a fund taking in $100M of new money per year, growing at 10%/year. In year 2, inflows are about 50% of total assets. In year 25, they're trivial- 1%.

Mutual funds are a bit of a ponzi scheme in that you have to suffer for others' cap gains. I only hold large blend in taxable. If I did hold small it would be an ETF (though tax laws can change anytime). As I understand it, in kind distributions have been small for traditional funds. I believe Barry Barnitz has a spreadsheet showing Vanguard fund in-kind distributions. I can't find it now though.

Nick

[Barry Barnitz]

Hi Al:

First, Vanguard has only today issued the FY 2006 annual reports for Mid and Small Cap Index Funds, as well as Tax-Managed Funds. It will take me some time to draft the FY 2006 monograph on Vanguard tax attributes for Index and Tax Managed Funds.

I will link you to two monographs that carry data through the FY 2006 semiannual report period.

Vanguard Tax Managed Funds Accounting Data

Vanguard Tax-Managed Funds Tax Attributes (Semiannual FY2006 Report)

[alvinsch]

Nick & Barry: Thanks for the replies and the links. I look forward to your updates for 2006, but it looks like the loss carryforwards are now gone as of 1/31/07.

I took a quick gander at the 2006 annual report and one thing that stood out to me was that the turnover ratio jumped from 20% in 2005 to 42% in 2006. Unless there is some other explanation, it looks like they had to do quite a bit of dancing to avoid CG's for 06 which doesn't bode well for 07.

They also underperformed their index by 0.9% (14.2% vs 15.1%) which might be another indication of having to make more difficult tradeoffs of tax management versus tracking error.

Just more ammunition for those who believe TM funds might be rendered obsolete by ETFs, and ironically by their own success of generating unrealized gains. Once TM's start distributing CG's there's not much advantage, if any over ETFs (especially if QDI's expire and with the negative of redemption fees; also didn't a study suggest tax loss harvesting was worth 0.5% on average?).

I wonder if Vanguard has other weapons at their disposal to counter some of these effects. They could eliminate the redemption fees to try to increase inflows but than might just encourage more outflows or at least more turnover, counter to their TM mandate. I suppose they could try to create an ETF version to try to flush more of the cap gains but that would have negative QDI and turnover implications. Seems like they are between a rock and a hard space.

- Al

[indexfundfan]

Great thread.

Perhaps it is time to seriously look into using ETFs in the taxable account using one of the free trade platforms.

I have been holding VTMSX and VTMGX for the past few years. I am now considering putting new money into ETF versions using the Wells Fargo free trade platform. For small-cap, I will use VB and for VTMGX, I intend to use Vanguard's up-coming FTSE All world ex-USA index ETF.

Some think that the free trade platforms will not last, but the cost is really a $50 transfer-out fee if the brokerage you are using raises fees. One cap-gain distribution from either VTMSX or VTMGX alone is going to cost me much more in taxes that this fee.

[coastn]

I know it's a bother, but please do not use symbols alone without a least some other text descriptor.
-David

[oneleaf]

Thanks for this thread, interesting information. I am invested in VTMSX and VTMGX (tax-managed small cap and international, respectively). Overall, I am inclined to stick with them, since I don't want to open a discount brokerage account elsewhere just to buy ETF's. The low fees and convenience still makes them attractive to me. With only 12 free trades per year (as a Flagship member), i really can't have too many ETF's in my brokerage account .

[stebul]

TM Small is really between a rock and a hard place because SV and REITs have been on such a run for the past few years (relative to SG). They also don't have an ETF share class (like most other Vanguard index funds) that benefit from arbitrage.

I would like Vg to take the gains now before the tax rate goes up, but its really a Catch 22 for them becauase as soon as they start taking gains people will stop contributing; then they will start taking funds out, forcing sales, and generating even more realized gains. Even with 5% CG distributions, at a combined 38% tax rate after 2010 that is 1.9% paid out in taxes -- you'd break even with the 1% redemption fee in just one year.

As long as the tax codes permit arbitrage, I think ETFs (or Vg index funds with large ETF share classes) are the way to go. For example -- the Small Value Index ETF is about 10% of the total assets -- that might not be enough.

For comparison, does anyone know how close the iShares S&P 600 ETF is to paying out capital gains?

[AzRunner]

Interesting topic since I also own VTMSX and VTMGX. VTMSX may well have to take a capital gain distribution given the success of the stocks in the underlying portfolio. It is still too early to say that these tax managed funds are doomed compared to ETFs since we do not have enough of a time horizon on the ETFs yet. Qualified dividends continue to be a plus for the Tax Managed Funds.

Norm

[alvinsch]

It is still too early to say that these tax managed funds are doomed compared to ETFs since we do not have enough of a time horizon on the ETFs yet. Norm

I would agree that it's too early to "know" but when people ask about taxable investing, the diehard forums usually "say" to use VTMSX, so many believe it's not too early to say.

At the moment I'm kinda 50/50, having moved from a bias toward VTMSX. VTMSX still has higher QDI and brokerless convenience with no purchase fees; while ETF's don't have the 1% redemption fee so one can tax loss harvest. I view those issues as pretty close in my case, so for me it comes down to who is going to be distributing the least CG's over time, and here it seems the edge has to go to ETF's (but I could be wrong).

I started the thread with the hopes of maybe gaining additional insights into the debate. Specifically, divining the tea leafs in the VTMSX data to see if any trends were evident that would affect the decision.

- are net fund inflows slowing?
- how fast are unrealized gains growing?
- are in-kind redemptions having any meaningful affect?
- did turnover double due to increased tax management difficulty?
- can ETF's really avoid almost all CG distributions over time?

Just another attempt to do what we often do on these forums: "Divine the unknowable".

Thanks to all who have already participated and any additional insights would be most welcome.

- Al

[fire5soon]

I have decided not to use this fund due to potential distributions. If the DFA gods can't keep from making 10% NAV distributions I'm not sure anyone can.

I know tax-managed doesn't mean tax-free, but that's a huge risk to take IMO.

In taxable accounts I'll stick with TSM & TM Intl and diversify in deferred accounts.

[indexfundfan]

I have decided not to use this fund due to potential distributions. If the DFA gods can't keep from making 10% NAV distributions I'm not sure anyone can.

fire5soon, can you share the source of the new of the 10% distribution. I would be very uncomfortable if this were also a "tax-managed" fund.

[alvinsch]

I have decided not to use this fund due to potential distributions. If the DFA gods can't keep from making 10% NAV distributions I'm not sure anyone can.

fire5soon, can you share the source of the new of the 10% distribution. I would be very uncomfortable if this were also a "tax-managed" fund.

DTMVX, DFA Tax-Managed US Small Cap Value Portfolio, had nearly a 10% CG distribution for 2006 and according to other diehard conversations, it had a 9% CG distribution in 2005. Here's the 2006 distribution from the horses mouth ($2.439 CG dist with $24.96 reinvestment price).

http://www.dfaus.com/strategies/us/tm_small_cap_value_port/

- Al

[fire5soon]

DTMVX, DFA Tax-Managed US Small Cap Value Portfolio, had nearly a 10% CG distribution for 2006 and according to other diehard conversations, it had a 9% CG distribution in 2005. Here's the 2006 distribution from the horses mouth ($2.439 CG dist with $24.96 reinvestment price).

http://www.dfaus.com/strategies/us/tm_small_cap_value_port/

- Al

yeah... what he said... 8)

I didn't have the reference off hand, just stored up in the memory banks somewhere which is always dangerous.

[indexfundfan]

DTMVX, DFA Tax-Managed US Small Cap Value Portfolio, had nearly a 10% CG distribution for 2006 and according to other diehard conversations, it had a 9% CG distribution in 2005. Here's the 2006 distribution from the horses mouth ($2.439 CG dist with $24.96 reinvestment price).

http://www.dfaus.com/strategies/us/tm_small_cap_value_port/

- Al

Thanks Al. I guess this is all the more reason for me to look seriously into using ETFs.

[Barry Barnitz]

I am collecting the data for a FY 2006 Tax Managed Fund Report. Please be patient, it will take a couple of days for me to write it up

[actuaryinvestor]

(I like the new board)

Do you think there's an actual possibility Vanguard will remove the 1% redemption fee? That fee was one of the main reasons for me to buy the fund in the first place, because it gives me confidence in the long term motives of those buying the fund. Secondly, it's nice to know I'm partially compensated for anyone who causes premature capital gains distributions.

[alvinsch]

(I like the new board)

Do you think there's an actual possibility Vanguard will remove the 1% redemption fee? That fee was one of the main reasons for me to buy the fund in the first place, because it gives me confidence in the long term motives of those buying the fund. Secondly, it's nice to know I'm partially compensated for anyone who causes premature capital gains distributions.

I have no particular special insight on that question but I would guess the odds are quite low. I was merely speculating on possible moves they could make if they clearly ended up not being competitive, tax management wise. Didn't mean to cause alarm.

- Al

[Barry Barnitz]

The following monograph contains FY 2006 and long term tax data for the Vanguard Tax-Managed Funds.

Vanguard Tax-Managed Funds Tax Attributes FY 2006

[alvinsch]

Barry, thanks for the updates. However, I think you have an error in table 1 for VTMGX (TM EAFE). You show the dividend yield as only 0.96% but I own VTMGX and it distributed $0.332 on 12/28/06 at a reinvestment price of $14.20. By my calculation that results in a 2.28% yield (.332 / (14.2+.332). BTW: they also distributed $0.004 on 3/24/06 that I didn't include.

Being intimately familiar with the data do you have any particular insights you'd like to share in regards to the future of TM funds and particularly VTMSX since it has essentially used up it's loss carryforward? Or any insights on the implications of the $65M of in kind gains that showed up in 2006? Has that already been integrated into the $2M loss carryforward you show?

Thanks
- Al

[Barry Barnitz]

Al:

Thanks for catching the data error. I will correct it.

Vanguard's accounting will show all gains, both sales of stocks and in-kind gains in the realized gain category. Both of these gains were a part of the unrealized gains accrued and deferred in the fund. An in-kind gain, however, is not taxable; so in order to derive the taxable realized gain, one must subtract out the in-kind gain (the in-kind gain does not disappear: it is added into the paid-in-capital basis of the fund.)

If when you subtract out the in-kind gain, you have a gain this will be the net taxable gain. If there is no carryforward loss, this gain will become a distributed gain and will be a taxable capital gain to the fund shareholder. If a fund has carryover losses, they will be applied to the gain. As you will note, each fund had a small realized capital gain, which was negated by the application of the loss carryforward.

If after netting out any in-kind gains, the net gain results in a loss, that loss will accrue to the losscarryforward, where it can be used to offset future realized gains. By the way, this phenomenon was quite frequent in the Vanguard (morningstar style box) Index Funds for FY 2006, which currently lacks small cap index FY 2006 results.

The TM 600 fund started FY 2006 with an approximate 5 million dollar loss carryforward; the net gain after the in-kind redemption adjustment was a little more than 2 million dollars. Applying the loss carryforward left the fund with an end-of- year loss carryforward of a little more than 2 million dollars.

The TM 600 fund is the only TM fund close to being forced to realize a distributed taxable gain (which if it occurs will be a long term capital gain.)

Much will depend on market results and the level and nature of index reconstitution. If there is a market downturn, the fund should be able to harvest some tax losses which can be used to offset any gains, and perhaps accrue to the loss carryforward.

The chances of a FY 2007 taxable distribution will be much higher if the market return is positive. The fund will likely make maximum use of in-kind redemption whenever possible during the upcoming few years.

[AzRunner]

Barry, Thanks for the details. It will be interesting to see what happens here, especially since many of us have dollars riding on the outcome.

Norm

[indexfundfan]

The following monograph contains FY 2006 and long term tax data for the Vanguard Tax-Managed Funds.

Vanguard Tax-Managed Funds Tax Attributes FY 2006

Thanks Barry for the document. I need to find some time to digest the information.

[alvinsch]

The fund will likely make maximum use of in-kind redemption whenever possible during the upcoming few years.

Basically the in-kind redemptions reduce the unrealized gains in the fund (increase the funds basis), so hopefully there will be enough in-kind redemptions to keep the unrealized gain manageable.

That begs the question of how likely are in-kind redemptions and is it something that Vanguard has some control over and/or can make more attractive. Seems odd they haven't had any in-kind transfers for years and then come up with over 3% in 2006.

I believe they can force large investors to take shares instead of redemptions if they want to sell but if no large blocks are selling they would still be stuck. There is also the risk that forcing large investors to take the shares and incur trading costs, would make them think twice about ever coming back to VTMSX thus decreasing future cash flows (or will Vanguard handle the trading for them or otherwise compensate them?). The sudden large in-kind redemptions could also just be some large institutions switching to ETFs which would also be a negative going forward.

I know with insufficient data it is all speculation but maybe others have more insight on this.

Thanks again Barry,
- Al

[alvinsch]

After seeing the realized gain in VTMSX (TM Small) increase to 0.38% on 2/28/07, as of 3/31/07 it has now dropped to a negative -0.38 so it appears Vanguard was very busy tax loss harvesting in March. Looks like they have a shot at keeping the CG distribution streak going.

On the other hand if you own any Vanguard active international funds in taxable, it looks like it's going to be another painful tax year.

Code: Select all

VWIGX 3.39% realized gains thru 3/31/07, Intl growth
VTRIX 1.90% realized gains thru 3/31/07, Intl value

- Al

[alvinsch]

As of 5/31/07, V's tax managed small cap fund, VTMSX, is once again showing a realized gain, 0.74% and unrealized gains of 39.51%. Anybody willing to do an in kind redemption to help them out before the end of the year?

Has anyone heard anything about Vanguard possibly starting an ETF share class of this TM fund like they are doing with TM intl, VTMGX? This might allow them to flush out more of those unrealized gains before more of them become realized.

- Al

[Soaker]

I don't believe Tax-Managed Small Cap can have an ETF class, because it's based on a Standard & Poor's index. From the VG website:

Investment strategy

The fund invests in stocks included in the Standard & Poor’s SmallCap 600 Index—an index that is made up of stocks of smaller U.S, companies. The fund will hold all or substantially all of the S&P SmallCap 600 Index stocks in approximately the same proportions as in the index.

Wasn't there a licensing battle between VG and S&P a few years ago? I think VG is forbidden from starting ETFs based on S&P indices, and that's why a number of VG funds switched to other indices.

[alvinsch]

I don't believe Tax-Managed Small Cap can have an ETF class, because it's based on a Standard & Poor's index. From the VG website:

Investment strategy

The fund invests in stocks included in the Standard & Poor’s SmallCap 600 Index—an index that is made up of stocks of smaller U.S, companies. The fund will hold all or substantially all of the S&P SmallCap 600 Index stocks in approximately the same proportions as in the index.

Wasn't there a licensing battle between VG and S&P a few years ago? I think VG is forbidden from starting ETFs based on S&P indices, and that's why a number of VG funds switched to other indices.

Thanks for the post as I hadn't thought of that. I remember the lawsuits with S&P but didn't recall that it was regarding ETF's. Thanks again.

- Al

[alvinsch]

Just a quick update.

VTMSX (tax managed small cap) is currently showing 1.29% in realized gains through the first 2 quarters (6/30). This is an increase of 0.55% over the previous month (5/31). Interesting as VISVX (small value) realized loss actually increased during the last month.

- Al

[RTR2006]

This thread exemplifies why I LOVE this Forum!

It's an honor (and an education) for me here in the peanut gallery to sit in on these amazing conversations.

Thank you!

RTR