Under the hood – Vanguard US stock index funds
Vanguard issues annual reports for the firm’s US stock index funds on December 31 of each year. The reports provide information that can highlight some of the underlying conditions affecting a fund’s future capital gains distribution outlook; the level of security lending in each fund, and a means of measuring investor turnover in the funds.
Mutual funds are legally structured as pass-through conduits of investment income. The income usually comes from dividends and interest received from securities or by profits realized by selling securities. By law, the fund must distribute income and gains to shareholders or else pay tax on retained income. Funds cannot, however, pass realized losses on to shareholders. These losses are retained by the fund, and can be used to offset future gains.
Taxable shareholders are no doubt pleased when they open their 2016 annual reports and see that none of the Vanguard US stock index funds has distributed a capital gain over the past five fiscal years.
While not distributing gains, the funds at times realize net gains during a given fiscal year. Often a fund will offset any realized gains with realized losses, or use retained loss carryovers to offset gains, thus providing shareholders zero capital gains distributions.
In addition Vanguard index funds contain both mutual fund share classes and exchange-traded fund share classes. The exchange-traded funds frequently realize in-kind redemption gains. Because in-kind redemption gains are not taxed to the fund or its shareholders, the fund manager will usually select shares with the lowest tax basis for redemption baskets.
Although these gains are not taxed, they are nonetheless included in a fund’s reported annual realized gain. Netting out these non-taxable gains produces the actual taxable gain or actual realized loss.
The table below shows the 2016 reported gain or loss realized for each Vanguard US stock fund, the in-kind redemption gain or loss, and the actual net realized gain or loss. As an accounting entry, in-kind redemption gains become a part of the fund’s paid in capital.
|Fund||Gain/Loss||In-kind redemption||Net Gain/Loss|
More on loss carryovers
As noted, realized losses cannot be distributed to shareholders. Surplus losses can be “carried over” to subsequent years when they can be used to offset future gains. Prior to 2010, these carryover losses where subject to expiration dates. The passage of the Regulated Investment Company Act Modernization Act of 2010 stipulated that mutual fund losses could be carried over indefinitely, but these losses must be used before taking any expiring loss carry forwards.
The table below shows each fund’s loss carry forward and shows both the amount and percentage of unexpiring carry forwards.
|Fund||Total loss carryforwards||2011 forward unexpiring||% unexpiring|
The considerable level of unexpiring carryover losses in most of the funds suggests that most, if not all, of the carryover losses with expiration dates will actually expire without being used. If a carryover loss expires, it becomes a part of the fund’s paid in capital.
|Fund||2016 expired||10/31/2017 expiring||10/31/2018 expiring|
The exchange-traded fund
Given that in-kind redemption helps improve a fund’s tax basis, it is somewhat helpful to examine a fund’s share class distribution. Most Vanguard index funds have mutual fund share classes (investor shares, lower cost admiral shares, and institutional shares) as well as exchange-traded fund shares. The following table shows the ratio of exchange-traded fund share class assets to total fund share class assets.
|Fund||Total assets||ETF assets||ETF/Total assets|
Vanguard US stock index funds earn additional income by lending securities to qualified institutional borrowers. The firm allocates 100% of after expense security lending earnings to the fund. A fund’s expenses are paid out of fund earnings. Given that the US tax code gives a tax preference to dividends that qualify for lower tax rates, it is prudent for fund managers to allocate non-qualified income to fund expenses. The table below shows the amount of security lending income earned by each fund in fiscal year 2016 and calculates its percentage ratio to total annual fund expenses.
|Fund||Net security lending income||Total expenses||% of expenses|
The annual report documents the rate of annual turnover of its assets by the fund manager. In addition, the reports also document the sales and redemption of fund shares by shareholders. This data allows us to compute a redemption to average net assets ratio (R/ANA) that corresponds to a shareholder annual turnover rate. The following table reports the investor sales and redemption in each fund using a composite total of all share classes.
|Fund||Average net assets||Sales||Redemptions|
The table below provides ratio data for each fund. The turnover percentage documents the fund manager turnover of assets. The R/ANA ratio documents the shareholder turnover of assets. The redemption to sales ratio ( R/S ) shows net shareholder purchase or net shareholder redemption in a fund. A ratio less than one shows net purchase; a ratio greater than one shows net redemption.
The R/ANA and R/S ratios, viewed together, can signal market timing activity within a fund. For example a fund showing an R/ANA ratio of 400% and an R/S ratio of 1 (equal buys and sells) is likely being market timed by fund shareholders.
- Table data is derived from fund annual reports. Average net asset data is derived from NSAR reports on EDGAR. The computations are derived from this google spreadsheet.