Under the hood – Vanguard international index funds in 2019
Vanguard issues annual reports for the firm’s international and global index funds on October 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; an indication of a fund’s dividend distributions and foreign tax credit; 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 2019 annual reports and see that none of the Vanguard international 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 2019, the Vanguard International High Dividend Index fund used loss carryovers to offset realized gains.
In addition, Vanguard international 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 2019 reported gain or loss realized for each Vanguard international 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.
Vanguard provides the following information regarding the Global ex US Real Estate Fund:
At October 31, 2019, one shareholder was the record or beneficial owner of 29% of the fund’s net assets. If this shareholder were to redeem its investment in the fund, the redemption might result in an increase in the fund’s expense ratio, cause the fund to incur higher transaction costs, or lead to the realization of taxable capital gains.
|Fund||Gain/Loss||In-kind redemption||Net Gain/Loss|
|FTSE all world ex US||(103,722,000.000)||420,361,000||(1,718,106,000)|
|FTSE all world ex US small||91,010,000||141,476,000||(50,466,000)|
|Global ex us real estate||4,956,000||7,763,000||(2,807,000)|
|International div appreciation||(23,897,000)||0||(23,897,000)|
|International high yield div||126,000||0||126,000|
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. As of 2019, all loss carryovers are no longer subject to expiration dates.
The table below shows each fund’s loss carry forward.
|Fund||Total loss carryforwards|
|FTSE all world ex US||2,125,627,000|
|FTSE all world ex US small||182,025,000|
|Global ex us real estate||244,734,000|
|International div appreciation||41,245,000|
|International high yield div||3,605,000|
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. As one can see, exchange-traded shares represent a majority share of most of Vanguard’s international index funds. The lone exception is the Total International Fund, which has a history dating back to 1994, but only added exchange-traded shares in 2011. In addition, mutual fund shares of the Total International Fund are used in Vanguard’s suites of balanced target date and target risk funds.; the positive investor inflows into these funds assures a large issuance of Total International mutual fund shares.
ETF to Fund ratios
|Fund||Total assets||ETF assets||ETF/Total assets|
|FTSE all world ex US||39,153,444,000||24,651,560,000||62.96%|
|FTSE all world ex US small||6,624,722,000||5,400,228,000||81.52%|
|Global ex us real estate||6,794,370,000||5,944,546,000||87.49%|
|International div appreciation||1,523,392,000||1,304,960,000||85.66%|
|International high yield div||1,462,593,000||1,264,332,000||86.44%|
Investors holding international index funds in taxable accounts are required to pay taxes on dividend distributions. Certain dividends, designated as qualifying dividends, are subject to reduced capital gains tax rates for federal taxes. The table below provides a fund’s total net investment income distribution, the amount of qualifying dividends, and the qualifying dividend percentage of total dividend distributions.
|Fund||Net Investment Income distributions||Qualifying dividends||QDI pct.|
|FTSE all world ex US||1,266,277,000||902,548,000||71.28%|
|FTSE all world ex US small||179,887,000||110,597,000||61.48%|
|Global ex us real estate||228,005,000||55,171,000||24.20%|
|International div appreciation||28,631,000||17,121,000||59.80%|
|International high yield div||57,030,000||39,108,000||68.57%|
Foreign tax credit
The annual report reveals the amount of foreign tax a fund has paid during the fiscal year. The foreign tax paid on the fund’s dividend income can qualify for a foreign tax credit on a taxable investor’s tax return. Dividing the foreign tax by a fund’s average net assets provides a percentage estimate of the value of the credit.
Foreign Tax Credit
|Fund||Average net assets||Foreign tax||Foreign tax credit|
|FTSE all world ex US||37,422,223,434||120,873,000||0.32%|
|FTSE all world ex US small||6,442,296,998||19,109,000||0.30%|
|Global ex us real estate||6,449,446,343||21,135,000||0.33%|
|International div appreciation||1,292,123,941||2,382,000||0.18%|
|International high yield div||1,256,809,126||5,774,000||0.46%|
Vanguard international 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 2019 and calculates its percentage ratio to total annual fund expenses. 
|Fund||Net security lending income||Total expenses||% of expenses|
|FTSE all world ex US||14,347,000||31,396,000||45.70%|
|FTSE all world ex US small||18,543,000||7,757,000||239.05%|
|Global ex us real estate||3,162,000||7,763,000||40.73%|
|International div appreciation||119,000||2,499,000||4.76%|
|International high yield div||399,000||3,318,000||12.03%|
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|
|FTSE all world ex US||37,422,223,434||7,175,843,000||6,054,645,000|
|FTSE all world ex US small||6,442,296,998||1,976,003,000||1,730,990,000|
|Global ex us real estate||6,449,446,343||729,335,000||740,521,000|
|International div appreciation||1,292,123,941||331,839,000||58,326,000|
|International high yield div||1,256,809,126||380,800,000||56,101,000|
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. As can be seen, investors executed net redemption in the Vanguard regional stock index funds (Europe, Pacific) and modest redemption in the Total World and Global ex US Real Estate funds.
|FTSE all world ex US||4%||16%||0.84|
|FTSE all world ex US small||17%||27%||0.88|
|Global ex us real estate||7%||11%||1.02|
|International div appreciation||42%||5%||0.18|
|International high yield div||15%||4%||0.15|
Mutual funds buy and sell stocks as investors purchase and liquidate fund shares. Funds also buy and sell shares in order to track changes in index reconstitution. These transactions incur brokerage commission expense, bid/asks spreads and market index costs. However, in-kind transactions do not bear these transaction costs. The following table provides the dollar totals of share transactions and in-kind transactions for the funds. The percentage of in-kind transactions to total transactions is also included.
In-kind Purchases and Sales Transactions (‘000’s)
|Fund||Purchases||In-kind Purchases||Pct.||Sales||In-kind Sales||Pct.|
|FTSE all world ex US||4,374,720||1,699,566||38.85%||2,607,315||974,263||37.37%|
|FTSE all world ex US small||1,766,178||510,395||28.90%||1,528,665||471,094||30.82%|
|Global ex us real estate||1,049,857||407,950||38.86%||1,014,467||553,638||54.57%|
|International div appreciation||812,147||219,924||27.08%||529,414||0||0.00%|
|International high yield div||511,064||275,166||53.84%||179,098||0||0.00%|
John Bogle, in his writings, and Vanguard, in its marketing materials, argue that Vanguard is structured as a “mutual” organization with the mutual funds owning the investment management company.
In the Funds’ Service Agreement, a fund may be requested to invest up to 0.40% of its net assets as capital in Vanguard, however the funds currently have investments in the company representing approximately 0.01% of net assets. The capital investment is included in a fund’s net asset value.
In addition, the fund’s have payable obligations to the company that do require current reimbursement. These deferred costs are for deferred compensation/benefits and risk/insurance costs.
The table below provides the capital investment and deferred payables for each international index fund.
Capital accounts (in ‘000’s)
|Fund||Net assets||Capital||% of Vanguard||Payables||Pct|
|FTSE all world ex US||39,153,444||1,781||0.71%||7,641||0.02%|
|FTSE all world ex US small||6,624,722||299||0.12%||1,142||0.02%|
|Global ex us real estate||6,880,612||306||0.12%||1,009||0.01%|
|International div appreciation||1,523,392||67||0.03%||151||0.01%|
|International high yield div||1,426,930||65||0.03%||199||0.01%|
 The Vanguard Developed Market Index Fund has a fiscal year ending December 31. The annual report is not issued along with Vanguard’s international and global stock funds examined in this report.
 Vanguard’s net after expense security lending revenue for fiscal year 2018 is tabulated in Index fund net security lending income (2018). The fiscal year of the annual report and the fund prospectus do not always cover the same time frames.