Under the hood – Vanguard US S&P and Russell index funds in 2019
Vanguard issues annual reports for the firm’s US S&P and Russell 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; the level of security lending in each fund, and a means of measuring investor turnover in the funds. We can also derive an estimate of transaction costs, and also examine a fund’s capital investment in Vanguard Inc.
The funds included in this report represent the S&P index funds that Vanguard does not actively market to individual mutual fund investors. With the exception of the S&P 500 and S&P completion index funds, which have long been marketed to individuals, the remaining S&P and Russell index funds have been targeted to the financial planner, brokerage and institutional market. These funds consist of an exchange-traded share class and an institutional share class.
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 following Vanguard index funds have 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.
n addition, theses Vanguard index funds contain both institutional 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 index fund, the in-kind redemption gain or loss, and the actual net realized gain or loss. All of the funds, with the exceptions of the Russell 1000 index fund, and Russell 1000 Value index fund, report a net loss for the year. The two funds realizing taxable gains used a portion of loss carry forwards to nullify the gain.
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|
|S&P 500 Growth||57,659,000||129,870,000||(72,211,000)|
|S&P 500 Value||15,623,000||60,144,000||(44,521,000)|
|S&P 400 Growth||(36,171,000)||69,359,000||(105,530,000)|
|S&P 400 Value||(2,049,000)||45,520,000||(47,569,000)|
|S&P 600 Growth||2,191,000||52,348,000||(50,157,000)|
|S&P 600 Value||(17,064,000)||14,040,000||(31,104,000)|
|Russell 1000 Growth||266,393,000||335,242,000||(68,849,000)|
|Russell 1000 Value||244,418,000||223,632,000||20,786,000|
|Russell 2000 Growth||19,075,000||60,885,000||(41,810,000)|
|Russell 2000 Value||15,080,000||21,763,000||(6,683,000)|
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|
|S&P 500 Growth||104,197,000|
|S&P 500 Value||59,693,000|
|S&P 400 Growth||160,033,000|
|S&P 400 Value||92,425,000|
|S&P 600 Growth||62,589,000|
|S&P 600 Value||44,517,000|
|Russell 1000 Growth||145,242,000|
|Russell 1000 Value||81,313,000|
|Russell 2000 Growth||95,856,000|
|Russell 2000 Value||28,104,000|
Given that in-kind redemption helps improve a fund’s tax basis, it is somewhat helpful to examine a fund’s share class distribution. 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 sizeable share of most of the S&P and Russell index funds.
ETF to Fund ratios
|Fund||Total assets||ETF assets||ETF/Total assets|
|S&P 500 Growth||2,761,387,000||2,754,813,000||99.76%|
|S&P 500 Value||1,077,863,000||983,645,000||91.26%|
|S&P 400 Growth||941,218,000||736,680,000||78.27%|
|S&P 400 Value||870,923,000||684,597,000||78.61%|
|S&P 600 Growth||392,257,000||392,257,000||100.00%|
|S&P 600 Value||408,007,000||372,784,000||91.37%|
|Russell 1000 Growth||5,947,869,000||2,871,804,000||48.28%|
|Russell 1000 Value||3,802,993,000||1,914,067,000||50.33%|
|Russell 2000 Growth||773,246,000||300,961,000||38.92%|
|Russell 2000 Value||391,273,000||251,272,000||64.22%|
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.
|Qualified dividends||QDI Pct|
|S&P 500 Growth||34,358,000||32,137,000||93.54%|
|S&P 500 Value||25,260,000||25,121,000||99.45%|
|S&P 400 Growth||11,104,000||9,287,000||83.64%|
|S&P 400 Value||15,759,000||12,822,000||81.36%|
|S&P 600 Growth||4,130,000||3,450,000||83.54%|
|S&P 600 Value||6,818,000||5,366,000||78.70%|
|Russell 1000 Growth||68,842,000||57,112,000||82.96%|
|Russell 1000 Value||86,224,000||79,928,000||92.70%|
|Russell 2000 Growth||5,609,000||4,700,000||83.79%|
|Russell 2000 Value||6,850,000||4,770,000||69.64%|
Vanguard 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|
|S&P 500 Growth||61,544||987,000||6.24%|
|S&P 500 Value||64,106||2,415,000||2.65%|
|S&P 400 Growth||61,545||1,309,000||4.70%|
|S&P 400 Value||38,303||1,216,000||3.15%|
|S&P 600 Growth||64,106||673,000||9.53%|
|S&P 600 Value||101,975||592,000||17.23%|
|Russell 1000 Growth||231,000||3,948,000||5.85%|
|Russell 1000 Value||104,000||2,533,000||4.11%|
|Russell 2000 Growth||1,117,000||825,000||135.39%|
|Russell 2000 Value||144,000||452,000||31.86%|
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|
|S&P 500 Growth||2,461,004,974||802,230,000||422,847,000|
|S&P 500 Value||1,021,609,372||439,822,000||323,082,000|
|S&P 400 Growth||964,054,710||330,273,000||422,042,000|
|S&P 400 Value||901,678,465||291,513,000||300,770,000|
|S&P 600 Growth||430,517,048||143,774,000||213,358,000|
|S&P 600 Value||410,128,325||131,096,000||77,995,400|
|Russell 1000 Growth||5,353,236,855||1,963,385,000||1,503,939,000|
|Russell 1000 Value||3,439,702,799||1,905,661,000||1,188,163,000|
|Russell 2000 Growth||771,778,831||197,191,000||200,966,000|
|Russell 2000 Value||370,942,836||168,203,000||93,950,000|
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, in 2019 investors executed net redemption in the mid cap and several small cap index funds
|S&P 500 Growth||23%||17%||0.53|
|S&P 500 Value||28%||32%||0.73|
|S&P 400 Growth||40%||44%||1.28|
|S&P 400 Value||38%||33%||1.03|
|S&P 600 Growth||47%||50%||1.48|
|S&P 600 Value||39%||19%||0.59|
|Russell 1000 Growth||17%||28%||0.77|
|Russell 1000 Value||17%||35%||0.62|
|Russell 2000 Growth||28%||26%||1.02|
|Russell 2000 Value||27%||25%||0.56|
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 a second table.
In-kind Purchases and Sales Transactions (‘000’s)
|Fund||Purchases||In kind purchases||Sales||In kind Sales|
|S&P 500 Growth||1,324,831||750,634||926,459||408,211|
|S&P 500 Value||714,202||402,305||593,942||314,195|
|S&P 400 Growth||619,782||163,811||704,677||319,577|
|S&P 400 Value||552,432||151,818||558,042||209,961|
|S&P 600 Growth||315,767||103,535||385,721||181,567|
|S&P 600 Value||276,908||102,037||232,290||89,391|
|Russell 1000 Growth||2,196,556||1,098,096||1,658,581||774,729|
|Russell 1000 Value||2,159,785||1,055,849||1,393,228||813,744|
|Russell 2000 Growth||344,140||127,502||343,136||70,342|
|Russell 2000 Value||248,442||122,980||167,938,||66,701|
|Fund||Pct. Purchases||Pct. Sales|
|S&P 500 Growth||56.66%||44.06%|
|S&P 500 Value||56.33%||52.90%|
|S&P 400 Growth||26.43%||45.35%|
|S&P 400 Value||27.48%||37.62%|
|S&P 600 Growth||32.79%||47.07%|
|S&P 600 Value||36.85%||38.48%|
|Russell 1000 Growth||49.99%||46.71%|
|Russell 1000 Value||48.89%||58.41%|
|Russell 2000 Growth||37.05%||20.50%|
|Russell 2000 Value||49.50%||39.72%|
In addition to in-kind redemption, Vanguard also engages in cross trading of stocks.
A cross trade takes place when an investment manager “swaps” a security between separate funds that he or she manages. These types of transactions are regulated by section 17 CFR 270.17a-7 of the Investment Company Act of 1940 and, for plans governed by ERISA, the Statutory Exemption for Cross-Trading of Securities. The manager must prove a fair market price for the transaction and record the trade as a cross for proper regulatory classification.
An example will let us see how a cross trade eliminates transaction costs. Suppose our manager operates both a small cap growth index fund and a mid cap growth index fund. When the tracker indexes reconstitute, a small growth company is reclassified as a mid cap growth company. If the manager uses market transactions to sell the stock from the small cap index fund, and then buy the stock for the mid cap index fund, the funds will pay brokerage commissions and spread costs on both the sale and purchase. Alternately, with a cross sale transaction, the manager will trade internally between the funds. There will be no commission expense for this trade and there is no need for a bid ask spread.
Cross trading (in ‘000’s)
|S&P 500 Growth||1,324,831||217,202||926,459||255,283|
|S&P 500 Value||714,202||193,989||593,942||169,405|
|S&P 400 Growth||619,782||207,410||704,677||205,757|
|S&P 400 Value||552,432||269,020||558,042||190,609|
|S&P 600 Growth||315,767||95,898||385,721||110,095|
|S&P 600 Value||276,908||106,089||232,290||89,391|
|Russell 1000 Growth||2,196,556||171,298||1,658,581||291,695|
|Russell 1000 Value||2,159,785||311,907||1,393,228||148,291|
|Russell 2000 Growth||344,140||42,864||343,136||70,342|
|Russell 2000 Value||248,442||52,927||167,938||36,859|
|Fund||Pct. Purchases||Pct. Sales|
|S&P 500 Growth||16.39%||27.55%|
|S&P 500 Value||27.16%||28.52%|
|S&P 400 Growth||33.46%||29.20%|
|S&P 400 Value||48.70%||34.16%|
|S&P 600 Growth||30.37%||28.54%|
|S&P 600 Value||38.31%||38.48%|
|Russell 1000 Growth||7.80%||17.59%|
|Russell 1000 Value||14.44%||10.64%|
|Russell 2000 Growth||12.46%||20.50%|
|Russell 2000 Value||21.30%||21.95%|
Transaction cost estimates
John Bogle, in his Financial Analysts Journal article, The Arithmetic of “All-In” Investment Expenses, provides a simple framework for estimating mutual fund transaction expenses. Here are the inputs:
- Total transactions: Bogle argues that the officially defined mutual fund turnover ratio (the lesser of purchases or sales divided by average net assets) is inappropriate for cost analysis, since both purchases and sales incur costs.
- Transaction expense: Bogle conservatively estimates an 0.50% transaction cost X modified turnover for active mutual funds and a zero percent cost for index funds, although open to the use of the 0.50% cost for both active and index funds.
For our estimates we use the following inputs:
- Total transactions: We follow the Bogle suggestion of using both purchases and sales as a turnover input. However since in-kind transactions and cross trades do not incur transaction expense, we subtract these from the turnover calculation.
- Transaction expense: We use the 0.50% transaction cost estimate. This should represent an upper bound for transaction costs.
The table below provides our modified Bogle turnover calculations and transaction cost estimates for the Vanguard suites of S&P and Russell index funds.
|Fund||Bogle modified turnover||Bogle transaction cost|
|S&P 500 Growth||25%||0.13%|
|S&P 500 Value||22%||0.11%|
|S&P 400 Growth||44%||0.22%|
|S&P 400 Value||32%||0.16%|
|S&P 600 Growth||49%||0.24%|
|S&P 600 Value||30%||0.15%|
|Russell 1000 Growth||28%||0.14%|
|Russell 1000 Value||36%||0.18%|
|Russell 2000 Growth||49%||0.24%|
|Russell 2000 Value||37%||0.18%|
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 not require current reimbursement. These deferred costs are for deferred compensation/benefits and risk/insurance costs.
The tables below provide the capital investment and deferred payables for each index fund.
Capital accounts (in ‘000’s)
|Fund||Net Assets||Capital investment||% of Vanguard|
|S&P 500 Growth||2,761,387||132||0.05%|
|S&P 500 Value||1,077,863||53||0.02%|
|S&P 400 Growth||941,218||46||0.02%|
|S&P 400 Value||870,923||44||0.02%|
|S&P 600 Growth||392,257||18||0.01%|
|S&P 600 Value||408,007||20||0.01%|
|Russell 1000 Growth||5,947,869||284||0.11%|
|Russell 1000 Value||3,802,993||186||0.07%|
|Russell 2000 Growth||773,246||38||0.01%|
|Russell 2000 Value||391,273||19||0.02%|
Payables to Vanguard (‘000’s)
|Fund||Net Assets||Payables||% of Net Assets|
|S&P 500 Growth||2,761,387||170,||0.01%|
|S&P 500 Value||1,077,863||85||0.01%|
|S&P 400 Growth||941,218||135||0.01%|
|S&P 400 Value||870,923||93||0.01%|
|S&P 600 Growth||392,257||27||0.01%|
|S&P 600 Value||408,007||32||0.01%|
|Russell 1000 Growth||5,947,869||463||0.01%|
|Russell 1000 Value||3,802,993||357||0.01%|
|Russell 2000 Growth||773,246||86||0.01%|
|Russell 2000 Value||391,273||43||0.01%|