Under the hood: Vanguard Tax – Managed funds in 2019
Vanguard’s three tax-managed funds are specifically designed for taxable accounts. The funds attempt to avoid capital gains distributions and to provide tax advantaged income distributions. We shall examine the capital gains environment of the funds; the dividend income distributions; fund and investor turnover in the funds. An estimate of transaction costs and the funds’ capital investment in Vanguard Inc. are also examined. 
None of the three tax-managed funds (Balanced, Capital Appreciation, and Small Cap) have distributed capital gains. While these funds do not have an exchange-traded share class, they do take advantage of in-kind redemption. In-kind redemption gains are not taxable. The following table provides the 2019 realized gain for each fund; the in-kind redemption gain, and the net gain/loss for each fund.
Capital gains and in-kind redemption
|Fund||Gain/Loss||In-kind redemption gain||Net Gain/Loss|
|TM Cap App||95,096,000||134,152,000||(39,056,000)|
|TM Small Cap||145,349,000||315,990,000||(170,641,000)|
Investment losses cannot be distributed to investors. The losses can be used to offset gains and can be carried forward to offset gains in future years. The funds have the following capital gains carryforwards.
|Fund||Total loss carryforwards|
|TM Cap App||12,823,600|
|TM Small Cap||446,348,000|
The funds are designed to provide tax preferences for income distributions. These preferences include maximizing qualified dividends, which qualify for reduced federal taxation; providing qualified business income deductions on the federal return; and in the case of the Balanced fund, federal tax exempt income from municipal bond interest.
In 2019, 100% of fund distributions were tax preferred.
Dividends: Qualified and tax-free
|Fund||Dividends||Qualified dividends||Non-taxable dividends||Non-taxable Pct.||QDI Pct|
|TM Cap App||177,611,000||177,611,000||0||0.00%||100.00%|
|TM Small Cap||81,406,000||73,299,000||0||0.00%||90.04%|
The second table provides qualified business income dividends.
|Fund||Dividends||Business income||QBI Pct|
|TM Cap App||177,611,000||0||0.00%|
|TM Small Cap||81,406,000||8,108,000||9.96%|
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|
|TM Cap App||10,644,115,461||880,217,000||684,320,000|
|TM Small Cap||6,631,647,546||1,220,420,000||1,187,689,000|
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.
|TM Cap App||6%||6%||0.78|
|TM Small Cap||17%||18%||0.97|
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|
|TM Cap App||87,804||0||673,588||18,055|
|TM Small Cap||4,056,702||0||3,990,369||519,567|
|Fund||Pct. Purchases||Pct. Sales|
|TM Cap App||0.00%||2.68%|
|TM Small Cap||0.00%||13.02%|
n addition to in-kind redemption, Vanguard also engages in cross trading of stocks and
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. A cross trade eliminates commissions, spreads, market impact, and in the case of bonds, dealer mark-ups.
Cross trades (in ‘000’s)
|TM Cap App||87,804||0||673,588||0|
|TM Small Cap||4,056,702||0||3,990,369||0|
|Fund||Pct. Purchases||Pct. Sales|
|TM Cap App||0.00%||0.00%|
|TM Small Cap||0.00%||0.00%|
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 tax- managed funds.
|Fund||Modified Bogle turnover||Modified Bogle transaction expense|
|TM Cap App||7%||0.03%|
|TM Small Cap||114%||0.57%|
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 tax-managed fund.
Capital accounts (in ‘000’s)
|Fund||Net Assets||Capital investment||% of Vanguard|
|TM Cap App||11,802,667||517||0.21%|
|TM Small Cap||7,099,317||310||0.12%|
Payables (in ‘000’s)
|Fund||Net Assets||Payables||% of Net Assets|
|TM Cap App||11,802,667||2,697||0.02%|
|TM Small Cap||7,099,317||1,516||0.02%|