Under the hood – Vanguard US stock index funds in 2019

Vanguard issues annual reports for the firm’s US stock index funds on December 31 of each year.[1] 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. In addition, we can estimate fund transaction costs, as well as examine a fund’s capital investment in Vanguard Inc.

Tax implications

Capital gains

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 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.

n 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 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 report a net loss for the year.

As an accounting entry, in-kind redemption gains become a part of the fund’s paid-in capital.

Capital gains

FundGain/LossIn-kind redemptionNet Gain/Loss
Total Market3,830,856,0008,345,326,000(4,514,470,000)
S&P 50014,339,484,00016,453,255,000(2,113,771,000)
Extended 3,506,067,0003,942,264,000(436,197,000)
Large cap220,693,000390,342,000(169,649,000)
Large growth2,779,185,0003,230,685,000(451,500,000)
Large value1,616,230,0002,600,682,000(984,452,000)
Mid cap6,128,015,0006,719,631,000(591,616,000)
Mid growth1,246,267,0001,313,573,000(67,306,000)
Mid value209,834,000682,076,000(472,242,000)
Small cap 3,514,715,0005,586,779,000(2,072,064,000)
Small growth1,874,382,0002,349,926,000(475,544,000)
Small value79,349,0001,250,629,000(1,171,280,000)

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.

Loss Carryforwards

FundTotal loss carryforwards
Total Market6,156,034,000
S&P 5003,054,001,000
Extended 1,247,223,000
Large cap260,027,000
Large growth2,534,635,000
Large value1,465,507,000
Mid cap3,876,921,000
Mid growth788,437,000
Miid value1,276,443,000
Small cap 3,162,458,000
Small growth1,758,188,000
Small value1,339,428,000

ETF ratio

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 sizeable share of most of the Vanguard index funds. The lone exceptions are the Total Stock Market Index Fund and the Extended Market index, both of which have a history dating back to the early 1990’s, well before the advent of exchange-traded shares. In addition, mutual fund shares of the Total Market Index Fund are used in Vanguard’s suites of balanced target date and target risk funds; the positive investor inflows into these funds assure a large issuance of Total Market Index mutual fund shares.

ETF to Fund ratios

FundTotal assetsETF assetsETF/Total assets
Total Market897,623,869,000138,067,205,00015.38%
S&P 500536,305,537,000130,728,195,00024.38%
Extended 74,543,567,0008,119,074,00010.89%
Large cap25,642,004,00016,270,420,00063.45%
Large growth101,582,674,00048,480,989,00047.73%
Large value91,132,786,00055,909,128,00061.35%
Mid cap111,567,326,00029,013,611,00026.01%
Mid growth15,232,329,0006,995,335,00045.92%
Miid value21,539,551,00010,339,126,00048.00%
Small cap 96,764,677,00027,441,753,00028.36%
Small growth25,940,078,0009,833,174,00037.91%
Small value32,601,641,00014,808,261,00045.42%

Dividends

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. In addition, starting in 2019, certain expenses are deemed as qualified business expenses and can be taken as an adjustment to taxable income.

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

Fund Net Investment
Income dividends
Qualified dividendsQDI Pct.
Total market15,557,351,00014,591,240,00093.79%
S&P 5009,934,658,0009,934,658,000100.00%
Extended 978,780,000653,146,00066.73%
Large cap453,569,000440,642,00097.15%
Large growth953,871,000889,008,00093.20%
Large value2,202,182,0002,202,183,000100.00%
Mid cap1,655,879,0001,377,526,00083.19%
Mid growth117,402,00092,091,00078.44%
Miid value442,945,000386,106,00087.17%
Small cap 1,355,693,000940,445,00069.37%
Small growth149,581,000108,581,00072.59%
Small value661,069,000460,897,00069.72%

The table below provides a fund’s total net investment income distribution, the amount of qualifying business expense income, and the qualifying business expense percentage of total dividend distributions.

Qualified business expense

Fund Net Investment
Income dividends
Qualified Business QBI Pct
Total market15,557,351,000910,105,0005.85%
S&P 5009,934,658,00000.00%
Extended 978,780,000210,146,00021.47%
Large cap453,569,00012,927,0002.85%
Large growth953,871,00064,863,0006.80%
Large value2,202,182,00000.00%
Mid cap1,655,879,000184,299,00011.13%
Mid growth117,402,00023,974,00020.42%
Miid value442,945,00029,024,0006.55%
Small cap 1,355,693,000324,553,00023.94%
Small growth149,581,00041,000,00027.41%
Small value661,069,000146,956,00022.23%

Security lending

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.

Security Lending

FundNet security lending income
Total expenses
% of expenses
Total Market152,182,000388,872,00039.13%
S&P 5007,853,000174,670,0004.50%
Extended 71,208,00032,516,000218.99%
Large cap793,0009,989,0007.94%
Large growth3,465,00041,340,0008.38%
Large value2,771,00035,314,0007.85%
Mid cap8,600,00047,241,00018.20%
Mid growth1,628,0009,989,00016.30%
Miid value981,00013,835,0007.09%
Small cap 49,080,00044,857,000109.41%
Small growth11,826,00017,747,00066.64%
Small value17,029,00021,979,00077.48%
Total327,416,000838,349,00039.05%

Turnover

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.

Turnover

FundAverage net assetsSalesRedemptions
Total Market810,057,137,876113,631,777,00085,983,152,000
S&P 500482,070,021,80276,842,256,00065,561,137,000
Extended 69,617,364,80318,041,672,00018,171,014,000
Large cap22,872,965,9902,858,388,0002,140,587,000
Large growth90,422,923,93017,019,381,00015,573,219,000
Large value81,124,565,64217,521,417,00010,552,295,000
Mid cap104,238,678,16224,410,554,00026,224,893,000
Mid growth13,861,661,0624,720,323,0004,089,111,000
Mid value19,194,765,9914,928,492,0003,843,793,000
Small cap 91,547,731,38520,837,407,00022,746,566,000
Small growth24,324,074,6147,255,602,0007,927,407,000
Small value30,377,509,2107,015,458,0006,389,190,000

Ratios

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 small cap blend index funds, as well as the small cap growth index fund,

Turnover Ratios

FundTurnoverR/ANAR/S
Total Market4%11%0.76
S&P 5004%14%0.85
Extended 13%26%1.01
Large cap5%9%0.75
Large growth11%17%0.92
Large value12%13%0.60
Mid cap15%25%1.07
Mid growth18%24%0.87
Mid value17%20%0.78
Small cap 17%25%1.09
Small growth18%33%1.09
Small value18%21%0.91

Transaction costs

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)

FundPurchases In-kind PurchasesSales In-kind Sales
Total Market77,124,21116,479,628 44,189,839 11,228,7270
Large Cap2,655,742818,5071,758,407599,283
Growth18,394,4788,430,61316,465,8047,039,641
Value21,837,0699,895,58016,052,4866,489,626
Mid Cap26,492,15210,925,12827,042,99311,299,183
Mid Growth5,603,7132,741,3724,889,7212,496,501
Mid Value6,151,8551,841,0904,892,4371,740,061
Small Cap22,990,4907,983,30723,887,7909,952,229
Small Growth7,995,0523,187,4818,562,1184,224,259
Small Value9,411,2242,670,7668,388,1512,813,508

Percentages

FundIn-kind Purchase Pct. In-kind Sales Pct.
Total Market 21.37% 25.41%
Large Cap 30.82% 34.08%
Growth 45.83% 42.75%
Value 45.32% 40.43%
Mid Cap 41.24% 41.78%
Mid Growth 48.92% 51.06%
Mid Value 29.93% 35.57%
Small Cap 34.72% 41.66%
Small Growth 39.87% 49.34%
Small Value 8.38% 33.54%

Cross trading

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) [2]

FundPurchases Cross Sales Cross
Total Market77,124,211044,189,8390
Large Cap2,655,742226,4211,758,407213,935
Growth18,394,4781,239,10016,465,8044,457,532
Value21,837,0693,819,12116,052,4861,857,206
Mid Cap26,492,152737,48627,042,9934,853,122
Mid Growth5,603,713164,2344,889,721957,835
Mid Value6,151,855748,7844,892,4371,336,039
Small Cap22,990,4904,385,50123,887,7901,082,834
Small Growth7,995,052845,6428,562,1181,489,858
Small Value9,411,2243,228,9908,388,151692,284

Percentages

FundCross Purchase Pct.Cross Sale Pct.
Total Market 0.00% 0.00%
Large Cap 8.53% 12.17%
Growth 6.74% 27.07%
Value 17.49% 11.57%
Mid Cap 2.78% 17.95%
Mid Growth 2.93% 19.59%
Mid Value 12.17% 27.31%
Small Cap 19.08% 4.53%
Small Growth 10.58% 17.40%
Small Value 34.31% 8.25%

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:

  1. 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.
  2.  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:

  1. 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.
  2.  Transaction expense: We use the 0.50% transaction cost estimate. This provides an upper bound for fund transaction costs.

The table below provides our modified Bogle turnover calculations and transaction cost estimates for the Vanguard suite of CRSP index funds.

FundBogle modified turnoverBogle transaction cost
Vanguard Total Market12%0.06%
Vanguard Large Cap11%0.06%
Vanguard Growth15%0.08%
Vanguard Value20%0.10%
Vanguard Mid Cap25%0.12%
Vanguard Mid Growth30%0.15%
Vanguard Mid Value28%0.14%
Vanguard Small Cap26%0.13%
Vanguard Small Growth28%0.14%
Vanguard Small Value28%0.14%

Capital accounts

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 AssetsCapital Pct.
Total market897,623,86939,34515.74%
S&P 500536,305,53723,4139.36%
Extended 74,543,5673,2951.32%
Large cap25,642,0041,1230.45%
Large growth101,582,674,4371.77%
Large value91,132,7864,0041.60%
Mid cap111,567,3264,9461.98%
Mid growth15,232,3296720.27%
Mid value21,539,5519410.38%
Small cap 96,764,6774,2861.71%
Small growth25,940,0781,1480.46%
Small value32,601,6411,4290.57%
Total2,030,476,03989,03935.61%

Payables to Vanguard (‘000’s)

Fund Net AssetsPayablesPct.
Total market897,623,869127,7980.01%
S&P 500536,305,53723,4130.00%
Extended 74,543,56715,2670.02%
Large cap25,642,0043,5110.01%
Large growth101,582,6717,8630.02%
Large value91,132,78613,1860.01%
Mid cap111,567,32620,6710.02%
Mid growth15,232,3292,1330.01%
Miid value21,539,5512,5850.01%
Small cap 96,764,67719,0940.02%
Small growth25,940,0785,8770.02%
Small value32,601,6417,1070.02%
Total2,030,476,039258,505,0000.01%

Notes

[1] Table data is derived from fund annual reports. Average net asset data is derived from N-CEN reports on EDGAR. The computations are derived from this google spreadsheet.

[2] Vanguard’s cross trading in 2019 is tabulated in Vanguard Cross Trading – 2019.

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