Unwanted Capital Gains in mutual fund index during a drawdown

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67Bosox
Posts: 47
Joined: Sat Apr 28, 2018 7:48 am

Unwanted Capital Gains in mutual fund index during a drawdown

Post by 67Bosox » Tue Sep 10, 2019 5:31 pm

Could someone provide some insight on this question?
Is this issue even worth considering?

I hold vanguard equity index mutual funds, including:
Total Stock Market admiral (VTSAX)
Total Int'l Admiral (VTIAX)
I intend to stay invested even if the stock market is in a decline, and will just rebalance from my vanguard total bond index exposure to get back to my preferred asset allocation.
But here is my question, as a result of listening to a Rick Ferri podcast this week.
If many others in the equity mutual funds act emotionally and sell out, I believe that could lead to capital gains for me even if I do not sell.
But if I were instead holding the ETF share class (VTI for total stock market, or VXUS for total int'l), then is it true that I would experience less capital gains?
Would this be a reason to consider converting my Vanguard equity index mutual fund holdings listed above, to the ETF share class (so as to protect against unwanted cap gains from others selling during a bear market)?
OR - is the difference so small as to not be concerned about it?
AND/OR are there other considerations that I am not considering or I am wholly unaware of?

Thank you for any insight you can provide me.

Silk McCue
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Joined: Thu Feb 25, 2016 7:11 pm

Re: Unwanted Capital Gains in mutual fund index during a drawdown

Post by Silk McCue » Tue Sep 10, 2019 5:48 pm

Vanguard Total Stock hasn’t paid any capital gains since 2000, neither has the S&P500. The mutual funds are as tax efficient as the ETFs at Vanguard due to a patented process.

If it could handle the market meltdown 10 years ago it can do so today.

Cheers

Geologist
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Re: Unwanted Capital Gains in mutual fund index during a drawdown

Post by Geologist » Tue Sep 10, 2019 6:02 pm

As the mutual funds and ETF’s for Vanguard are different share classes of the same fund, my understanding is that they will distribute the same capital gains, so changing to the ETF class will not protect you.

Keep in mind too that if the market falls, the unrealized capital gains in the Total Stock Market Fund will also fall. As of June 30, 2019 (most recent semi-annual report), net unrealized appreciation was about 38% of the net assets. This means if the market falls by 38%, there will be no capital gain. Even along the way to this decrease, some of the shares that Vanguard can sell will have been purchased at prices above the market and can be sold at a loss. This is why there were no capital gains distributions in past bear markets. (There is also a rather modest $1.7 billion capital loss carryforward to offset gains.) There is certainly a risk for capital gains to be realized as the market falls, but I don’t think it great for the Total Stock Market Fund.

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asset_chaos
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Re: Unwanted Capital Gains in mutual fund index during a drawdown

Post by asset_chaos » Tue Sep 10, 2019 7:11 pm

If markets fall a lot and fund holders of total market and 500 index funds redeem shares, vanguard will in fact be able to book a lot of capital losses that it can use to offset capital gains if the redemptions continue. An example may help.

For argument's sake let's say vanguard gets in new money and uses it to buy $100 of shares, i.e. the tax lot cost is $100. Then the market falls 20% and people redeem shares so that there is a net outflow of money from the fund; vanguard needs to sell shares to raise cash to pay off investors. They could choose to sell the shares bought 20 years ago with a tax basis of $5, which shares current price is still well above their tax cost. That would realize capital gains. But they aren't obligated to sell the oldest shares. In fact, first they'll sell the shares today for $80 that they bought yesterday for $100 and book a $20 tax loss. If markets continue to fall and investors to redeem, they'll sell the shares in the index fund bought last week for $98 and book further capital losses. It's only if investors keep redeeming and redeeming that the index fund will finally have to sell shares that have a capital gain, but the fund has booked all these capital losses first that offset the first tranche of capital gains generated by redemptions. How much of the fund they can liquidate before being forced to generate net distributable capital gains depends on how deep the market falls. Vanguard had a paper on this issue around 2000, when this supposed issue came up too, where their simulations said---and I can't recall the exact numbers---that for a 30% market fall they could liquidate about half of the 500 index fund before realizing net capital gains.

This issue is on par with the "if everyone indexed, there would be market failure" argument against index funds. Yes, if literally every one indexed, there would be a problem. Likewise, if markets did not fall, yet implausibly at the same time 90% of index fund investors cashed out their index fund shares, then, yes, the fund would give the remaining shareholders capital gains distributions. But in the much more likely scenario that net fund redemptions occur during down markets, capital gains distributions are highly unlikely. Our last data point was 2008. The stock market fell 50%. I don't know if vanguard index funds had net redemptions, but they did not distribute any capital gains.

Note that this is different for active funds. There the active manager likely has more concentrated stock positions that were more likely to be bought around the same time. So in the face of redemptions, more likely to generate capital gains to distribute to remaining shareholders.
Regards, | | Guy

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grabiner
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Re: Unwanted Capital Gains in mutual fund index during a drawdown

Post by grabiner » Tue Sep 10, 2019 8:32 pm

While this can happen in theory, it is not likely to happen in practice, particularly given the ETF classes of Vanguard funds. It is much more of a risk with active funds.

When investors flee a mutual fund, the fund will have to sell some of its holdings. But if that fund is an index fund, the holdings will have been bought at different prices because index funds buy the same stocks as they grow; if a fund bought stock at prices of $20-60 per share, and must sell at $50, it can sell the shares bought at $40-60 for no capital gain. (In contrast, actively-managed funds move in and out of whole positions; if the manager decided that a stock was a good deal in 2015, the fund might have purchase almost all of its holdings of that stock in 2015). In addition, investors are more likely to flee a fund following poor performance; index funds are unlikely to have poor performance relative to their peer group, and if they have poor performance on an absolute basis, this means they will have capital losses, not gains.

The ETF class makes capital gains even less likely. The ETF structure allows funds to get rid of unrealized capital gains. And if the investors who pull out of the fund are ETF shareholders, there will be no capital gain to the fund; they will sell their ETF shares to authorized participants, who redeem shares in kind, receiving the stock. ETF shareholders are only likely to encounter forced gains if an ETF liquidates, or changes its strategy so that old investors need to sell because it no longer meets their needs; neither of these will happen for a broad-based index ETF.
Wiki David Grabiner

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Nate79
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Re: Unwanted Capital Gains in mutual fund index during a drawdown

Post by Nate79 » Tue Sep 10, 2019 9:40 pm

67Bosox wrote:
Tue Sep 10, 2019 5:31 pm
Could someone provide some insight on this question?
Is this issue even worth considering?

I hold vanguard equity index mutual funds, including:
Total Stock Market admiral (VTSAX)
Total Int'l Admiral (VTIAX)
I intend to stay invested even if the stock market is in a decline, and will just rebalance from my vanguard total bond index exposure to get back to my preferred asset allocation.
But here is my question, as a result of listening to a Rick Ferri podcast this week.
If many others in the equity mutual funds act emotionally and sell out, I believe that could lead to capital gains for me even if I do not sell.
But if I were instead holding the ETF share class (VTI for total stock market, or VXUS for total int'l), then is it true that I would experience less capital gains?
Would this be a reason to consider converting my Vanguard equity index mutual fund holdings listed above, to the ETF share class (so as to protect against unwanted cap gains from others selling during a bear market)?
OR - is the difference so small as to not be concerned about it?
AND/OR are there other considerations that I am not considering or I am wholly unaware of?

Thank you for any insight you can provide me.
You are confusing the capital gain distributions that a mutual fund may distribute during the year due to stocks they sell within the mutual fund vs the capital gains you have when selling a fund. ETFs in general due to their structure do not distribute capital gains. But these distributions can be reinvested but you have to pay taxes on them each year (but in return your basis is increased so the actual impact isn't that big of a deal).

But as others pointed out the Vanguard mutual funds generally do not distribute capital gains due to the special fund structure. Other fund companies will have some small distributions for index mutual funds.

The other type of capital gain is the tax on the gain when you sell shares of any security - mutual fund, ETF, or individual stock. The sale price minus the purchase price is the gain and you pay tax on the gain. This only happens when you SELL the fund. This is different from the fund distributing a capital gain due to their operation of the fund. You will pay a capital gain tax if you sell a Vanguard mutual fund or ETF (and you have a gain).

Topic Author
67Bosox
Posts: 47
Joined: Sat Apr 28, 2018 7:48 am

Re: Unwanted Capital Gains in mutual fund index during a drawdown

Post by 67Bosox » Wed Sep 11, 2019 11:04 am

As always, great insight and help from experienced Bogleheads. Thank you, All!!

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