FTSE vs. S&D - Tax Implications

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tan
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FTSE vs. S&D - Tax Implications

Post by tan » Mon Jan 07, 2008 11:56 am

Many people here talk about the benefits of FTSE vs. S&D (EU/Pac/EM) for the international component of your portfolio. The argument for FTSE mainly is that it is 100% qualified dividends, whereas the three other funds are not. Maybe I'm wrong, but I don't really see a big difference considering the S&D premium (approx. 1%) for the S&D approach, other than simplicity and FTSE being better than total international since that is not 100% qualified dividends. That is, if someone is going to only use one fund in a taxable account, use FTSE over Total Int'l. However, if one is willing to rebalance, then the three fund approach works best. Consider the below before and after tax returns since inception for all funds:

FTSE: b/f - 16%, after - 15.65, diff - .43%
EU: b/f - 10.89, after - 10.21, diff - .68%
PAC: b/f - .2.66 after - 2.33, diff - .33%
EM: b/f - 11.24, after - 10.64, diff - .60%

Given that Vanguard calculates these #s assuming the highest tax bracket, the premium gained by S&D appears to overcome the tax difference of approximately 75% qdi and 100% qdi, no?

Am I Mr. Moron here?

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PiperWarrior
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Re: FTSE vs. S&D - Tax Implications

Post by PiperWarrior » Mon Jan 07, 2008 1:43 pm

Maybe you can further improve the three fund approach. You could have half of international in the FTSE fund and S&D the other half. Think of the FTSE fund as core. Rebalancing would take place in the S&D portion. This way, you get to take 100% QDI for the FTSE portion while you get any premium from rebalancing in the S&D portion.

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House Blend
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Post by House Blend » Mon Jan 07, 2008 2:04 pm

Keep in mind that the FTSE fund is still in its infancy. Any extrapolations you make from 9-10 months of data should be considered wild guesses.

In particular:

-there's no reason to expect that dividends will continue to be 100% qualified. (My prediction: it will drift down to maybe 80%.)

-there's no reason to expect special tax treatment to continue indefinitely for qualified vs. unqualified dividends.

-you should expect that the yield on the FTSE fund will creep up to something comparable to Total International. Roughly 2%? Consider that my wild guess.

-the ER on the FTSE fund is likely to drop as assets accumulate.

Don't forget the foreign tax credit, although I think it's a fair guess to assume that between VFWIX and S&D, it's a wash.

I think VFWIX and the Europe/Pacific/Emerging blend approach are both good. Given that we are talking about a taxable account, I prefer VFWIX so I don't have to fuss with rebalancing among the three funds to maintain some fixed exposure. Your mileage may vary.

Rick Ferri had this to say about the issue in his Core Four thread:
Finally, extension funds may replace a core fund if the strategy behind the extension has the potential for higher risk adjusted returns. For example, rather than using the Vanguard FTSE All-World ex-US Index Fund, I prefer to use a 40% fixed weight in the Vanguard Pacific Stock Index Fund (VPACX – fee 0.22%), 40% inhe Vanguard European Stock Index Fund (VEURX - fee 0.22%), and 20% in the Vanguard Emerging Markets Stock Index Fund (VEIEX – fee 0.37%). The slice and dice sategy has returned slightly higher returns than an All-World ex-US without adding more risk.

tan
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Post by tan » Mon Jan 07, 2008 5:51 pm

Thanks much. The concern I have about Rick Ferri's comment there is that he does not address whether this is appropriate for a taxable account. The consensus on this Board appears to be that FTSE is most appropriate for taxable accounts due to the foreign tax credit and QDI issue, although nobody to my knowledge has looked at the numbers to substantiate this inclination. Hence my clunky attempt at doing so.

SteveB3005
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Post by SteveB3005 » Mon Jan 07, 2008 9:30 pm

grabiner , one of the sharpest guys on the board for fund tax efficiency posted these thoughts back in October.
Given that you have the Europe Index, you probably also want to add the Pacific Index, which is just as good in a taxable account, and probably the Emerging Markets Index, which is almost as good but should be tax-deferred if you can only tax-defer one of the three. All three funds will have low capital gains and will be eligible for the foreign tax credit, and all three have Admiral shares for when you get to $50,000 after ten years.

The advantage of having the three separate funds is that you can control your own allocation; if you want 40% Europe, 40% Pacific, and 20% Emerging Markets, you can do that and not worry about whether Europe actually has a higher market capitalization.
The advantage of having allocation control is the number one reason I hold them separate. Rick Ferri has made this point in his books and Larry Swedroe has stated his preference for holding them as individual funds. The tax efficiency is probably not as good as FTSE and the rebalance bonus is probably not enough to warrant the trouble of three funds as opposed to one, but you do have the control to diversify risk, and that is trump.

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Post by market timer » Mon Jan 07, 2008 9:37 pm

I agree with PiperWarrior. Let VEU be the core fund you hold in a taxable account. Let this be 50-80% of your int'l exposure. The other 20-50% can be S&D, preferably in an IRA. I try to use my Roth for all rebalancing, so its composition changes wildly month to month.

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Re: FTSE vs. S&D - Tax Implications

Post by alvinsch » Mon Jan 07, 2008 10:10 pm

tan wrote:Many people here talk about the benefits of FTSE vs. S&D (EU/Pac/EM) for the international component of your portfolio. The argument for FTSE mainly is that it is 100% qualified dividends, whereas the three other funds are not. Maybe I'm wrong, but I don't really see a big difference considering the S&D premium (approx. 1%) for the S&D approach, other than simplicity and FTSE being better than total international since that is not 100% qualified dividends. That is, if someone is going to only use one fund in a taxable account, use FTSE over Total Int'l. However, if one is willing to rebalance, then the three fund approach works best. Consider the below before and after tax returns since inception for all funds:

FTSE: b/f - 16%, after - 15.65, diff - .43%
EU: b/f - 10.89, after - 10.21, diff - .68%
PAC: b/f - .2.66 after - 2.33, diff - .33%
EM: b/f - 11.24, after - 10.64, diff - .60%

Given that Vanguard calculates these #s assuming the highest tax bracket, the premium gained by S&D appears to overcome the tax difference of approximately 75% qdi and 100% qdi, no?

Am I Mr. Moron here?
One thing you are ignoring is that the rebalancing bonus doesn't come free in a taxable account. Since by definition you will be selling the outperformer to invest in the underperformer, you will normally be realizing taxable gains each time you rebalance (creating a tax drag), while the single fund solution gains from the tax deferral of the gains.

The other issue is that there is no guarantee there will be a rebalancing bonus. Let's assume the world markets are 40% Europe, 40% Pacific, 20% EM but that the EM market grows by 12% over the next 20 years while Europe and Pacific only grow 8% a year. In 20 years EM would actually be larger than either Europe or Pacific but you'd still be only holding 20% of the faster growing EM economies while the single fund would be more than 33% EM. Seems like the rebalancing bonus presupposes that if one area outperforms it must be overvalued when in fact those economies might actually be growing faster.

Just my two cents.
- Al

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Post by SteveB3005 » Mon Jan 07, 2008 10:43 pm

alvinsch,

Let me first say I've seen nothing that suggests there is any rebalance bonus to speak of and I believe the only real advantage of three funds is risk diversification. I'm sure youv'e looked at this more ways than I have but I don't see rebalancing as a big tax hurdle except for those who in retirement are lucky enough to never have to touch principle.

In the investing years you rebalance with fresh money to the laggard and in retirement your going to drag from taxable accounts first anyway, so you draw from the winners. Any additional rebalancing that needs to be done as far as the equity to fixed ratio is done in tax advantaged accounts.

Am I off base here?

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alvinsch
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Post by alvinsch » Mon Jan 07, 2008 11:01 pm

SteveB3005 wrote:alvinsch,

Let me first say I've seen nothing that suggests there is any rebalance bonus to speak of and I believe the only real advantage of three funds is risk diversification. I'm sure youv'e looked at this more ways than I have but I don't see rebalancing as a big tax hurdle except for those who in retirement are lucky enough to never have to touch principle.

In the investing years you rebalance with fresh money to the laggard and in retirement your going to drag from taxable accounts first anyway, so you draw from the winners. Any additional rebalancing that needs to be done as far as the equity to fixed ratio is done in tax advantaged accounts.

Am I off base here?
You make a good point but while those factors reduce the tax cost of rebalancing they don't totally eliminate it. Sometimes cash flows aren't sufficient to handle all rebalancing and I can personally attest to the fact that in retirement I've had to suspend rebalancing because I'd already realized too many gains (more CG's would push me into 22% CG AMT bracket).

In good years ones rebalancing and fund distributions can generate too much income and in bad years not enough. Even in retirement while syphoning off my 3%, I still rebalance from outperforming assets to underperforming assets and its almost all in taxable. Some of us don't have the luxury of large tax advantaged accounts.

FWIW: I do believe there is some rebalancing bonus because I believe there is some level of RTM (flip side of momentum).

Regards,
- Al

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Post by SteveB3005 » Mon Jan 07, 2008 11:44 pm

alvinsch,

Excellent insights, I knew you had looked into this from a lot of angles. Thank you.

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alvinsch
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Post by alvinsch » Mon Jan 07, 2008 11:59 pm

SteveB3005 wrote:alvinsch,

Excellent insights, I knew you had looked into this from a lot of angles. Thank you.
Thanks for the compliment but while I do try to look at things from a lot of angles I have a tendency to view them through the prism of my own situation. Thanks for broadening my view!

- Al

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Post by market timer » Tue Jan 08, 2008 12:11 am

alvinsch wrote:FWIW: I do believe there is some rebalancing bonus because I believe there is some level of RTM (flip side of momentum).
What do you mean by this parenthetical comment?

As I was reading your issue with rebalancing constraints, I thought about an alternative you should consider: sell deep in the money calls on asset classes that have exceeded your target. For example, if emerging markets have grown beyond your target, you can sell calls on EEM. These could reduce your exposure without forcing the realization of capital gains.

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alvinsch
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Post by alvinsch » Tue Jan 08, 2008 12:28 am

market timer wrote:
alvinsch wrote:FWIW: I do believe there is some rebalancing bonus because I believe there is some level of RTM (flip side of momentum).
What do you mean by this parenthetical comment?
My understanding is that there is considerable academic support that momentum exists. To my way of thinking momentum shouldn't exist in an EMH world but if momentum exists in the short term then this inefficiency is undone in the long term by reversion to mean. So to the extent that momentum exists I believe it implies RTM exists. If RTM exists then I believe there may be a rebalancing bonus. Others will disagree but I was just trying to give background on the basis of my comments about a rebalancing bonus.

- Al

tan
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Post by tan » Tue Jan 08, 2008 10:23 am

Very interesting points. Looks like it's a clear "it depends" answer, which is interesting considering there are those that claim FTSE is "clearly" the way to go. Thanks very much for all of your comments.

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Re: FTSE vs. S&D - Tax Implications

Post by grabiner » Tue Jan 08, 2008 10:47 pm

tan wrote:if one is willing to rebalance, then the three fund approach works best. Consider the below before and after tax returns since inception for all funds:

FTSE: b/f - 16%, after - 15.65, diff - .43%
EU: b/f - 10.89, after - 10.21, diff - .68%
PAC: b/f - .2.66 after - 2.33, diff - .33%
EM: b/f - 11.24, after - 10.64, diff - .60%
The FTSE fund hasn't been around for very long, so its dividend yield this year was based on stocks that were held for part of the year. The yield is likely to go up next year. Conversely, the other funds have been around for a long time, and they paid out more in capital gains in the past than they are likely to do now that they have ETF classes.

There is one specific advantage to having the individual funds in taxable, even if you keep the market proportions; you can more easily harvest losses. If emerging markets drop by 20% this year, you can sell them (and buy them back 31 days later), taking the tax loss.

Costs are also an important consideration; Tax-Managed International costs less than any of the funds you listed, and Admiral shares of the FTSE fund (once it adds them) will be easier to get than Admiral shares of the three regional funds.
Wiki David Grabiner

tan
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Post by tan » Wed Jan 09, 2008 9:48 am

thanks for your thoughts, David.

Greenberry
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Post by Greenberry » Wed Jan 09, 2008 1:45 pm

I've run some numbers to compare the various VG international options. Lots of assumptions, of course, about how things work over the next 30 years, but the following are the ones I used: (a) ordinary income rate of 25%, capital gains and QDI are 15% rate, inflation of 3%, and nominal returns of 8% for all asset classes and (b) funds manage to avoid capital gains distributions and dividend rates, QDI percentage, and foreign tax credit percentage are taken from the 2006 or semi-annual 2007 reports, except for FTSE which I've used 93% as an approximation coming from a mix of tax-managed intl with EM. Most of what follows isn't that dependent on the assumptions listed under (a) -- absolute values change, but not by much. Changes in assumptions under (b) have a bigger impact. I used expense ratios from the ETF or admiral classes where available.

I ran the numbers for each fund assuming you put it in a taxable account for 30 years then sold, and for a deductible IRA (same answers for 401k or Roth assuming no tax rate changes) for 30 years then withdrew, to determine the advantage of the IRA as a percentage of increase over the taxable value.

For bonds, not a huge surprise: $1 becomes $2.75 held in taxable or $4.03 held in Roth IRA, for a 46.5% advantage to IRA.

For TSM, $3.39/$4.06, a 19.8% advantage to being held in tax-deferred.

A surprise to me came from the 3 regional funds: Europe/Pacific/EM. Europe was $3.11/3.76 for a 20.7% tax-deferred advantage (greater than TSM, primarily due to the higher dividend rate). Pacific was $3.22/3.86 or 19.6% and EM was $3.08/3.52 or 14.2%.

Note that the counterintuitive result comes from EM, which is the most efficient of the 3 to hold in a taxable account, which contradicts advice I've seen to hold EM in a tax-deferred account. Its FTC was 0.29%, which is the primary reason why holding it in a tax-deferred account gains you the least compared to the others. The advice to hold it in tax-deferred, however, comes from the possibility of large CG distributions if countries migrate out.

There's a fundamental conflict, it seems, with EM: it has (had) the largest FTC percentage of 0.29%, which makes holding it in tax-deferred painful. However, it only has 59% qualified dividends and the possibility of large CG distributions, which makes taxable painful. However, by holding EM as part of FTSE in a taxable account, you can avoid both of those drawbacks (the CG distributions being the bigger threat, in my opinion).

In the end, you have a set of options that seem to make sense (VEU=FTSE, VEA=Tax-managed Intl)
100% VEU: $3.17
100% VEA: $3.27
80/20 VEA/EM: $3.23
40/40/20 Eur/Pac/EM: $3.15

If you're content to skip EM, tax-managed international (VEA) is a clear winner.

If you want EM and are willing to live with potential CG distributions, VEA/EM has about a 2.6% advantage over Eur/Pac/EM over 30 years. It's possible a future rebalancing bonus between Eur/Pac could overcome that 0.1% a year hurdle, but also possible it wouldn't.

Finally, FTSE lets you hold EM without the potential CG distributions over the next 30 years, while still getting that 0.29% FTC. If a sizable distribution occurred, that would compensate for the 2% advantage of VEA/EM. Also, if FTSE's ER drops to 0.20 from 0.25%, its value rises to $3.21, making it just as effective as holding VEU/EM when there are no distributions. If FTSE maintains 100% QDI, it's even better.

At the end of the day, though, these are less than 3% return differences after 30 years, so it's not worth obsessing about which combo to hold.

If you want to play the rebalancing game, the suggestions of some to have your core international holdings in FTSE or tax-managed intl and do your balancing on the fringes makes sense, especially if you can avoid the potential EM CG hit, but realize that the cost of playing is either taking the FTC hit by holding in tax-deferred or taking increased risk of capital gains distributions by holding in taxable. Of course, as David points out above, you may have more tax loss harvesting options with the regional split. I'm not sure where on the risk-reward spectrum that puts you.

tan
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Post by tan » Wed Jan 09, 2008 5:37 pm

Thank you so much for that review, Greenberry. You clearly spent some time pulling that information together. I'm grateful.

It's still interesting to me that this issue hasn't already been discussed/dealt with in greater detail by the pundits. Pretty cool!

Thanks again.

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Post by jackal » Thu Jan 14, 2010 8:21 pm

Awesome discussion in the posts: I am a newbie and tried to make the best possible sense of the discussion.

In response to greenberry's post, historically emerging markets have been extremely volatile: Do you guys think slice and dice would maximize tax loss harvesting and off set the low % of QDI's and risk of sporadic high capital gains?

There was a threat of capital gain distribution with holding VEIEX(emerging market): Does anyone know how often this might occur?(Read a post saying that Korea may be reclassified as developed: Would that mean a 12.2% capital gains in 1 year??(which would cause a loss of investment of 15-20% of 12.2% or 2.4%). My current portfolio has an international allocation of about 40% and I wanted to split it into 13-13-13 but after reading the discussion I am not sure if it's the right thing to do.

FTSE==> Slightly higher ER and bubble risk and inability to "currency" diversify. I am not sure if the low QDI's would persist in the long term.

VEIEX==> Risk of huge capital gains but would avoid bubbles (hopefully since I would try to keep a fixed %). No exposure to canada even when mixed with pacific and european: But this could be good given the fact that most of our portfolio is in the US and canada correlates pretty closely to US.

I guess there would not be a right answer but do you guys know what most people do? slice and dice or stick with FTSE for the most part and micromanage the other indices as needed or just invest in FTSE?

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