Gus Sauter comments on Vanguard ETF structure

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
User avatar
Topic Author
Rick Ferri
Posts: 9284
Joined: Mon Feb 26, 2007 11:40 am
Location: Georgetown, TX. Twitter: @Rick_Ferri
Contact:

Gus Sauter comments on Vanguard ETF structure

Post by Rick Ferri »

Below are a few interesting Gus Sauter quotes from a new book:

Exchange Traded Funds: Conceptual and Practical Investment Approaches
Edited By A. Seddik Meziani, Professor of Economics and Finance at Montclair State University, Department of Economics and Finance.

Chapter 6: Understanding ETF Structures Important in Building Portfolios
Gus Sauter - Vanguard

Writing on the subject of tax-efficiency using the the share-class of Vanguard ETFs as opposed to standalone ETFs:
"As mentioned earlier, some posit that share-class ETFs are less tax-efficient than standalone ETFs (including those with both the UIT and open-end structure). The argument focuses on the gains realized from the sales of portfolio securities in the event of net redemption requests from holders of conventional shares. In theory, a large market decline might trigger large-scale redemptions of the conventional shares, forcing the managers to sell portfolio securities and realize gains. Because any capital gains would be allocated pro rata across all share classes, the ETF holder would receive an unwanted taxable distribution.

This hypothesis has never materialized, however. In fact the opposite has been true, as conventional index funds have generally enjoyed net cash inflows even during the declining market of 2000-2, and more recently 2007-8. In addition any sales that resulted from relatives modest redemptions led to realized losses, not gains, that can be carried forward to enhance the tax efficiency in future years.

Interestingly, share-class ETFs have an additional tax management tool at their arsenal. The conventional share classes of such funds typically receive actual cash that can he used to rebalance the fund to changes in the underlying benchmark. Over time, the fund accumulates a large number of share lots, with a distribution of low-cost lots and high-cost lots. Should securities need to be sold from the fund in order to meet redemptions, the manager can sell the highest-cost lots potentially at a loss, thereby realizing capital losses that may be used to offset any gains. Capital losses can be used to offset subsequent realized gains of a fund for up to eight years after the loss are realized, providing a cushion if it would ever be necessary.”
I believe this is the first time that Gus or anyone from Vanguard has put in writing their belief that the proprietary Vanguard ETF share-class structure has been at least as tax-efficient as standalone ETFs, and that cash creation and redemptions from conventional shareholders help the tax-efficiency of the ETF share class, not hurt it.

Rick Ferri
User avatar
stratton
Posts: 11083
Joined: Sun Mar 04, 2007 5:05 pm
Location: Puget Sound

Post by stratton »

So will Vanguard license this out to other fund companies?

There's an income trade off versus possible asset losses. Then again your average ETF buyer wouldn't even know about this.

Paul
User avatar
Topic Author
Rick Ferri
Posts: 9284
Joined: Mon Feb 26, 2007 11:40 am
Location: Georgetown, TX. Twitter: @Rick_Ferri
Contact:

Post by Rick Ferri »

stratton wrote:So will Vanguard license this out to other fund companies?
Yes. Vanguard holds the ETF share-class patent and they will license it. There were a few interested parties last I was told. IMO, it is a great idea for other fund companies to do this. But, paying Vanguard at licensing fee may be hard to swallow.

Rick Ferri
User avatar
Robert T
Posts: 2747
Joined: Tue Feb 27, 2007 9:40 pm
Location: 1, 0.2, 0.4, 0.5
Contact:

Post by Robert T »

.
Thanks Rick,

This spurred by recollection of an earlier Q&A when Sauter was asked about tax efficiency of ETFs and open-ended mutual funds.
ETFs are widely touted as more tax-efficient than traditional index funds. Is that claim true?

Mr. Sauter: No. I'm not sure how that myth began, but I see it perpetuated in virtually every article that I read about ETFs. The potential for high tax-efficiency of index funds, including ETFs, stems primarily from the low turnover of the underlying benchmark. Secondly, index funds, again including ETFs, employ an "in-kind" redemption process that contributes to tax-efficiency. This tax-sensitive technique enables funds to sweep out shares with a low cost basis and serves to minimize or eliminate capital gains distributions. ETFs are limited to the in-kind redemption process; traditional index funds have an additional technique to aid tax management. The latter are able to fund redemptions from the portfolio by selling high cost lots at a loss, which can be used to offset future gains in the portfolio.

The element that I rarely see in these reports about ETF tax-efficiency is dividend income. The tax law change of 2003 made dividend management at least as important as capital gains management because of the reduced tax rates applied to qualified dividends. On this score, ETFs face a disadvantage because there is a holding period test for whether a dividend is subject to the lower 15% rate. If an ETF churns too much through the in-kind redemption process, then a portion of the dividends may not qualify for the 15% rate. Many ETFs have had lower percentages of qualified dividend income than comparable Vanguard index funds over the past three years, and this has an impact on after-tax returns.

I realize that this tax discussion is "inside baseball," but I'd encourage investors who are tax-sensitive not to be oversold on ETF tax-efficiency claims.
From: https://personal.vanguard.com/us/Vangua ... 06_ALL.jsp

Robert
.
User avatar
HueyLD
Posts: 8126
Joined: Mon Jan 14, 2008 10:30 am

Post by HueyLD »

I have always been curious about the relative tax efficiency between conventional ETFs and Vanguard’s ETFs. Based on Rick’s recap and Robert T’s quote from Vanguard, I believe Vanguard has invented yet another winning formula for making ETFs as a share class (vs. a free-standing product).
detifoss
Posts: 554
Joined: Sat Oct 13, 2007 10:38 pm

Post by detifoss »

thanks rick

I think this point has been alluded to before in this forum, but it is nice to see it coming directly from the folks at Vanguard.

I'm actually of the opinion that the tax efficiency of the Vanguard ETFs is as good if not better than that of other ETFs. My guess is that it all evens out in the end, and any difference is likely negligible.

Thus, as in most cases, expenses matter, and other things seeming relatively equal, I stick with Vanguard ETFs because their expense ratios are almost always the best in class.
dodonnell
Posts: 416
Joined: Wed Oct 29, 2008 6:48 pm

Post by dodonnell »

Yes. I am liking Vipers over iShares ETFs.

However, one thing is holding me back from accumulating Vipers instead of iShares:

Vipers seem to trade "above NAV", while iShares are trading at NAV.

Examples would be BND, BSV, VPL, VGK, etc. (not the most liquid Vipers), but i suspect, overtime, as liquidity improves, they will trade more closely to NAV.

BND is trading 0.36 above NAV as of Friday.

So, i can't buy them "at a PREMIUM" now, because i will lose that premium over time.

Am i thinking correctly here?
VennData
Posts: 579
Joined: Mon Feb 26, 2007 5:52 pm

Post by VennData »

This is a business process, not an invention. This patent should not hold up.

Having said that, it may never get tested during its lifetime and I am benefiting from it.
KyleAAA
Posts: 8760
Joined: Wed Jul 01, 2009 5:35 pm
Contact:

Post by KyleAAA »

VennData wrote:This is a business process, not an invention. This patent should not hold up.
Agreed, our patent system is fubar'd. I'd like to see us move to a more European model.
richard
Posts: 7961
Joined: Tue Feb 20, 2007 3:38 pm
Contact:

Post by richard »

Secondly, index funds, again including ETFs, employ an "in-kind" redemption process that contributes to tax-efficiency. This tax-sensitive technique enables funds to sweep out shares with a low cost basis and serves to minimize or eliminate capital gains distributions.
There's an incentive for institutions to engage in in-kind redemptions with ETFs - if the trading price of the ETF diverges from the value of the underlying index, the institution can make a quick arbitrage profit. For example (made up numbers), buy the ETFs for $995, take an in-kind redemption, sell the underlying securities for $1,000.

What's the incentive to get an in-kind redemption from an open-ended fund? I've never seen a mention of open-ended funds using in-kind redemptions for tax-efficiency (or any purpose other than facilitating massive withdrawals from the fund).
Post Reply