Vanguard Emerging Markets Stock Index Fund tax distributions

The Vanguard Emerging Market Index Fund is a suitable candidate for placement in taxable accounts. The fund is usually held by investors who wish to hold specific targeted allocations to regional stock markets. Thus, the fund is usually held in combination with the following regional international funds:


 * Vanguard Pacific Stock Index
 * Vanguard European Stock Index



The fund is also held by investors who hold a developed market index and wish to add emerging market exposure. Vanguard developed market funds include:


 * Vanguard Tax-Managed International‎
 * Vanguard Developed Markets Index



The following tables provide long term data on the fund's history of both dividend and capital gains distributions. The first table also provides the historical distribution of qualified dividends and an estimate of the foreign tax credit. One should note that the fund has a fiscal year ending in October, so its reported distributions for a year reflect the prior year's December distribution of dividends and capital gains.

The second table provides a database of the fund's accounting figures: the annual level of realized and distributed gains; its level of unrealized gains and loss carryforwards; as well as the annual in-kind redemption gains the fund has realized. These figures highlight the level of a fund's tax liabilities.

Because both manager turnover of securities inside the portfolio and investor turnover of fund shares can affect the level of gains realization, a third table provides historical turnover ratios.

When dividing international allocations among regional index funds in taxable accounts, an investor will need to occasionally rebalance the allocation in a tax efficient manner, and should remain aware of any opportunities to  harvest tax losses. Because the mutual fund share class of the Emerging Market Index fund imposes both purchase and redemption fees, an investor should consider holding the ETF share class of the fund, if the total costs, including transaction costs, of using the ETF are advantageous.

Distributions
The following table provides a view of the fund's historical distributions expressed in terms of yields. We can see that the fund distributed one capital gains distribution during 1994, its first year of existence, but has not distributed a gain since. Approximately 60% of dividend distributions have been qualified dividends, which under the current tax regime, are taxed at lower capital gains tax rates.


 * FY 1994 - annualized dividend, fund inception.
 * FY 2002 - MSCI transitions to "free-float" market weighting.
 * FY 2003 - Introduction of 2% transaction fee on redemptions of shares held < 2 mos.
 * FY 2005 - Fund introduces ETF shares, dividend annualized.
 * FY 2006 - Fund transitions to MSCI Emerging Markets Index.
 * FY 2006 - Fund adds admiral shares, dividend annualized.
 * FY 2008 - Fund removed from Total Market fund of funds, transition completed March 2009.
 * FY 2010 - Fund introduces admiral shares with lower $10,000 minimum investment.

Accounting data
The accounting figures and associated ratios (tables 4 and 5) can help one visualize some of the major determinants of a fund’s tendency to distribute taxable gains. These determining features include:

Turnover: The rate at which a fund manager sells securities within the fund has a major effect on potential gains realization. Single digit annual fund turnover percentages result in a low rate of realized gains. Similarly, fund shareholders' sales flows have major effects on a fund’s distribution tendencies. Net flows into the fund have the following effects:


 * 1) Constant inflows allow a fund manager to purchase a wide range of price lots for shares. The manager can select high basis shares when forced to sell a stock (this may realize a loss). The manager can also select low basis shares when redeeming a stock in-kind (a non-taxable transaction that can remove an unrealized gain out of the portfolio.) This redemption technique is primarily employed with institutional creation and redemption of ETF shares.  Net inflows mean that shareholders are not forcing the manager to liquidate assets (and realize gains or losses) in order to meet redemptions. Large outflows can force such liquidation.
 * 2) A large and growing net asset base serves to diffuse any realized capital gains across a large base of shareholders and reduces the per share gain distribution. Large outflows have the opposite effect; any gains realized are spread across a smaller asset base and result in higher per share distributed gains.

The level of unrealized gains and carryover realized losses in a fund: Index funds defer gains realization and often accumulate significant unrealized appreciation, which if distributed, would be taxed; thus the unrealized gain/loss figure shows the potential gain (or loss) that would be realized if the portfolio was to be entirely liquidated. Any loss carryovers a fund possesses can be used to offset future realized gains (carryovers have an eight year expiration period). The third tab on the Table 2. spreadsheet shows the data in percentage of total assets form.

In-kind redemption gains are included in the realized gains accounting. The second tab (tax attributes) in the Table 3. spreadsheet shows the true taxable net realized gain /loss for the fund. In kind redemption gains are added to the fund's cost basis.

Fund analysis
The annual fund accounting figures indicate that the Vanguard Emerging Market Index Fund annual turnover ratio is consistently higher than the turnover realized by the European and Pacific index funds. Factors driving this higher turnover:


 * 1) The fund has experienced two structural shifts in the fund's underlying tracking index during its history. In 2002 MSCI adopted free float market weighting for its international indexes (2002 turnover 65%). In 2006 Vanguard shifted the fund's tracking index from a proprietary MSCI index to the currently tracked MSCI Emerging Markets Index (2006 turnover 26%).
 * 2) Stock migration in and out of the index affects turnover. As a large and mid cap index, the MSCI Emerging Market Index can have stocks reclassified as small cap stocks and removed from the index. A significant migration also occurs on a country level when a nation is reclassified among developed, emerging, and frontier markets. Table (2) documents the historical migrations into and out of the index. Malaysia (2000) and Argentina (2009) are the only countries to have been reclassified as frontier markets; all other migrations out of the portfolio have been to developed market indexes. Historically, the migration of markets has not resulted in the fund distributing a taxable gain to shareholders. However, a realized gain remains a possibility should one of the heavier weighted markets in the index (China, South Korea, Brazil, or Taiwan) be reclassified as a developed market.

The fund has received net inflows every year of its history. In recent years investors have flocked to the ETF share class of the fund, making it the largest Emerging Market ETF in the ETF market place. The ETF possesses competitive advantages: it has the lowest expense ratio in the market and has exhibited superior tracking error performance since inception.

Shareholder turnover, revealed in the Redemptions/Average Net Assets (R/ANA) metric, shows that prior to the introduction of the the ETF shareholders had historically turned over their holdings in the mutual fund shares at 10%-30% annual rates, suggesting average holding periods of between three and ten years. Since the advent of the ETF share class, the R/ANA ratio for mutual fund shares has increased. One element in this increase is share class conversion activity. Vanguard allows investors to convert mutual fund shares to ETF shares. These conversions are included in the mutual fund's redemption total (although no actual sale has transpired). A similar inflation in the R/ANA ratio takes place with investor share / admiral share conversion.

In 2010, investor share turnover also increased due to the policy decision to transform the Vanguard Total International Stock Index Fund from a  fund of funds to direct ownership of securities. The Emerging market mutual fund shares were removed from the holdings in the fund.

As table (4) indicates, the fund has frequently realized net capital losses during its fiscal years (often during years of positive market gains) and, as a result, has always maintained, and steadily increased, its loss carryforward. [Refer to the second tab (Table 4.) for the actual realized net loss in the fund, adjusted for in kind redemption gains].

Table 4.

Turnover
Reference article: Average net assets Table 5.