Vanguard European Stock Index Fund tax distributions

The Vanguard European 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 Emerging Market 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.

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 modest levels of capital gains during its first decade of existence, a period coinciding with a long bull market, but has not distributed a gain since 2000, a period which included two bear markets. Approximately 75% of dividend distributions have been qualified dividends, which under the current tax regime, are taxed at lower capital gains tax rates.


 * FY 2001 - annualized dividends (investor and admiral), fund changed fiscal years.
 * 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.
 * FY 2008 - Fund removed from Total Market and Developed fund of funds, transition completed March 2009.
 * FY 2010 - Fund removed from suite of Target Retirement fund of funds.
 * FY 2010 - Fund introduces admiral shares with lower $10,000 minimum investment.

Accounting data
The accounting figures and associated ratios (tables 3 and 4) 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 2. spreadsheet shows the true taxable net realized gain /loss for the fund.

Fund analysis
The annual fund accounting figures show that the Vanguard European Index fund turnover ratio usually stays in single digits, although there has been an uptick in turnover for the past three fiscal years. The MSCI European Index holds large and mid cap stocks. Stock migration out of the index can come in two dimensions:
 * 1) An individual company is reclassified as a small cap stock and is removed from the index;
 * 2) A developed market country is reclassified as an emerging market and is removed from the index.

Shareholder turnover, revealed in the Redemptions /Average Net Assets (R/ANA) and the Redemption /Sales (R/S) metrics, shows that shareholders have historically turned over their holdings in the fund at 10%-20% annual rates, suggesting average holding periods of between five and ten years. The anomalous large increase in shareholder redemption and the initiation of heavy outflows in the fund during 2008, 2009, and 2010 is primarily due to policy changes Vanguard introduced in its fund of funds portfolios. These changes included:


 * Total International Index fund removed the European, Pacific, and Emerging funds from the portfolio and now directly holds stocks.
 * Developed Market Index fund removed the European and Pacific funds from the portfolio and now directly holds stocks.
 * The Target Retirement funds removed the European and Pacific funds from the portfolio and now hold the Total International Index fund.

The policy move increased the proportion of ETF shares to the fund's mutual shares (investor, admiral, signal, institutional). The transaction and tax efficiencies provided by the ETF shares should continue to provide benefits for the fund.

A look at realized net gains/losses shows that the fund realized net losses during the 2000-2002 and the 2008 bear markets. These losses produced loss carryforwards. Low fund and shareholder turnover has retained most of these carryforward losses as offsets to potential future gains. For the past three years the fund has shown an unrealized loss as its cost basis. Table 3.

Turnover statistics
Reference article: Average net assets

Table 4.