Vanguard ETF vs Vanguard Index Fund Tax Efficiency

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Author Topic: Vanguard ETF vs Vanguard Index Fund Tax Efficiency  (Read 224 times)

travis_cooper

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Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« on: July 13, 2013, 09:34:57 am »

I'm very new to investing and MMM. I have read several times the suggestion to just open an account at Vanguard and throw your money into an index fund, specifically the total stock market one. So, I decided to try it out this week. I opened an account and put some of my savings in there. However, I've been doing some reading on tax efficiency and now I'm wondering if that was the best idea. Part of this is just my not understanding how things work.

From what I can tell if I use the VTI ETF through Vanguard I don't have any commission fees. On top of that the expense ratio is a lot lower. I think that means I have to buy complete shares though. From my understanding if I leave my money in for more than a year then when I pull money out it would be taxed as long term gains.

On the flip side, with VTSMX which I purchased the expense ratio is a little higher. Also, there is potential that they could make distributions (although it looks like that doesn't happen often). Because of those distributions I think that means I could get taxed as short term gains.

So, it looks to me that I should have invested in the VTI instead. It has a lower ratio, through Vanguard I don't have to pay commissions when I buy more shares, and I control when I realize capital gains.  What am I missing?  I did notice that the index fund hasn't done any distributions for the last year and a half (I couldn't figure out how to go back further than that), so maybe I'm worrying over nothing.

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extole

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Re: Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« Reply #1 on: July 13, 2013, 10:13:36 am »

It's pretty much a matter of personal preference. I prefer Vanguard mutual funds over their ETFs because they're a little less of a hassle. For instance the mutual funds default to automatically reinvest distributions. Also, mutual funds only having a price quote at the end of the day, I find it discourages getting overly obsessed with market noise.

For tax purposes and distributions all three: VTSMX, VTI and VTIAX are identical.

Don't worry about the expense ratio difference between VTI and VTSMX. You'll hit 10K in no time and your shares will convert over to VTIAX -- which has the same expense ratio as VTI.

Cheers

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rugorak

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Re: Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« Reply #2 on: July 13, 2013, 12:35:04 pm »

As far as reinvestment that is whatever you want regardless of ETF or mutual fund (or even stock). The expense ration is lower on VTI than VTSMX but the same as VTSAX so if you are investing $10,000 or more that works out to be the same too. Personally I went with VTI with my taxable investments because at first I didn't have $10k to put in at first so the lower expense ration was available.

I think the biggest difference assuming you have $10k or more is that the ETF price fluctuates all day long and the mutual fund settles up everything at the end of the day. Maybe someone more knowledgeable than I can chime in but honestly I don't think you can really go wrong either way.

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travis_cooper

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Re: Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« Reply #3 on: July 13, 2013, 04:38:40 pm »

I think I understand that the funds are pretty much the same thing. My real question is in regards to being taxed. Are all three truly identical?  My understanding was that if the mutual fund manager decided to make some changes that could lead to distributions which would then cause capital gains to come into affect. So, if I don't have my money in for a year yet I would get taxed as a short term investment. I thought that was a big reason to stay away from managed funds particularly because they are being changed a lot. So, if the three are identical, then that means the VTI would have the same problem. If that is the case I guess I'm even more confused than when I started. Because I thought the VTI is considered to be an ETF and so capital gains can't be realized unless I pull money out.

Also, will it truly jump over to VTIAX automatically?  I thought I would have had to switch it. Right now I don't have $10K, but it shouldn't take me too long to hit that mark.

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matchewed

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Re: Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« Reply #4 on: July 13, 2013, 04:47:50 pm »

I just switched mine and it was manual. Not complicated at all but there was no automation in initiating the change.

I personally haven't heard of forced distributions, but then again I don't know of anything expressly saying that it is impossible either. I think it's a strange fear to have as what would be the incentive? Also the managed funds "changing a lot" worry is a bit off base as the index fund just tracks the index. Take for example VTSMX it has a turnover rate of 3.2%, not exactly meeting anyone's definition of changing a lot.

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travis_cooper

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Re: Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« Reply #5 on: July 13, 2013, 05:08:11 pm »

Yes, my fears may not be reasonable. This is all because I just don't know how it works. I probably used the wrong terminology. I wasn't trying to say that the VTSMX fund was changing. What I meant by managed funds was a fund that is actively changing a lot. I realize that wasn't the right term, but I'm not sure what is.

I guess my concerns aren't warranted since this fund hasn't forced distributions lately and isn't likely to. I'm mostly just trying to understand the tax implications on each of these because I just don't know how it works. My understanding is that dividends get taxed as a long term investment and realized capital gains get taxed as short term if under a year or long term if over a year. That is the extent of what I know. So I was trying to learn how a mutual fund would come in to play since in theory you could have realized gains when the fund manager makes changes. So, please educate me. I'd just like to understand it better. And in regards to realized gains how is the mutual fund version (in theory) different from the VTI version? Even if in practice they aren't.

Outside of my 401K this is the first time I've tried investing. Mostly due to not understanding how things work, so any new knowledge would be awesome.

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matchewed

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Re: Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« Reply #6 on: July 13, 2013, 05:24:13 pm »

But what do you mean by makes changes? Maybe you can describe what you mean instead of trying for a term?

Dividend taxation for the US - http://en.wikipedia.org/wiki/Qualified_dividend

Capital Gains taxation for the US - http://en.wikipedia.org/wiki/Capital_gains_tax_in_the_United_States

Gains should be treated exactly the same. My recommendation would be to stick with the index fund and educate yourself in the short term. Read up on jlcollinsnh, particularly his stock series which is good for beginners. After that get some books on investing and start researching ETFs as it is probably a good idea to know why you should invest in something.

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travis_cooper

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Re: Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« Reply #7 on: July 13, 2013, 06:04:46 pm »

https://www.fidelity.com/learning-center/etf/etfs-tax-efficiency

That is what I'm basically referring to. My understanding is that a mutual fund is reallocating assets which would trigger capital gains. That is what I mean by them changing. So in theory the VTSMX could trigger more capital gains than the VTI would. Is that just wrong?

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matchewed

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Re: Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« Reply #8 on: July 13, 2013, 06:23:53 pm »

I'll be honest in that you're jumping into the deep end of the pool here.

But I'll quote something from the Vanguard website -

Quote

What is the difference between an actively managed fund and an index fund?

In an actively managed fund, a fund manager tries to outperform similar funds or an appropriate market benchmark. To do this, managers use research, market forecasts, and their own judgment and experience to buy and sell securities.

Index funds, sometimes called "passively" managed funds, don't try to beat the market. Instead, managers of index funds seek to closely track the performance of a target market index. Index funds buy and hold all, or a representative sample, of the securities in the index.
Which kind of fund is better—an actively managed fund or an index fund?

Both actively managed funds and index funds can play a role in an investment portfolio. Some investors who seek to outpace the market favor actively managed funds. However, actively managed funds may also do worse than the market average—and they often do.

Index funds typically enjoy a bit of a head start compared with actively managed funds because their operating and transaction costs are usually very low. Also, reduced trading activity tends to make index funds more tax-efficient, because index funds typically generate smaller capital gains distributions than actively managed funds. (Capital gains distributions are subject to taxes when the investment is held in a taxable account.)

Vanguard believes you can run an effective investment program using only index funds. But we recognize that it sometimes makes sense to index a major portion of your investments and use active funds to make your portfolio more conservative or aggressive, or to provide more or less income. A good rule of thumb to pursue this "core and more" approach is to consider investing at least 50% of your long-term investments in broadly diversified index funds.

From https://personal.vanguard.com/us/help/FAQMutualFundContent.jsp

Basically index funds do not encounter the circumstances that you are concerned about as often as a mutual fund.

Hope this helps, remember do some reading and educate yourself. Use an index fund in the meantime until you have a good grasp on what you want to invest in and what your risk tolerance is.

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travis_cooper

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Re: Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« Reply #9 on: July 13, 2013, 08:53:12 pm »

Yes, that is helpful thanks. I agree that I shouldn't do more until I understand better, so that is what I'm trying to do. So, since VTSMX, is an index and is "passively" managed it is more tax efficient than an actively managed fund. I guess I'm just trying to figure out what the differences are between VTSMX and VTI. From what I'm hearing it sounds like in practice they aren't really that much different. So I'll stick with the VTSMX and read up some more.

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kyleaaa

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Re: Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« Reply #10 on: July 14, 2013, 09:25:35 am »

At Vanguard, the index fund and ETF versions are actually just different share classes of the exact same fund. The index fund will never make capital gains distributions when the ETF does not and vice versa. This is patented and Vanguard is currently the only company allowed to implement things this way. With every other fund company, ETFs tend to be slightly more tax efficient. Vanguard is different. If you want to know more, there's a good white paper on this on the Vanguard institutional site somewhere. The bottom line is that the index fund will be exactly as tax efficient as the ETF, ignoring differences in the expense ratios. In fact, the index fund will actually be MORE tax-efficient than the ETF in this case because the higher ER will lower the taxable dividend yield.

FWIW, ETFs can and do distribute capital gains distributions, just like any other mutual fund. They are required by law to do so, in fact.

« Last Edit: July 14, 2013, 09:29:01 am by kyleaaa »

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grantmeaname

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Re: Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« Reply #11 on: July 14, 2013, 11:56:11 am »

kyleaaa, do you think you could find that whitepaper and link it here? That sounds fascinating, but I couldn't find it.

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travis_cooper

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Re: Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« Reply #12 on: July 14, 2013, 12:29:46 pm »

I agree, if you could find it that would be interesting to read. I just finished up all the stock series over at jlcollinsnh. It was really good stuff, thanks for the suggestion on that as well. I think my concerns are gone about the differences between the index version and the ETF version. Now I just need a couple more months to get over $10K so I can switch to the admiral shares. Thanks for all the comments you provided here. I've learned a lot and feel more at ease about my investment.

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kyleaaa

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Re: Vanguard ETF vs Vanguard Index Fund Tax Efficiency

« Reply #13 on: July 14, 2013, 03:43:03 pm »

I can't find it at the moment, but the advisor section of the site is easier to navigate. Here are two somewhat-relevant links, although they aren't very technical in nature.

https://advisors.vanguard.com/iwe/pdf/FASETFB.pdf
https://advisors.vanguard.com/iam/pdf/Efficiency_transcript2.pdf

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