Under the hood – Vanguard international index funds

underthehood

Vanguard issues annual reports for the firm’s international and global index funds on October 31 of each year. The reports provide information that can highlight some of the underlying conditions affecting a fund’s future capital gains distribution outlook; an indication of a fund’s foreign tax credit; the level of security lending in each fund, and a means of measuring investor turnover in the funds.

Tax implications

Capital gains

Mutual funds are legally structured as pass-through conduits of investment income. The income usually comes from dividends and interest received from securities or by profits realized by selling securities. By law, the fund must distribute income and gains to shareholders or else pay tax on retained income. Funds cannot, however, pass realized losses on to shareholders. These losses are retained by the fund, and can be used to offset future gains.

Taxable shareholders are no doubt pleased when they open their 2016 annual reports and see that none of the Vanguard international index funds has distributed a capital gain over the past five fiscal years.

While not distributing gains, the funds at times realize net gains during a given fiscal year. Often a fund will offset any realized gains with realized losses, or use retained loss carryovers to offset gains, thus providing shareholders zero capital gains distributions.

In addition Vanguard international index funds contain both mutual fund share classes and exchange-traded fund share classes. The exchange-traded funds frequently realize in-kind redemption gains. Because in-kind redemption gains are not taxed to the fund or its shareholders, the fund manager will usually select shares with the lowest tax basis for redemption baskets.

Although these gains are not taxed, they are nonetheless included in a fund’s reported annual realized gain. Netting out these non-taxable gains produces the actual taxable gain or actual realized loss. The table below shows the 2016 reported gain or loss realized for each Vanguard international fund, the in-kind redemption gain or loss, and the actual net realized gain or loss.

As an accounting entry, in-kind redemption gains become a part of the fund’s paid in capital.

Fund Gain/Loss In-kind redemption Net Gain/Loss
Total international (469,376,000) 104,860,000 (574,236,000)
FTSE all world ex US 37,290,000 259,929,000 (222,639,000)
Europe (249,917,000) (141,245,000) (108,672,000)
Pacific 34,253,000 23,054,000 11,199,000
Emerging markets (362,456,000) 215,435,000 (577,891,000)
FTSE all world ex US small 3,810,000 87,460,000 (83,650,000)
Total World 6,772,000 133,515,000 (126,743,000)
Global ex us real estate (31,723,000) 7,366,000 (39,089,000)

More on loss carryovers

As noted, realized losses cannot be distributed to shareholders. Surplus losses can be “carried over” to subsequent years when they can be used to offset future gains. Prior to 2010, these carryover losses where subject to expiration dates.

The passage of the Regulated Investment Company Act Modernization Act of 2010 stipulated that mutual fund losses could be carried over indefinitely, but these losses must be used before taking any expiring loss carry forwards.

The table below shows each fund’s loss carry forward and shows both the amount and percentage of unexpiring carry forwards.

Fund Total loss carry forwards Post 2011 unexpiring % unexpiring
Total international 1,827,738,000 1,364,725,000 74.67%
FTSE all world ex US 1,284,197,000 1,034,342,000 80.54%
Europe 2,065,201,000 0.00%
Pacific 691,470,000 0.00%
Emerging markets 9,280,265,000 7,171,663,000 77.28%
FTSE all world ex US small 158,672,000 149,956,000 94.51%
Total World 166,213,000 142,639,000 85.82%
Global ex us real estate 88,065,000 86,177,000 97.86%

The considerable level of unexpiring carryover losses in most of the funds suggests that most, if not all, of the carryover losses with expiration dates will actually expire without being used. As the table below indicates, both the Vanguard FTSE All World ex-US Index Fund  and the Vanguard Emerging Markets Index Fund had carryover losses expire in 2016.

If a carryover loss expires, it becomes a part of the fund’s paid in capital.

Fund 2016 expired 10/31/2017 expiring 10/31/2018 expiring 10/31/2019 expiring
Total international 463,013,000
FTSE all world ex US 29,919,000 138,342,000 32,560,000 79,230,000
Europe 1,500,333,000 282,885,000 166,753,000
Pacific 607,373,000 29,743,000 54,384,000
Emerging markets 59,681,000 1,591,794,000 212,374,000 301,434,000
FTSE all ex US small 8,716,000
Total World 777,000 1,086,000 14,711,000
Global ex us real estate 1,948,000

 The exchange-traded fund

Given that in-kind redemption helps improve a fund’s tax basis, it is somewhat  helpful to examine a fund’s share class distribution. Most Vanguard index funds have mutual fund share classes (investor shares, lower cost admiral shares, and institutional shares) as well as exchange-traded fund shares. The following table shows the ratio of exchange-traded fund share class assets to total fund share class assets. As one can see, exchange-traded shares represent a majority share of most of Vanguard’s international index funds. The lone exception is the total international fund, which has a history dating back to 1994, but only added exchange-traded shares in 2011.

Fund Total assets ETF assets ETF/Total assets
Total international 224,342,756,000 6,376,574,000 2.84%
FTSE all world ex US 24,794,448,000 13,982,600,000 56.39%
Europe 15,423,083,000 10,533,175,000 68.29%
Pacific 5,771,648,000 3,216,633,000 55.73%
Emerging markets 62,588,324,000 44,636,253,000 71.32%
FTSE all world ex US small 3,346,669,000 2,652,168,000 79.25%
Total World 8,807,937,000 6,112,245,000 69.39%
Global ex us real estate 4,212,703,000 3,615,983,000 85.84%

Foreign tax credit

The annual report reveals the amount of foreign tax a fund has paid during the fiscal year. The foreign tax paid on the fund’s dividend income can qualify for a foreign tax credit on a taxable investor’s tax return. Dividing the foreign tax by a fund’s average net assets provides a percentage estimate of the value of the credit.

Fund Average net assets Foreign tax paid
Foreign tax credit
Total international 202,714,183,000 440,080,000 0.22%
FTSE all world ex US 23,845,133,000 49,957,000 0.21%
Europe 18,645,512,000 38,969,000 0.21%
Pacific 5,462,150,000 9,440,000 0.17%
Emerging markets 53,483,810,000 168,824,000 0.32%
FTSE all world ex US small 3,141,534,000 6,335,000 0.20%
Total World 8,371,988,000 8,364,000 0.10%
Global ex us real estate 3,932,070,000 9,691,000 0.25%

Security lending

Vanguard international stock index funds  earn additional income by lending securities to qualified institutional borrowers. The firm allocates 100% of after expense  security lending earnings to the fund.

A fund’s expenses are paid out of fund earnings. Given that the US tax code gives a tax preference to dividends that qualify for lower tax rates, it is prudent for fund managers to allocate non-qualified income to fund expenses. The table below shows the amount of security lending income earned by each fund in fiscal year 2016 and calculates its percentage ratio to total annual fund expenses.

Fund Net security lending income Total expenses % of expenses
Total international 227,362,000 250,732,000 90.68%
FTSE all world ex US 20,548,000 25,126,000 81.78%
Europe 22,159,000 19,006,000 116.59%
Pacific 5,840,000 5,773,000 101.16%
Emerging markets 33,951,000 73,923,000 45.93%
FTSE all ex US small 11,288,000 4,699,000 240.22%
Total World 4,632,000 9,995,000 46.34%
Global ex us real estate 2,846,000 5,975,000 47.63%

 Turnover

The annual report documents the rate of annual turnover of its assets by the fund manager. In addition, the reports also document the sales and redemption of fund shares by shareholders. This data allows us to compute a redemption to average net assets ratio (R/ANA) that corresponds to a shareholder annual turnover rate. The following table reports the investor sales and redemption in each fund using a composite total of all share classes.

In fiscal year 2016 investors were net redeemers of shares in the Vanguard European Stock  and Vanguard Pacific Stock index funds.

Fund Average net assets Sales Redemptions
Total international 202,714,183,000 55,744,501,000 22,445,198,000
FTSE all world ex US 23,845,133,000 4,255,165,000 3,648,657,000
Europe 18,645,512,000 1,060,853,000 5,299,755,000
Pacific 5,462,150,000 888,414,000 914,136,000
Emerging markets 53,483,810,000 10,951,814,000 5,665,493,000
FTSE all world ex US small 3,141,534,000 683,793,000 410,783,000
Total World 8,371,988,000 2,225,311,000 1,323,799,000
Global ex us real estate 3,932,070,000 711,061,000 169,649,000

The table below provides ratio data for each fund. The turnover percentage documents the fund manager turnover of assets. The R/ANA ratio documents the shareholder turnover of assets. The redemption to sales ratio ( R/S ) shows net shareholder purchase or net shareholder redemption in a fund. A ratio less than one shows net purchase; a ratio greater than one shows net redemption.

The R/ANA and R/S ratios, viewed together, can signal market timing activity within a fund. For example a fund showing an R/ANA ratio of 400% and an R/S ratio of 1 (equal buys and sells) is likely being market timed by fund shareholders.

Fund Turnover R/ANA R/S
Total international 3% 11% 0.40
FTSE all world ex US 5% 15% 0.86
Europe 6% 28% 5.00
Pacific 4% 17% 1.03
Emerging markets 13% 11% 0.52
FTSE all world ex US small 14% 13% 0.60
Total World 15% 16% 0.59
Global ex us real estate 7% 4% 0.24

Notes

  • Table data is derived from fund annual reports. Average net asset data is derived from NSAR reports on EDGAR. The computations are derived from  this google spreadsheet.
  • The Vanguard Developed Market Index Fund has a fiscal year ending December 31. The annual report is not issued along with Vanguard’s international and global stock funds examined in this report.
About

Barry Barnitz, administrator of both the Bogleheads® wiki and of Financial Page, a Bogleheads® blog

Posted in international stocks, Market statistics, Vanguard
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