Under the hood – Vanguard US stock index funds

underthehood

Vanguard issues annual reports for the firm’s US stock index funds on December 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; 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 US stock 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 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 US stock 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 market 4,014,156,000 3,628,320,000 385,836,000
S&P 500 6,689,644,000 6,081,373,000 608,271,000
Extended 2,901,190,000 2,995,349,000 (94,159,000)
Large cap 134,455,000 199,956,000 (65,501,000)
Large growth 1,085,171,000 1,361,993,000 (276,822,000)
Large value 1,023,424,000 1,144,327,000 (120,903,000)
Mid cap 1,581,507,000 2,668,928,000 (1,087,421,000)
Mid growth 162,893,000 286,582,000 (123,689,000)
Mid value 347,074,000 578,156,000 (231,082,000)
Small cap 1,377,249,000 1,372,134,000 5,115,000
Small growth 233,693,000 515,782,000 (282,089,000)
Small value 705,795,000 792,428,000 (86,633,000)

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 carryforwards 2011 forward unexpiring % unexpiring
Total market 463,562,000 463,562,000 100.00%
S&P 500 840,474,000 840,474,000 100.00%
Extended 588,093,000 513,931,000 87.39%
Large cap 143,755,000 119,578,000 83.18%
Large growth 1,314,208,000 1,014,031,000 77.16%
Large value 727,435,000 394,058,000 54.17%
Mid cap 3,040,157,000 2,745,184,000 90.30%
Mid growth 483,894,000 410,680,000 84.87%
Mid value 497,430,000 493,393,000 99.19%
Small cap 2,454,536,000 1,508,379,000 61.45%
Small growth 1,462,399,000 958,199,000 65.52%
Small value 1,328,580,000 451,998,000 34.02%

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.

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
Total market 488,298,000
S&P 500 1,763,970,000
Extended 49,578,000 24,584,000
Large cap 24,177,000
Large growth 300,177,000
Large value 333,377,000
Mid cap 294,968,000
Mid growth 73,214,000
Mid value 4,037,000
Small cap 342,008,000 604,149,000
Small growth 243,082,000 26,118,000
Small value 487,808,000 388,774,000

 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.

Fund Total assets ETF assets ETF/Total assets
Total market 498,451,932,000 69,888,585,000 14.02%
S&P 500 282,566,005,000 56,648,348,000 20.05%
Extended 51,549,471,000 4,387,040,000 8.51%
Large cap 13,930,686,000 8,468,323,000 60.79%
Large growth 54,328,435,000 23,040,383,000 42.41%
Large value 50,821,374,000 27,126,412,000 53.38%
Mid cap 76,489,779,000 16,543,668,000 21.63%
Mid growth 7,959,422,000 3,575,811,000 44.93%
Mid value 12,997,846,000 6,382,813,000 49.11%
Small cap 69,441,629,000 16,152,927,000 23.26%
Small growth 16,794,104,000 5,327,546,000 31.72%
Small value 24,750,316,000 10,042,425,000 40.57%

Security lending

Vanguard US 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 market 106,116,000.00 271,381,000.00 39.10%
S&P 500 10,155,000.00 128,238,000.00 7.92%
Extended 52,750,000.00 31,145,000.00 169.37%
Large cap 762,000.00 7,713,000.00 9.88%
Large growth 4,328,000.00 32,775,000.00 13.21%
Large value 2,041,000.00 26,165,000.00 7.80%
Mid cap 9,486,000.00 42,717,000.00 22.21%
Mid growth 1,095,000.00 5,720,000.00 19.14%
Mid value 1,002,000.00 7,973,000.00 12.57%
Small cap 51,566,000.00 37,662,000.00 136.92%
Small growth 20,574,000.00 12,616,000.00 163.08%
Small value 9,671,000.00 15,550,000.00 62.19%

 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.

Fund Average net assets Sales Redemptions
Total market 440,969,702,000 95,895,015,000 51,498,624,000
S&P 500 242,719,121,000 72,162,665,000 35,913,371,000
Extended 42,368,425,000 18,920,634,000 16,934,749,000
Large cap 12,279,972,000 2,886,081,000 1,356,555,000
Large growth 50,886,247,000 9,893,003,000 8,153,452,000
Large value 42,368,425,000 13,560,482,000 6,695,429,000
Mid cap 69,548,210,000 18,807,916,000 15,244,923,000
Mid growth 7,387,830,000 2,176,724,000 1,893,721,000
Mid value 10,500,799,000 5,514,241,000 2,778,376,000
Small cap 59,060,632,000 15,992,026,000 10,531,925,000
Small growth 15,346,605,000 4,232,523,000 4,059,635,000
Small value 19,442,575,000 8,743,614,000 4,789,519,000

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 market 4% 12% 0.54
S&P 500 4% 15% 0.50
Extended 6% 40% 0.90
Large cap 5% 11% 0.47
Large growth 11% 16% 0.82
Large value 7% 16% 0.49
Mid cap 15% 22% 0.81
Mid growth 21% 26% 0.87
Mid value 20% 26% 0.50
Small cap 14% 18% 0.66
Small growth 27% 26% 0.96
Small value 18% 25% 0.55

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.
About

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

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Posted in indexing, Market statistics, Vanguard
March 2017
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