Under the hood – Vanguard international index funds in 2018

Female driver inspects her car engine

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 2018 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 2018,  the Vanguard Europe Stock Market Index fund,  the Vanguard Pacific Stock Market Index fund and the Vanguard FTSE All-World ex US Small Cap Index fund used loss carryovers to offset realized gains.

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 2018 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 (595,636,000) (189,375,000) (406,261,000)
FTSE all world ex US (324,877,000) 56,429,000 (381,306,000)
Europe 664,347,000 478,939,000 185,408,000
Pacific 330,396,000 277,404,000 52,992,000
Emerging markets (730,458,000) 781,913,000 (1,512,371,000)
FTSE all world ex US small 198,737,000 175,546,000 23,191,000
Total World 424,260,000 473,959,000 (49,699,000)
Global ex us real estate 37,970,000 49,332,000 (11,362,000)

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 10/31/2019 expiring % unexpiring
Total international 2,832,810,000 2,832,810,000 100.00%
FTSE all world ex US 1,697,428,000 1,618,198,000 79,230,000 95.33%
Europe 166,753,000 0 166,753,000 0.00%
Pacific 30,179,000 0 30,179,000 0.00%
Emerging markets 9,555,764,000 9,254,331,000 301,434,000 96.85%
FTSE all world ex US small 127,557,000 118,842,000 8,716,000 93.17%
Total World 230,696,000 215,985,000 14,711,000 93.62%
Global ex us real estate 132,727,000 130,779,000 1,948,000 98.53%

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, six of the international funds had carryover losses expire in 2017.

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

Fund 2017 Expired 2018 Expiring 10/31/2019 Expiring
Total international 463,014,000
FTSE all world ex US 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 1,591,794,000 212,374,000 301,434,000
FTSE all world ex US small 8,716,000
Total World 777,000 1,086,000 14,711,000
Global ex us real estate 1,948,000

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. In addition, mutual fund shares of the Total International Fund are used in Vanguard ‘s suites of  balanced target date and target risk funds.; the positive investor inflows into these funds  assures a large issuance of Total International mutual fund shares.

Fund Total Assets ETF Assets ETF/Total Assets
Total international 336,345,742,000 10,388,594,000 3.09%
FTSE all world ex US 34,670,286,000 21,347,772,000 61.57%
Europe 20,272,396,000 14,624,418,000 72.14%
Pacific 6,798,050,000 3,927,266,000 57.77%
Emerging markets 73,793,367,000 53,764,653,000 72.86%
FTSE all world ex US small 6,015,802,000 5,008,576,000 83.26%
Total World 15,623,716,000 11,372,077,000 72.79%
Global ex us real estate 5,910,583,000 5,269,877,000 89.16%

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 Foreign tax credit
Total international 343,637,448,362 785,158,000 0.23%
FTSE all world ex US 37,740,222,709 90,394,000 0.24%
Europe 24,261,983,308 82,529,000 0.34%
Pacific 7,938,723,109 14,701,000 0.19%
Emerging markets 87,867,786,876 246,058,000 0.28%
FTSE all world ex US small 6,248,183,927 14,657,000 0.23%
Total World 16,078,812,270 22,221,000 0.14%
Global ex us real estate 6,592,457,927 18,393,000 0.28%

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 2018 and calculates its percentage ratio to total annual fund expenses.

Fund Net Security Lending Income Total Expenses % of Expenses
Total international 227,820,000 396,908,000 57.40%
FTSE all world ex US 16,117,000 35,329,000 45.62%
Europe 15,331,000 22,386,000 68.48%
Pacific 6,893,000 7,529,000 91.55%
Emerging markets 43,295,000 110,741,000 39.10%
FTSE all ex US small 16,583,000 8,355,000 198.48%
Total World 5,105,000 8,355,000 32.78%
Global ex us real estate 6,208,000 8,024,000 77.37%

 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 international 343,637,448,362 89,822,911,000 36,789,219,000
FTSE all world ex US 37,740,222,709 6,312,802,000 3,584,681,000
Europe 24,261,983,308 2,809,864,000 4,168,643,000
Pacific 7,938,723,109 944,664,000 1,601,195,000
Emerging markets 87,867,786,876 8,400,166,000 11,163,685,000
FTSE all world ex US small 6,248,183,927 2,045,851,000 727,669,000
Total World 16,078,812,270 4,561,053,000 2,253,651,000
Global ex us real estate 6,592,457,927 1,374,943,000 592,709,000

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. As can be seen, investors executed net redemption  in all three of the Vanguard regional stock index funds (Europe, Pacific, and Emerging Markets).

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% 0.41
FTSE all world ex US 4% 9% 0.57
Europe 6% 17% 1.48
Pacific 4% 20% 1.69
Emerging markets 11% 13% 1.33
FTSE all world ex US small 15% 12% 0.36
Total World 9% 14% 0.49
Global ex us real estate 7% 9% 0.43

Transaction costs

Mutual funds buy and sell stocks as investors purchase and liquidate fund shares. Funds also buy and sell shares  in order to track changes in index reconstitution. These transactions incur brokerage commission expense, bid/asks spreads and market index costs.  However, in-kind transactions do not bear these transaction costs. The following table provides the dollar totals of share transactions and in-kind transactions for the funds. The percentage of in-kind transactions to total transactions is also included.

Fund Purchases In-kind Purchases Pct. Sales In-kind Sales Pct.
Total international 72,170,144,000 1,777,153,000 2.46% 12,236,580,000 484,775,000 3.96%
FTSE all world ex US 5,077,779,000 1,816,919,000 35.78% 2,177,605,000 116,988,000 5.37%
Europe 3,129,238,000 2,928,007,000 93.57% 4,311,809,000 2,928,007,000 67.91%
Pacific 662,927,000 284,903,000 42.98% 1,238,076,000 942,547,000 76.13%
Emerging markets 10,023,584,000 625,255,000 6.24% 12,130,320,000 2,113,945,000 17.43%
FTSE all world ex US small 2,690,811,000 976,170,000 36.28% 1,341,474,000 430,716,000 32.11%
Total World 4,695,239,000 2,710,284,000 57.72% 2,309,219,000 909,943,000 39.40%
Global ex us real estate 1,630,564,000 988,439,000.00 60.62% 787,971,000 353,169,000 44.82%

Notes

  • Table data is derived from fund annual reports. Average net asset data is derived from N-CEN 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. In addition I serve as an administrator of finiki, the Canadian financial wiki, and as an administrator of the John C. Bogle Center for Financial Literacy site.

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