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; a means of measuring investor turnover in the funds; and a look at how mutual fund trading techniques reduce transaction costs.
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 following 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 2018 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. Note that in 2018, the Vanguard S&P 500 Index Fund, the Vanguard Large Cap Index Fund, and the Vanguard Small Cap Index Fund used loss carryover losses to offset net realized gains.
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|
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 carryovers. At year-end 2018, all unused expiring loss carryovers have been added to a fund’s tax cost basis, so that the remaining loss carryovers have no expiration dates.
The table below shows each fund’s loss carryover.
|Fund||Total loss carryovers|
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|
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 2018 and calculates its percentage ratio to total annual fund expenses.
|Fund||Net security lending income||Total expenses||% of expenses|
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. In addition 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. For the 2018 fiscal year all of the funds documented below experienced net investor inflows.
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.
One of the main arguments for investing in passive index funds is the relative assurance of reaping a fair share of market returns. But as market benchmarks bear no costs, an index fund manager needs to reduce frictional costs in order to better attain the market return. Costs include not only the fund expense ratio, but also the fund’s transaction expenses for buying and selling securities.
While mutual fund managers rarely provide specific details concerning proprietary trading techniques, there are certain trading mechanisms that clearly reduce transaction costs. For example, mutual fund managers can reduce transaction expenses through the use of cross trading securities and by making in-kind transactions when buying and selling securities.
A cross trade takes place when an investment manager “swaps” a security between separate funds that he or she manages. These types of transactions are regulated by section 17 CFR 270.17a-7 of the Investment Company Act of 1940 and, for plans governed by ERISA, the Statutory Exemption for Cross-Trading of Securities. The manager must prove a fair market price for the transaction and record the trade as a cross for proper regulatory classification.
An example will let us see how a cross trade eliminates transaction costs. Suppose our manager operates both a small cap growth index fund and a mid cap growth index fund. When the tracker indexes reconstitute, a small growth company is reclassified as a mid cap growth company. If the manager uses market transactions to sell the stock from the small cap index fund, and then buy the stock for the mid cap index fund, the funds will pay brokerage commissions and spread costs on both the sale and purchase. Alternately, with a cross sale transaction, the manager will trade internally between the funds. There will be no commission expense for this trade and there is no need for a bid ask spread.
In-kind transactions are permitted for both mutual funds and exchange-traded funds. In-kind purchases and sales of securities are specifically used by exchange-traded funds. With securities being transferred in-kind, there are no brokerage commissions or bid ask spreads incurred since there are no sales or purchases of the transferred shares.
The following table shows both the separate and the combined percentage of cross trades and in-kind transactions in US stock index funds.
|Fund||Cross purchase||In-kind purchase||Total purchase||Cross sale||In-kind sale||Total sale|
|Vanguard Total Market||0.00%||23.37%||23.37%||0.00%||31.13%||31.13%|
|Vanguard Large Cap||0.00%||69.01%||69.01%||0.00%||56.02%||56.02%|
|Vanguard Mid Cap||8.68%||25.77%||34.45%||13.60%||25.05%||38.65%|
|Vanguard Mid Growth||14.06%||26.42%||40.48%||22.09%||29.48%||51.57%|
|Vanguard Mid Value||15.35%||37.62%||52.97%||12.80%||39.96%||52.76%|
|Vanguard Small Cap||8.25%||44.95%||53.20%||10.51%||47.02%||57.53%|
|Vanguard Small Growth||10.90%||47.01%||57.91%||21.15%||45.93%||67.08%|
|Vanguard Small Value||22.66%||37.23%||59.89%||15.55%||38.44%||53.99%|
Transaction cost estimates
John Bogle, in his Financial Analysts Journal article, The Arithmetic of “All-In” Investment Expenses, provides a simple framework for estimating mutual fund transaction expenses. Here are the inputs:
- Total transactions: Bogle argues that the officially defined mutual fund turnover ratio (the lesser of purchases or sales divided by average net assets) is inappropriate for cost analysis, since both purchases and sales incur costs.
- Transaction expense: Bogle conservatively estimates an 0.50% transaction cost X modified turnover for active mutual funds and a zero percent cost for index funds, although open to the use of the 0.50% cost for both active and index funds.
For our estimates we use the following inputs:
- Total transactions: We follow the Bogle suggestion of using both purchases and sales as a turnover input. However since in-kind transactions and cross trades do not incur transaction expense, we subtract these from the turnover calculation.
- Transaction expense: We use the 0.50% transaction cost estimate.
The table below provides our modified Bogle turnover calculations and transaction cost estimates for the Vanguard suite of CRSP index funds.
|Fund||Bogle modified turnover||Bogle transaction cost|
|Vanguard Total Market||14%||0.07%|
|Vanguard Large Cap||10%||0.05%|
|Vanguard Mid Cap||29%||0.14%|
|Vanguard Mid Growth||40%||0.20%|
|Vanguard Mid Value||32%||0.16%|
|Vanguard Small Cap||26%||0.13%|
|Vanguard Small Growth||31%||0.16%|
|Vanguard Small Value||26%||0.13%|