/ Taxes

ETFs are Generally More Tax Efficient than Mutual Funds, but Vanguard is Special

Firstly, none of this matters in a retirement account; this is only relevant in a taxable account.

In General

Mutual Funds

When a mutual fund sells shares of securities for a gain, it realizes a capital gain. This capital gain must be passed onto shareholders as a capital gains distribution. You then pay the taxes on these capital gains distributions as if they were your own capital gains.[1].

ETFs

ETFs on the other hand, do not have this problem. Now I'm no expert as to why this is the case, but my understanding is this has to do with the way ETFs are structured. Mutual funds pool the mutual fund shareholders' money together, and they all collectively own the underlying investments. When a mutual fund sells its shares, it's the same as if you individually sold some securities.
But with an ETF, you're not actually pooling money together to buy securities. The entity that set up the ETF has already bought all the underlying securities and is selling shares of this fund. When you sell a ETF, the underlying securities aren't sold. You're just selling your ETF shares to someone else.

Regardless of whether I got the how correct, the point here is that there's no such thing as a capital gains distribution for an ETF.

Vanguard is Special

From the Bogleheads wiki:

Vanguard ETFs are structured as another share class of a mutual fund, like Admiral or Investor shares. This is a process unique to Vanguard, protected by a patent until 2023, with two important consequences for the mutual fund investor:

  1. Tax efficiency: the mutual fund shares benefit from the disposition of capital gains through ETF shares, making Vanguard funds with ETF share classes as efficient as an ETF.
  2. Conversion: mutual fund shares can be converted to ETF shares without a taxable event. This helps when transferring assets to another broker, including charitable donations. Conversion in the other direction is not possible.

The second point is an argument to start with mutual fund shares at Vanguard, if unsure. One can always convert to ETF later if needed.

I am not entirely certain on how exactly capital gains are disposed of through the ETF shares. I tried reading through the patent[2] but I couldn't quite make sense of it. One way would be to issue and sell more ETF shares instead of selling the underlying securities, but shouldn't that devalue everyone's ETF shares? Regardless, we can examine the history of capital gains distributions from Vanguard mutual funds.

Years of the last capital gains distributions for some Vanguard index funds:

  • VTSAX (Total Stock Market Index): 2000
  • VFIAX (S&P 500 Index): 1999
  • VEXAX (Extended market index, complement to the S&P 500 that if held in an approximately 1:4 ratio with the S&P 500 fund, is equivalent to a total market fund): 2001
  • VTIAX (Total International Index): 2000
  • VFWAX(Total World Index): since its inception in 2008[3]

So the last time there were any capital gains distributions from the funds I examined was 2001. I expect this to hold true for Vanguard's other funds that have ETF shares available.

But why did they issue capital gains distributions in 2001 and prior? Well patents only last 20 years. Vanguard's patent expires in 2023, meaning it was approved in 2003[4], so they hadn't implemented this technique yet.

Come 2023, we may see other companies implement something similar for their mutual funds. Until then, if you want the tax efficiency of an ETF but the conveniences of mutual funds, Vanguard is your only option.


  1. If the fund realizes losses, there's no such thing as a capital loss distribution for you to deduct on your taxes. However, this does reduce any future capital gains distributions that you would receive ↩︎

  2. US Patent 6879964 ↩︎

  3. The Bogleheads wiki has 0.005 in the long term capital gains column for 2008. I believe this to be a typo in that they typed 5 instead of shift+5 for %. This is also corroborated by the fact that they have the sentence "The Vanguard Total World Index Fund has not distributed a capital gains distribution from its inception in 2008" ↩︎

  4. The earliest patent I could find for this from Vanguard using the US Patent Office website was filed in March 2001 and granted in April 2005, which conflicts with what the Bogleheads wiki says. Regardless, Vanguard didn't even file the patent until 2001, so it stands to reason that they weren't using this technique yet ↩︎

ETFs are Generally More Tax Efficient than Mutual Funds, but Vanguard is Special
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