Author Topic: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"  (Read 23652 times)

brooklynguy

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Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« on: November 04, 2015, 11:36:22 AM »
In the comments to one of his recent blog posts, Josh Kennon highlighted a potential tax issue lurking under the surface for investors who invest in mutual funds (including index funds) in their taxable accounts:  "embedded gains."  In a nutshell, the concern is that many mutual funds have unrealized capital gains from appreciation of their underlying shareholdings that could, under the right circumstances, result in a (potentially massive) tax liability for current holders of the mutual fund shares.  I've read about this issue before but never really gave it much thought until I read Kennon's (alarmist?) description.

Given the overlap between this forum's membership and Kennon's blog's readership, I was surprised not to have seen his comments (made over a week ago) talked about here.  So I just searched the forum and found that, sure enough, someone actually did bring this up:

Another thing regarding index funds' youth : they have never failed, yet. But, at some point in their history, they certainly will. There will be some fraud. Or some unjustified panic. Here in Europe, most index funds aren't invested only in the stocks in the index they are replicating. They handle complicated derivatives that allow them to be less expensive ; some more serious houses (I guess even Vanguard does it) do lend shares for short sellers, here again to reduce costs. I a bad bear market, this can go wrong. And even if you index fund does not fail, even if he was very cautious, panicking investors might try to sell massively their shares. On these hard days, the value of your shares can go far away from the underlying index, or can become very illiquid (which can be a problem if you need the money at that moment).

Joshua Kennon wrote a very salient comment on this (I'll try to dig up a link). His point was that many index funds, Vanguard especially, are massively loaded with unrecognized capital gains. On a normal day to day basis they can fund redemptions with incoming cash flow, but if there was ever a run on the fund they would be forced to sell and recognize part of these gains and passing them on to shareholders. For tax-advantaged accounts this is not an issue, but if you hold index funds in taxable accounts you have to be aware that at some point, you may be forced to pay part of someone else's tax bill because Vanguard forced capital gains on you.

Edit: Link to Joshua's comment. That whole article and the comments are very interesting.

Surprisingly, though, not one person reacted to or commented on protostache's post, perhaps because it got lost in the broader debate occurring in that thread.  So I'm starting a new thread on this topic to hopefully generate more discussion, because I think it's a topic worth discussing (or at least being aware of).

Here is the full text of the primary relevant comment from Kennon's blog post:

Quote from: Josh Kennon
I'd bet 95%+ of investors don't [give any thought to the potential "embedded gain" tax issue]. It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery. They, quite literally, could be putting a massive amount of their winnings on the chopping block for the IRS to come in and grab it if the stars happen to line up in the wrong configuration. It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.

If you want to see a truly, jaw-dropping example, go back and look at the famous Sequoia Fund report from years past. Here is just one example. It was setup by a friend of Warren Buffett following the dissolution of the main Buffett partnership and continued to hold a lot of Berkshire Hathaway stock. In that particular, randomly chosen year (2005), of the $3,772,382,901 in net asset value, $2,345,962,204 represented unrealized capital gains. While the fund was closed to outside investors for decades, management used to outright warn existing shareholders to stop buying it in taxable accounts because the (first world, to be sure) problem had grown so excessive due to their fantastic record they were going to get slaughtered at some point; it was all but an inevitability.

Smaller investors don't have to worry about this sort of thing because almost all of their money is in Roth IRAs or whatnot. That's what I mean when I say they take a rational solution for them (if you don't know what you are doing, have a tiny amount of money, and want good diversification, index funds are a Godsend) and attempt to scale it beyond amounts they can possibly comprehend or understand. It would be like trying to build a skyscraper using the same tools and technology as a log cabin. It's gong to end in disaster because there are complications, rules, regulations, tax quirks, and other things that suddenly become an issue, which they never confronted and don't even know to guard against.

Vanguard's S&P 500 fund is one of the worst in this respect. Of the $198,712,172,000 in assets it had at the end of its fiscal year, a whopping $89,234,130,000 consisted of unrealized capital gains that could someday be triggered. (Take a look at the 2014 annual report in PDF format for yourself.) That's almost 45% of the entire capital base! Stop for a moment and let the horror of that set in. If you're affluent and in a top tax bracket, subject to the 20% rate + the 3.8% Obamacare tax + a state tax on capital gains, we're talking real money that could potentially flow out the door even if you're simultaneously suffering losses (assuming you don't want to sell at a loss to try and offset the gain) as you pick up someone else's tab. What sane person would buy the fund in a taxable account under these circumstances? A 401(k), 403(b), SEP-IRA, whatever ... sure. A brokerage account? No. Absolutely not. Why take on the risk? The generational tax consequences are severe, too. If you held the individual securities, instead, you could potentially pass them on to your children using the stepped-up basis loophole, whereas you can't do it with the underlying appreciated shares of an index fund.

If - if - indexing continues to receive a disproportionate share of asset inflows over the coming few decades and we reach a tipping point where it decouples from underlying intrinsic value due to money flows exerting a bigger influence on market quotations (and therefore market capitalizations), between the potential tax consequences and the silent methodology changes over the past decade and a half that have torn the S&P 500 off its underlying historical hinges, favoring the rich insiders over the mom and pop investors, I think there could come a day, under the wrong set of circumstances, John Bogle - a man for whom I have enormous respect - is scapegoated as having unleashed the equivalent of the CDO or sub-prime debt on the world when the real culprit was the fact that so many of the people adhering to his philosophy lacked his common sense. Bogle wouldn't have been buying an equity index fund at 70x earnings or if it had some how gone off the rails. He's too smart. He's got too much Graham in him. Yet, so many of the acolytes have no idea what they own, why they own it, or why indexing works. They worship its form while remaining totally ignorant to its substance. I vacillate between feeling, "they'll get what they deserve" and "maybe they're good people who, though they'll view you as the enemy for pointing this out, don't know better and you should write about it".

(emphasis in original)

Thoughts?

Gone Fishing

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #1 on: November 04, 2015, 11:53:33 AM »
Interesting.  Posting to follow.

Interest Compound

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #2 on: November 04, 2015, 12:00:42 PM »
Quote
It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery.

...

It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.

Honestly, this whole thing reads like click-bait, nothing more than an advisor trying to justify their services in a world where they are growing increasingly less relevant.

Telecaster

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #3 on: November 04, 2015, 12:09:36 PM »
I understand this is more of an issue for managed funds, when the fund manager decides to take some profits after a period of gains.   I'm not quite sure I see the problem for index funds, which tend to have low turn over.  And the stocks that do turn over,tend to be ones that aren't doing well and therefore get dropped from the index.   In that case, you are more likely to benefit from embedded losses than get penalized from embedded gains.   


Kennon posits there could be a problem if there is a "run on the fund."  Has that ever happened on an index fund?   

PathtoFIRE

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #4 on: November 04, 2015, 12:17:10 PM »
I certainly noticed that comment; he's also got a short post on his about.com site about it http://beginnersinvest.about.com/od/capitalgainstax/a/mutual_fund_tax.htm

Naturally, my first thought was "oh no, that's me he's talking about!" I'm certainly plowing tons of money into aftertax mutual funds (VTSAX and VTIAX), and my understanding of the stock market and company valuations is rudimentary. The one thing lacking from throwing me in a further worry though is that he didn't provide any examples of where this has happened. Yes, this rise of giant mutual funds supported by less-sophisticated investors is a relatively new phenomenon, but I began to wonder if this is simply something out of the sphere of my control.

Someone with more knowledge can chime in, but the only fund that I'm aware of that has suffered major outflows in recent years is PIMCO Total Return A (PTTAX) fund, which googling showing went from $293B in April 2013 to less than $100B in September 2015. I don't see reports of major capital gains distributions or other negative effects on investors, but this is a bond fund, so maybe we wouldn't expect as severe of consequences.

So then the question is, what are we to do? Diversifying into alternative but similar funds (substituting Fidelity for Vanguard, or SP500 for Total Stock Market) wouldn't help in the types of scenarios that are envisioned triggering these problems, because every one of these should be facing similar 1) capital gains + 2) records outflows. Individual stocks? Well I'm trying to avoid going down that rabbit hole, I guess my aftertax capital is sufficiently large now that I could try to replicate the SP500, but first I'm going to trigger personal capital gains, and second that will certainly involve a lot more research and work to maintain (I don't think Joshua Kennon would consider that an actual downside). I can't deny that I'm tempted to go in on his new fund that he's creating, but I'd need to liquidate most of my aftertax holdings to meet his minimum, and while he certainly seems like an honest and trustworthy person, I'd be substituting one form of risk for others. At least the potential capital gains bill is a known known, something that I can plan around and attempt to mitigate.

I think my final answer is that his warning won't deter me from continuing the course, but I will have an eye to diversifying my aftertax holdings beyond holding just VTIAX and VTSAX. I already hold a large chunk in DGEIX from my early days using an advisor, and while I have attempted to whittle that down, I think I'll stop and be happy to hold about 1/4 of my aftertax money in that fund, which should be diversified enough (and mostly in the hands of clients with financial advisors who aren't just brokers) from the large Vanguard funds. And maybe at some point, it'll make sense to divert a chunk over to an advisor to maintain a diversified basket of individual stocks.

PathtoFIRE

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #5 on: November 04, 2015, 12:19:36 PM »
Kennon posits there could be a problem if there is a "run on the fund."  Has that ever happened on an index fund?

It's buried in my long post above, but that's my question too, how likely is this scenario? I think he would argue that this world of large mutual funds with tons of unsophisticated investors is new and unpredictable, and I can't say that I'd disagree. But the only large run on any large fund that I'm aware of recently is at PIMCO, and I don't hear reports of this, although that is a bond fund, so we wouldn't expect capital gains to be nearly as large.

johnny847

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #6 on: November 04, 2015, 12:23:15 PM »
The Bogleheads wiki says

Quote
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:

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.
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.

Note the tax efficiency bullet. It makes it seem like Vanguard would distribute any capital gains in any of the mutual funds through the ETF versions instead. But I don't know if that's actually true. There's no reference in the wiki for me to follow up on.

EDIT: Since it says protected by patent, I should be able to find such a patent if it exists. But I have not yet done such a search.
« Last Edit: November 04, 2015, 01:33:30 PM by johnny847 »

Interest Compound

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #7 on: November 04, 2015, 12:35:05 PM »
The Bogleheads wiki says

Quote
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:

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.
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.

Note the tax efficiency bullet. It makes it seem like Vanguard would distribute any capital gains in any of the mutual funds through the ETF versions instead. But I don't know if that's actually true. There's no reference in the wiki for me to follow up on.

Nice find. Because Vanguard has been so successful with its index funds, it is hard to compete with Vanguard directly. A swarm of rivals now try to compete with things that can be called an "index" and thus benefit from the good reputation of indexing, but do something slightly different so they can be claimed to be better. The result is that there is a drumbeat of critics all saying the same thing: passive indexing with Vanguard sucks. And one of the commonest ways to attack it is to complain about something scary that most people don't know anything about (taxes).

bacchi

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #8 on: November 04, 2015, 12:36:42 PM »
Any distribution reduces the NAV; in effect, if VTSMX sold everything and distributed 45% as LTCG, it forces the holders to pay taxes on someone else's (Vanguard's) schedule. Of course, the NAV would also be reduced by 45%. If Vanguard were to close VTSMX, there wouldn't be (much of) a difference between selling at your whim or receiving a 45% distribution and selling.

This leads to a mitigation strategy since Vanguard publishes their distributions in early December.

protostache

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #9 on: November 04, 2015, 01:23:09 PM »
Quote
It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery.

...

It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.

Honestly, this whole thing reads like click-bait, nothing more than an advisor trying to justify their services in a world where they are growing increasingly less relevant.

So, I just spent the last few weeks reading basically all of Joshua's blog (except the recipe and family posts). He makes a compelling point, several times, that for a family in the right situation a trusted advisor more than makes up their fee. That situation boils down to having a large amount of assets and a tax profile that doesn't fit the standard mold of self-managed 401(K)/IRA/529 accounts. Once you get to a certain level of assets, an advisor can set you up with things like a charitable remainder trust or a family limited partnership that have a high absolute sticker price to start, but over time save immense amounts in taxes. This is money that then compounds on itself, letting the family leave a bigger legacy than they otherwise would have been able to.

For the majority of people on this forum an advisory service would be overkill, but they're still very much relevant to a certain segment of the population.

edit: Thanks for digging that comment up, brooklynguy!

Interest Compound

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #10 on: November 04, 2015, 01:57:35 PM »
Quote
It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery.

...

It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.

Honestly, this whole thing reads like click-bait, nothing more than an advisor trying to justify their services in a world where they are growing increasingly less relevant.

So, I just spent the last few weeks reading basically all of Joshua's blog (except the recipe and family posts). He makes a compelling point, several times, that for a family in the right situation a trusted advisor more than makes up their fee. That situation boils down to having a large amount of assets and a tax profile that doesn't fit the standard mold of self-managed 401(K)/IRA/529 accounts. Once you get to a certain level of assets, an advisor can set you up with things like a charitable remainder trust or a family limited partnership that have a high absolute sticker price to start, but over time save immense amounts in taxes. This is money that then compounds on itself, letting the family leave a bigger legacy than they otherwise would have been able to.

For the majority of people on this forum an advisory service would be overkill, but they're still very much relevant to a certain segment of the population.

edit: Thanks for digging that comment up, brooklynguy!

Agreed. The vast majority of people don't need an advisor. Scare-tactics like this, which don't seem to apply to Vanguard funds anyway, can safely be ignored.

protostache

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #11 on: November 04, 2015, 02:12:46 PM »
Quote
It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery.

...

It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.

Honestly, this whole thing reads like click-bait, nothing more than an advisor trying to justify their services in a world where they are growing increasingly less relevant.

So, I just spent the last few weeks reading basically all of Joshua's blog (except the recipe and family posts). He makes a compelling point, several times, that for a family in the right situation a trusted advisor more than makes up their fee. That situation boils down to having a large amount of assets and a tax profile that doesn't fit the standard mold of self-managed 401(K)/IRA/529 accounts. Once you get to a certain level of assets, an advisor can set you up with things like a charitable remainder trust or a family limited partnership that have a high absolute sticker price to start, but over time save immense amounts in taxes. This is money that then compounds on itself, letting the family leave a bigger legacy than they otherwise would have been able to.

For the majority of people on this forum an advisory service would be overkill, but they're still very much relevant to a certain segment of the population.

edit: Thanks for digging that comment up, brooklynguy!

Agreed. The vast majority of people don't need an advisor. Scare-tactics like this, which don't seem to apply to Vanguard funds anyway, can safely be ignored.

I don't understand why you're stuck on this advisor thing. The main point of the quote, and in fact to Kennon's entire body of work, is that you should be aware of what you're doing. He's a hyper-rationalist and also quite risk-averse. The embedded capital gains inherent in a long-running mutual fund are something to be aware of in a taxable account, since they present a considerable tax risk.

the_gastropod

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #12 on: November 04, 2015, 02:38:00 PM »
Following...

Telecaster

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #13 on: November 04, 2015, 02:43:05 PM »
I don't understand why you're stuck on this advisor thing. The main point of the quote, and in fact to Kennon's entire body of work, is that you should be aware of what you're doing. He's a hyper-rationalist and also quite risk-averse. The embedded capital gains inherent in a long-running mutual fund are something to be aware of in a taxable account, since they present a considerable tax risk.

Define "considerable."    Remember, in an index fund (which is what we were talking about), there is very little turnover, hence very little actual capital gains exposure. 

In theory, if your index fund is melting down, you could indeed be at risk for an unexpected tax bill.  However, why else would an index fund melt down unless it was losing huge amounts of value?    If your index fund is melting down, I suspect that you will benefit more from embedded losses than you will lose from embedded gains due to the loss of value.   I'm not seeing "considerable tax risk."   

That said, if your index fund is melting down, that means the broader market is also melting down and at that point I suspect your tax bill is the very least of your problems.   Basically, he seems to be saying you should take a guaranteed loss right now by paying the fee, in order to avoid an unlikely hypothetical loss in the future.   That's wandering off into the land to charlatans. 






tonysemail

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #14 on: November 04, 2015, 02:48:38 PM »
thanks for sharing.
I love vanguard and I had never considered this perspective.

There is more than one scenario to consider.
1) Yes, I agree that if the total stock market is melting down, then we are talking about a 'black swan' type event.
And in the context of this topic, that's simply not worth trying to insure against.
almost all mutual funds will melt down.
it's a fool's errand to pick the few hedge funds that will outperform the market through a black swan event.

2) But what about a new investment strategy that disrupts vanguard's business model?
vanguard disrupted the traditional asset management business model and has benefited from huge inflows of cash.
Is it reasonable to expect that another company will come along and disrupt vanguard which results in huge outflows in spite of healthy market returns?


Interest Compound

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #15 on: November 04, 2015, 02:49:11 PM »
Quote
It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery.

...

It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.

Honestly, this whole thing reads like click-bait, nothing more than an advisor trying to justify their services in a world where they are growing increasingly less relevant.

So, I just spent the last few weeks reading basically all of Joshua's blog (except the recipe and family posts). He makes a compelling point, several times, that for a family in the right situation a trusted advisor more than makes up their fee. That situation boils down to having a large amount of assets and a tax profile that doesn't fit the standard mold of self-managed 401(K)/IRA/529 accounts. Once you get to a certain level of assets, an advisor can set you up with things like a charitable remainder trust or a family limited partnership that have a high absolute sticker price to start, but over time save immense amounts in taxes. This is money that then compounds on itself, letting the family leave a bigger legacy than they otherwise would have been able to.

For the majority of people on this forum an advisory service would be overkill, but they're still very much relevant to a certain segment of the population.

edit: Thanks for digging that comment up, brooklynguy!

Agreed. The vast majority of people don't need an advisor. Scare-tactics like this, which don't seem to apply to Vanguard funds anyway, can safely be ignored.

I don't understand why you're stuck on this advisor thing. The main point of the quote, and in fact to Kennon's entire body of work, is that you should be aware of what you're doing. He's a hyper-rationalist and also quite risk-averse. The embedded capital gains inherent in a long-running mutual fund are something to be aware of in a taxable account, since they present a considerable tax risk.

From where I sit, the main point of the article is to scare people into giving his company (he's a financial advisor) their business. It starts with, "It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds..."

and ends with calling people who index with Vanguard "ignorant", saying they will "get what they deserve" but he's fighting the good fight by writing this article anyway and making himself the enemy, so he can cure our ignorance by informing us of his advisory services.

To the numerous new/scared investors of the forum, take note. This is what it looks like when someone's selling you on their product. Remember, there will always be someone who says this time is different, and indexing no longer works.  These people come and go.  This is why staying the course is so hard.  Ignore the noise, stay the course, and 30-60 years later odds are you'll be much better for it.

johnny847

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #16 on: November 04, 2015, 02:53:25 PM »
The Bogleheads wiki says

Quote
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:

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.
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.

Note the tax efficiency bullet. It makes it seem like Vanguard would distribute any capital gains in any of the mutual funds through the ETF versions instead. But I don't know if that's actually true. There's no reference in the wiki for me to follow up on.

Nice find. Because Vanguard has been so successful with its index funds, it is hard to compete with Vanguard directly. A swarm of rivals now try to compete with things that can be called an "index" and thus benefit from the good reputation of indexing, but do something slightly different so they can be claimed to be better. The result is that there is a drumbeat of critics all saying the same thing: passive indexing with Vanguard sucks. And one of the commonest ways to attack it is to complain about something scary that most people don't know anything about (taxes).

I'm not quite sure I understand you.
How would this lend support to critics who say Vanguard sucks?

protostache

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #17 on: November 04, 2015, 03:04:02 PM »
Quote
It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery.

...

It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.

Honestly, this whole thing reads like click-bait, nothing more than an advisor trying to justify their services in a world where they are growing increasingly less relevant.

So, I just spent the last few weeks reading basically all of Joshua's blog (except the recipe and family posts). He makes a compelling point, several times, that for a family in the right situation a trusted advisor more than makes up their fee. That situation boils down to having a large amount of assets and a tax profile that doesn't fit the standard mold of self-managed 401(K)/IRA/529 accounts. Once you get to a certain level of assets, an advisor can set you up with things like a charitable remainder trust or a family limited partnership that have a high absolute sticker price to start, but over time save immense amounts in taxes. This is money that then compounds on itself, letting the family leave a bigger legacy than they otherwise would have been able to.

For the majority of people on this forum an advisory service would be overkill, but they're still very much relevant to a certain segment of the population.

edit: Thanks for digging that comment up, brooklynguy!

Agreed. The vast majority of people don't need an advisor. Scare-tactics like this, which don't seem to apply to Vanguard funds anyway, can safely be ignored.

I don't understand why you're stuck on this advisor thing. The main point of the quote, and in fact to Kennon's entire body of work, is that you should be aware of what you're doing. He's a hyper-rationalist and also quite risk-averse. The embedded capital gains inherent in a long-running mutual fund are something to be aware of in a taxable account, since they present a considerable tax risk.

From where I sit, the main point of the article is to scare people into giving his company (he's a financial advisor) their business. It starts with, "It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds..."

and ends with calling people who index with Vanguard "ignorant", saying they will "get what they deserve" but he's fighting the good fight by writing this article anyway and making himself the enemy, so he can cure our ignorance by informing us of his advisory services.

To the numerous new/scared investors of the forum, take note. This is what it looks like when someone's selling you on their product. Remember, there will always be someone who says this time is different, and indexing no longer works.  These people come and go.  This is why staying the course is so hard.  Ignore the noise, stay the course, and 30-60 years later odds are you'll be much better for it.

So, three things, then I'm done. First, at this point he's an advisor for his family only and as far as I can tell he doesn't charge a fee. The thing he and his husband are building now is going to be some sort of wealth management service, it's true, but they haven't even announced details yet.

Second, you cut off the most important part of the first sentence: "It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery". Self-managed index funds are not appropriate for someone who has no idea what they're doing with a tremendous windfall. Professional advice will literally save them millions of dollars.

Third, the people he's talking about in that article, the people with millions of dollars in taxable accounts, are fundamentally playing a different game than us. They're preserving generational wealth, not accumulating new wealth that they intend to spend down during the course of their lives. Tools useful for one group are not useful for another, because they have different goals.

Also, if you actually took the time to read his work instead of taking a bunch of quotes out of context, you'll see that he's a strong advocate for index funds in tax advantaged accounts for almost everyone. He doesn't say "Vanguard sucks", he in fact says many times that he loves Vanguard because of the transparency and incredibly low fees.

Telecaster

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #18 on: November 04, 2015, 03:34:21 PM »

Second, you cut off the most important part of the first sentence: "It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery".

If I ever win the lottery I'll make sure to look this guy up  :)

brooklynguy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #19 on: November 04, 2015, 03:50:04 PM »
In theory, if your index fund is melting down, you could indeed be at risk for an unexpected tax bill.  However, why else would an index fund melt down unless it was losing huge amounts of value?    If your index fund is melting down, I suspect that you will benefit more from embedded losses than you will lose from embedded gains due to the loss of value.   I'm not seeing "considerable tax risk."   

Your index fund could be "losing huge amounts of value" as compared to recent history but still be realizing massive capital gains upon liquidating assets because the basis in those assets was created in comparatively ancient history (with a subsequent run-up in market value).

The one thing lacking from throwing me in a further worry though is that he didn't provide any examples of where this has happened.

Kennon provided a few actual historical examples (but none involving index funds):

Quote from: Josh Kennon
The best way to understand it is to look at what actually happens in the real world. Go back and pull the Oppenheimer Developing Markets Opportunity fund during the Great Recession. Let's take an extreme example to show how unbelievably ridiculous and unfair the disconnect can be. Imagine you bought it at $57.13 on 10/29/2007 before the world fell apart. You're a good, disciplined buy-and-hold seller so you don't plan on parting with it for a long, long time. On March 3rd, 2009, you are getting ready to file your upcoming taxes, due in April, for fiscal year 2008. You crack open your account. What do you find?

Your shares were at $13.52. You also had $8.88 in cash sitting in the account.

"That's odd", you think. Nope. The fund was forced to liquidate a lot of embedded gains, which occurred in a way that didn't offset perfectly on the way down. Specifically, $0.5583 per share in dividends, $8.0128 per share in long-term capital gains, and $0.3087 per share in short-term capital gains. Depending on the state, you might have owed $2.66 or more in taxes, leaving you $19.74. So, at this point, you've lost almost 35% of your money on paper and you have to write the government a fairly hefty check, picking up the tab for someone else's capital gains.

And if you had happened to buy a bit earlier? It was even worse. You would have had this happen to you two years in a row. Talk about injustice.

If you were willing to time the market - something I think is inherently dangerous - you could have sold some of your shares for a loss and attempted to offset much of the bill, hoping stock prices didn't turn around in the meantime. Who wants to live that way? It's a mess you shouldn't have had to deal with in the first place.

If you're looking for case studies, another example is the Vanguard mining fund - I forgot what it is called, it's the huge one - back around the same time or a few years thereafter. There was one year where it kicked out a big percentage of its NAV to shareholders for taxable gains based on redemptions forcing the managers to sell off holdings to raise cash. Those especially hurt because it turned around and skyrocketed like crazy within the years that followed if I remember correctly, meaning you'd have had to take money out of that which you had invested in the fund at the worst possible time to pay a tax bill that, in reality, wasn't really yours to begin with and is more of a by-product of our broken tax code; money that could have grown by huge amounts as the reversal was sudden and staggering.

There were some other high-profile examples back in 2008-2009. Search for "embedded gains" if you're starting a research file on it as that is what it usually called by the niche contingent of people who bother to worry about these sorts of things. It's almost entirely confined to professional circles. The retail market doesn't seem to care.

Interest Compound

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #20 on: November 04, 2015, 03:57:37 PM »
The Bogleheads wiki says

Quote
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:

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.
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.

Note the tax efficiency bullet. It makes it seem like Vanguard would distribute any capital gains in any of the mutual funds through the ETF versions instead. But I don't know if that's actually true. There's no reference in the wiki for me to follow up on.

Nice find. Because Vanguard has been so successful with its index funds, it is hard to compete with Vanguard directly. A swarm of rivals now try to compete with things that can be called an "index" and thus benefit from the good reputation of indexing, but do something slightly different so they can be claimed to be better. The result is that there is a drumbeat of critics all saying the same thing: passive indexing with Vanguard sucks. And one of the commonest ways to attack it is to complain about something scary that most people don't know anything about (taxes).

I'm not quite sure I understand you.
How would this lend support to critics who say Vanguard sucks?

It doesn't. The information you provided lends support to ignoring the click-bait scare mongering articles of financial advisors who want your money. This time is not different. Ignore the noise. Stay the course.

JetBlast

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #21 on: November 04, 2015, 04:28:28 PM »

Your index fund could be "losing huge amounts of value" as compared to recent history but still be realizing massive capital gains upon liquidating assets because the basis in those assets was created in comparatively ancient history (with a subsequent run-up in market value).

I too read this with great interest in Joshua Kennon's blog and expected it would pop up over here eventually. It is something many on here would largely avoid in taxable accounts due to the Mustachian lifestyle and low tax brackets many are able to stay in, as there are no long term capital gains if you are in the 15% bracket or below. However it would impact some and is certainly worth consideration by those in higher brackets with mutual funds of any type in a taxable account.

You've hit on precisely the problem that could happen at either an actively managed fund or index fund. The outflows from the fund are offset by inflows, so older shares are retained with excess inflows used to purchase new shares for the fund. If there is a period of excessive net outflows, the fund may not be able to meet redemptions with only recently acquired shares that have little to no embedded gains, and embedded losses may not be high enough to cover the gains either.

I actually wonder if this isn't more of an issue with index funds since they are managed in a mechanical manner, simply trying to maintain the proper ratio of each company in their respective index. Obviously the managers would try to sell shares that create the lowest tax liability, but an actively managed fund has more flexibility in altering their holdings to avoid triggering those capital gains.

Perhaps we've never seen a big index fund run into this problem because indexing tends to promote better investor bahavior. Perhaps it's because so many large index funds have a huge stream of constant inflows from 401k and 403b plans. Perhaps it's just a fluke.

Paul der Krake

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #22 on: November 04, 2015, 04:47:10 PM »
Searching for "embedded gains" on bogleheads.org hasn't yielded anything too interesting. Which is too bad, because it's fascinating stuff. Has Vanguard ever communicated about this?

@CompoundInterest, please critique Kennon's argument instead of calling him names. There's nothing wrong with pointing out flaws of indexing, no matter how much we all love and embrace it.




protostache

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #23 on: November 04, 2015, 04:57:27 PM »
Searching for "embedded gains" on bogleheads.org hasn't yielded anything too interesting. Which is too bad, because it's fascinating stuff. Has Vanguard ever communicated about this?

@CompoundInterest, please critique Kennon's argument instead of calling him names. There's nothing wrong with pointing out flaws of indexing, no matter how much we all love and embrace it.

The term of art, at least in Morningstar's world, is "potential capital gains exposure". You can find it on the "Tax" tab of Morningstar's mutual fund listings. VTSAX is currently 31.56.

brooklynguy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #24 on: November 04, 2015, 05:27:09 PM »
It is something many on here would largely avoid in taxable accounts due to the Mustachian lifestyle and low tax brackets many are able to stay in, as there are no long term capital gains if you are in the 15% bracket or below.

It would be a bigger problem for most here if it materialized during the (high-income, high-tax-bracket) accumulation phase.  And even during (low-income, low-tax-bracket) retirement, it would still be an issue for those of us subject to state and/or local taxes that don't follow the federal regime with respect to LTCGs (like me, unfortunately!), or if the realized embedded gains were significant enough to push you into a higher tax bracket.

Interest Compound

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #25 on: November 04, 2015, 05:40:35 PM »
Searching for "embedded gains" on bogleheads.org hasn't yielded anything too interesting. Which is too bad, because it's fascinating stuff. Has Vanguard ever communicated about this?

@CompoundInterest, please critique Kennon's argument instead of calling him names. There's nothing wrong with pointing out flaws of indexing, no matter how much we all love and embrace it.

No one has talked about it on bogleheads, and Vanguard hasn't communicated anything about it, because it's not an issue. This shows how strong click-bait fear marketing really is. He calls Vanguard investors "ignorant" and says they'll "get what they deserve" by not investing with him, but you claim I'm calling him names by pointing out this is a common marketing trick?

No, this time is not different. No, we don't need his "directly-held customized index of passive stocks in an individually managed account" to save us from certain doom. Johnny847 already posted this:

"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."
Source: https://www.bogleheads.org/wiki/ETFs_vs_mutual_funds

I'll add some more:

With ETFs, "New investors do not inherit embedded capital gains"
Source: http://www.investopedia.com/articles/mutualfund/05/etfwrap.asp

"Because of the structure of ETFs, embedded capital gains almost never occur."

Source: Predicting the Markets of Tomorrow, page 171 - https://books.google.com/books?id=VWhZ7iMyCw0C&lpg=PT171&dq=ETF%20%22embedded%20capital%20gains%22&pg=PT171#v=onepage&q=ETF%20%22embedded%20capital%20gains%22&f=false

"When an ETF experiences redemptions, it can hand over a basket of the fund’s underlying securities instead of cash. It can also pick which shares to hand over, ridding itself of tax lots with the greatest embedded capital gains. Because the trade is conducted in-kind, no capital gains are realized."
Source: http://www.morningstar.com/advisor/t/54272084/untangling-etf-tax-efficiency-myths.htm

Ignore the noise. Stay the course.

seattlecyclone

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #26 on: November 04, 2015, 06:08:41 PM »
My mental model for how mutual funds work is that the fund buys shares with investor money, these shares have a cost basis just like if you purchased them yourself, and if the fund sells some shares then any tax on the gain over the cost basis is paid by the mutual fund shareholders in proportion to their ownership in the fund.

These capital gains are commonly a major expense for people holding actively managed funds that would make lots of trades within the fund. So far this has not been an issue for most Vanguard funds because indexing is gaining in popularity and the funds have a net inflow of investor cash. Most of their transactions are then buying new shares, not selling old ones. They would basically only sell shares in the relatively rare circumstance where a company leaves the index, in which case they're likely recognizing a capital loss on those shares anyway. The net result of all this has been that most Vanguard funds only rarely have capital gains distributions that are taxable to shareholders.

The worry here is that as Vanguard grows and holds its portfolio for longer and longer amounts of time, they're accumulating lots of unrealized capital gains that must be realized and distributed to shareholders at some theoretical point in the future. As we've already acknowledged, the funds aren't likely to make many transactions where they swap their Company A stock for Company B stock in search of better returns. That's not Vanguard's business model. No, any large transactions will happen as a result of existing investors moving their money out of the fund faster than new investors come in. Maybe Schwab starts offering a line of index funds with half the expense ratio and people start to leave Vanguard. Maybe the economy experiences a serious meltdown, nobody is willing to invest new money, and many of the existing investors need to take their money out to put food on the table. Hypothetical scenarios abound.

Even in these scenarios it does look like Vanguard has some mechanisms available to help mitigate the damage. The ETF thing that johnny847 mentioned above is something I've heard mentioned before. It sounds like they have a mechanism whereby they can shift low-basis shares off of the mutual fund books by creating and selling new ETF shares. It's an impressive-sounding bit of financial engineering, albeit one that I don't fully understand. When they do sell shares, they can start with the shares that have higher cost basis. In the case of a market crash, a lot of the shares Vanguard holds will be underwater, so they wouldn't need to pass on any gains until a very high percentage of investors (50%? More?) liquidates their shares.

All in all, I view this as a relatively minor risk, especially for those of us who plan to retire in lower tax brackets.

Beaker

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #27 on: November 04, 2015, 06:17:57 PM »
Vanguard hasn't communicated anything about it, because it's not an issue.

I wouldn't say that, it's right there on the Distributions tab of the fund overview, with a link talking about exactly the unrealized gains/losses scenario that Kennon is discussing.

For example, VTSAX has unrealized gains equal to almost 30% of NAV. Which seems to imply that their ETF escape hatch is at least not 100% effective at avoiding the problem - though maybe if there were a lot of ETF redemptions that would help?

It seems to me that what he's talking about is something that could happen. It's a low probability, but if it did happen it would be an annoying expense at a very bad time.
« Last Edit: November 05, 2015, 08:32:17 AM by Beaker »

brooklynguy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #28 on: November 05, 2015, 08:30:30 AM »
Any distribution reduces the NAV; in effect, if VTSMX sold everything and distributed 45% as LTCG, it forces the holders to pay taxes on someone else's (Vanguard's) schedule. Of course, the NAV would also be reduced by 45%. If Vanguard were to close VTSMX, there wouldn't be (much of) a difference between selling at your whim or receiving a 45% distribution and selling.

This leads to a mitigation strategy since Vanguard publishes their distributions in early December.

I didn't follow this - what exactly is the proposed mitigation strategy?

Aphalite

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #29 on: November 05, 2015, 09:01:11 AM »
The reason a lot of his stuff doesn't get posted here is because there's an almost heretical standard towards indexing here - because indexing works fairly well, and much better than picking actively managed mutual funds, the posters in this forum have collectively (for the most part, there are exceptions) decided that they now know all there is to know about investing, and that there is little to no downside to indexing. You can already see Interest Compound stubbornly suggesting that there's nothing to be learned because Joshua is launching an asset management business. And just look at cyclone's post:

All in all, I view this as a relatively minor risk, especially for those of us who plan to retire in lower tax brackets.

the point posters don't see is that runs on a fund doesn't happen when it's convenient for you and your tax bracket, it can hit you when you're at your highest earning capacity. All the talk about ETF structure minimizing taxes and little to no turnover doesn't understand that for this to scenario to happen, YOU GET STUCK WITH THE CONSEQUENCES OF OTHER INDEXER'S ACTIONS. People here are confusing distributions of small sales (companies that have left the index) and dividends with a run on the index fund itself.

GRANTED, this scenario has very little chance of happening because it would require such a massive amount of indexers to sell, AND Vanguard could possibly issue the shares in kind instead of liquidating if such a run occurs. This means that a lot of the posters in this forum probably doesn't have to worry about such a scenario - sometimes ignorance is bliss, and indexing IS the best time/effort for value tradeoff when it comes to investing small amounts of money

JetBlast

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #30 on: November 05, 2015, 09:02:46 AM »
The structure of Vanguard funds with ETFs certainly gives managers an opportunity to reduce the impact during a run on the fund as they can use the in-kind transfer mechanism to exchange the shares with the lowest purchase price with redeeming ETF shares. But there appears to me to be a limit to that ability and it's the number of ETF shares being redeemed in relation to total outflows.

For example, Vanguard's site shows the Total Stock Market Index Fund has net assets of $371.5 billion, with the ETF shares responsible for $52.3 billion, or a little more that 14% of the total. In the event of a market crash with major redemptions in the fund, will the authorized participant be able to buy up enough shares to exchange and allow the fund to avoid the capital gains? The events of 2008 seem to indicate yes, but I honestly don't know.

As an aside, it looks a lot tougher for managers to use the ETF exchange mechanism during a run on the Total International Stock Index Fund. VXUS has net assets of $4.4 billion out of a fund total $174.6 billion. That's 2.5% of net assets held by the ETF.

I'm sure someone at Vanguard much smarter than myself has thought this through and modeled scenarios to find out how bad it has to get before the ETF can't absorb all the capital gains.
« Last Edit: November 05, 2015, 09:04:38 AM by JetBlast »

Aphalite

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #31 on: November 05, 2015, 09:07:30 AM »
I understand this is more of an issue for managed funds, when the fund manager decides to take some profits after a period of gains.   I'm not quite sure I see the problem for index funds, which tend to have low turn over.  And the stocks that do turn over,tend to be ones that aren't doing well and therefore get dropped from the index.   In that case, you are more likely to benefit from embedded losses than get penalized from embedded gains.   


Kennon posits there could be a problem if there is a "run on the fund."  Has that ever happened on an index fund?

It's not about the turnover, because you're right, turnover usually only occurs when securities move in and out of indices. Joshua is talking about runs on the fund, where redemptions > cash held by the index fund. This results in forced sales, even if you're an index. When you buy an open ended index fund, you're not buying fresh shares of the underlying securities, you're buying the mutual fund as it is that day - the passive mining fund Brooklyn posted is VGPMX, and if you go to the distribution link and go back a few years, you can see all of the LT and ST (which is even worse, since it's taxed at ordinary tax rates) Capital Gains: https://advisors.vanguard.com/VGApp/iip/site/advisor/investments/price?fundId=0053#state=0

Aphalite

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #32 on: November 05, 2015, 09:13:37 AM »
1) Yes, I agree that if the total stock market is melting down, then we are talking about a 'black swan' type event.
And in the context of this topic, that's simply not worth trying to insure against.
almost all mutual funds will melt down.
it's a fool's errand to pick the few hedge funds that will outperform the market through a black swan event.

The answer is holding the underlying securities within the index yourself, or constructing a similar basket of safe blue chip securities that you hold. That way it doesn't matter what other investors do, their sales of the index fund doesn't affect you because YOU don't have to follow the herd and sell the securities yourself

bacchi

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #33 on: November 05, 2015, 09:17:00 AM »
Any distribution reduces the NAV; in effect, if VTSMX sold everything and distributed 45% as LTCG, it forces the holders to pay taxes on someone else's (Vanguard's) schedule. Of course, the NAV would also be reduced by 45%. If Vanguard were to close VTSMX, there wouldn't be (much of) a difference between selling at your whim or receiving a 45% distribution and selling.

This leads to a mitigation strategy since Vanguard publishes their distributions in early December.

I didn't follow this - what exactly is the proposed mitigation strategy?

When there's a large fund loss, such as in the example ($53-$13), sell the shares, which will counter any distributed LTCG and taxes due. Since distributions at Vanguard are announced ahead of time, this can be done pre ex-div in 2008; or it can be done in 2009, per the example, moving the losses to the 2009 tax return.

In other words, this is easily solved with a little end of year planning.

1) See that Oppenheimer is going to make a large distribution at the end of December.
2) Realize that this will increase personal taxes due to LTCG, even though the market is doing poorly.
3) Look at the fund NAV and see how awful it's doing.
4) TLH the fund, taking a ~$30/share loss.

There's no need for individual stocks or an advisor or a managed fund.

Aphalite

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #34 on: November 05, 2015, 09:32:29 AM »
In other words, this is easily solved with a little end of year planning.

1) See that Oppenheimer is going to make a large distribution at the end of December.
2) Realize that this will increase personal taxes due to LTCG, even though the market is doing poorly.
3) Look at the fund NAV and see how awful it's doing.
4) TLH the fund, taking a ~$30/share loss.

There's no need for individual stocks or an advisor or a managed fund.

While true, the fact that there's no discussion on this topic at bogleheads and with seemingly none of the posters here except for you knowing about embedded gains before Brooklyn started this thread, what are the chances of indexers actually knowing/thinking up a strategy such as what you suggested?

It's a great strategy if adoption is minimal, I'm just questioning actual utility as you would have to really broadcast it loudly across the internet space, which, if the desired effect is reached, would result in even MORE redemptions - plus, you'd have to convince all of the dyed in the wool indexers that their 30 year habit of "dollar cost average in, never sell" is wrong for only this instance at this point in time and they should sell now. How many people on the boards would accuse you of fear mongering then?

EDIT: Brooklyn had posted this above, but Joshua already mentioned your strategy in his comment response:
"If you were willing to time the market - something I think is inherently dangerous - you could have sold some of your shares for a loss and attempted to offset much of the bill, hoping stock prices didn't turn around in the meantime. Who wants to live that way? It's a mess you shouldn't have had to deal with in the first place."
« Last Edit: November 05, 2015, 09:39:22 AM by Aphalite »

brooklynguy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #35 on: November 05, 2015, 09:33:19 AM »
When there's a large fund loss, such as in the example ($53-$13), sell the shares, which will counter any distributed LTCG and taxes due. Since distributions at Vanguard are announced ahead of time, this can be done pre ex-div in 2008; or it can be done in 2009, per the example, moving the losses to the 2009 tax return.

In other words, this is easily solved with a little end of year planning.

1) See that Oppenheimer is going to make a large distribution at the end of December.
2) Realize that this will increase personal taxes due to LTCG, even though the market is doing poorly.
3) Look at the fund NAV and see how awful it's doing.
4) TLH the fund, taking a ~$30/share loss.

There's no need for individual stocks or an advisor or a managed fund.

But that forces you to exit the market when you otherwise wouldn't be and may not want to (and, depending on when you bought in, by selling the fund shares, you may not be incurring a loss to harvest, but be realizing a gain), all in order to mitigate the problem of avoiding incurrence of a tax liability on someone else's capital gains.

Interest Compound

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #36 on: November 05, 2015, 09:53:48 AM »
Vanguard mutual fund shares benefit from the disposition of capital gains through ETF shares. Because the trade is conducted in-kind, no capital gains are realized. Remember, Vanguard mutual funds can be converted to ETFs without realizing capital gains, but not the other way around.

This is a non-issue.

bacchi

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #37 on: November 05, 2015, 09:57:30 AM »
When there's a large fund loss, such as in the example ($53-$13), sell the shares, which will counter any distributed LTCG and taxes due. Since distributions at Vanguard are announced ahead of time, this can be done pre ex-div in 2008; or it can be done in 2009, per the example, moving the losses to the 2009 tax return.

In other words, this is easily solved with a little end of year planning.

1) See that Oppenheimer is going to make a large distribution at the end of December.
2) Realize that this will increase personal taxes due to LTCG, even though the market is doing poorly.
3) Look at the fund NAV and see how awful it's doing.
4) TLH the fund, taking a ~$30/share loss.

There's no need for individual stocks or an advisor or a managed fund.

But that forces you to exit the market when you otherwise wouldn't be and may not want to (and, depending on when you bought in, by selling the fund shares, you may not be incurring a loss to harvest, but be realizing a gain), all in order to mitigate the problem of avoiding incurrence of a tax liability on someone else's capital gains.

You can easily TLH exchange from VTSMX into VFINX. Yes, this all takes a little work but so does managing 75-500 individual stocks.

The phrase "someone else's gains" doesn't really fit because the NAV takes care of it. This is more of a "someone else making tax decisions for you" situation. The fund manager can decide to distribute a large amount, forcing a taxable event (that can be a loss or a gain, as you noted). You never actually pay more taxes than what you would pay normally (more or less), which is why I dislike "someone else's gains," but you may pay taxes before you're ready.

Aphalite

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #38 on: November 05, 2015, 09:58:29 AM »
Vanguard mutual fund shares benefit from the disposition of capital gains through ETF shares. Because the trade is conducted in-kind, no capital gains are realized. Remember, Vanguard mutual funds can be converted to ETFs without realizing capital gains, but not the other way around.

This is a non-issue.

They have the CHOICE to conduct in kind distributions. But it's cheaper for Vanguard to just stick you with capital gains, which is what they did with the mining index fund from 2005 through 2012

bacchi

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #39 on: November 05, 2015, 10:03:44 AM »
In other words, this is easily solved with a little end of year planning.

1) See that Oppenheimer is going to make a large distribution at the end of December.
2) Realize that this will increase personal taxes due to LTCG, even though the market is doing poorly.
3) Look at the fund NAV and see how awful it's doing.
4) TLH the fund, taking a ~$30/share loss.

There's no need for individual stocks or an advisor or a managed fund.

While true, the fact that there's no discussion on this topic at bogleheads and with seemingly none of the posters here except for you knowing about embedded gains before Brooklyn started this thread, what are the chances of indexers actually knowing/thinking up a strategy such as what you suggested?

It's a great strategy if adoption is minimal, I'm just questioning actual utility as you would have to really broadcast it loudly across the internet space, which, if the desired effect is reached, would result in even MORE redemptions - plus, you'd have to convince all of the dyed in the wool indexers that their 30 year habit of "dollar cost average in, never sell" is wrong for only this instance at this point in time and they should sell now. How many people on the boards would accuse you of fear mongering then?

Oh, yeah, most index funders wouldn't do this. It's not the end of the world if nothing is done but, in the Oppenheimer case above, it would suck come April 15.

But the chances of a run are very unlikely. We have to balance the risk vs the time and effort of managing 75+ stocks vs. paying a manager 1%.


Quote
EDIT: Brooklyn had posted this above, but Joshua already mentioned your strategy in his comment response:
"If you were willing to time the market - something I think is inherently dangerous - you could have sold some of your shares for a loss and attempted to offset much of the bill, hoping stock prices didn't turn around in the meantime. Who wants to live that way? It's a mess you shouldn't have had to deal with in the first place."

Eh, it's standard TLH strategy. At most, you're out of the market for 31 days. At best, you take the tax loss and switch the money to a similar but not-the-same investment.

If he's a financial advisor and doesn't do TLH, then he's not much of a financial advisor.

Telecaster

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #40 on: November 05, 2015, 10:05:28 AM »
The reason a lot of his stuff doesn't get posted here is because there's an almost heretical standard towards indexing here - because indexing works fairly well, and much better than picking actively managed mutual funds, the posters in this forum have collectively (for the most part, there are exceptions) decided that they now know all there is to know about investing, and that there is little to no downside to indexing. You can already see Interest Compound stubbornly suggesting that there's nothing to be learned because Joshua is launching an asset management business.

And another reason is that a large number of posters here are financially literate and are able to rationally and unemotionally evaluate financial risks.

As you point out, for this scenario to come true a series of several unlikely events must first happen.  And if all those things do happen, the worst case scenario is your tax bill might be larger than you thought.   And of course remember that those capital gains can be offset by capital losses, and then capital gains receive favorable tax treatment anyway.   In short, the worse case scenario really doesn't sound very scary to me.  If something of this magnitude really does happen, I suspect our tax bills will be the very least of our problems.   

One thing I hate is when people claim the sky is falling without proposing a better solution.  Kennon's solution is to simply buy individual stocks.  Great. But we all know the large majority of stock pickers fail to be the market over any reasonable length of time.   Indeed, on average financial advisers actually do worse than random chance would suggest.  In short, they are even shittier at picking stocks than throwing darts.  That is not a criticism of buying individual stocks, by the way.  Just pointing out it isn't good advice for most people, and there are very real and non-trivial market risks by following his advice.  IMO much greater than the unlikely and hypothetical risks Kennon points out.   







Interest Compound

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #41 on: November 05, 2015, 10:08:37 AM »
Vanguard mutual fund shares benefit from the disposition of capital gains through ETF shares. Because the trade is conducted in-kind, no capital gains are realized. Remember, Vanguard mutual funds can be converted to ETFs without realizing capital gains, but not the other way around.

This is a non-issue.

They have the CHOICE to conduct in kind distributions. But it's cheaper for Vanguard to just stick you with capital gains, which is what they did with the mining index fund from 2005 through 2012

The Vanguard mining fund doesn't have ETF shares. Honestly, I feel like I'm wasting my time here.

Aphalite

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #42 on: November 05, 2015, 10:12:48 AM »
As you point out, for this scenario to come true a series of several unlikely events must first happen.  And if all those things do happen, the worst case scenario is your tax bill might be larger than you thought.   And of course remember that those capital gains can be offset by capital losses, and then capital gains receive favorable tax treatment anyway.   In short, the worse case scenario really doesn't sound very scary to me.  If something of this magnitude really does happen, I suspect our tax bills will be the very least of our problems.   

One thing I hate is when people claim the sky is falling without proposing a better solution.  Kennon's solution is to simply buy individual stocks.  Great. But we all know the large majority of stock pickers fail to be the market over any reasonable length of time.   Indeed, on average financial advisers actually do worse than random chance would suggest.  In short, they are even shittier at picking stocks than throwing darts.  That is not a criticism of buying individual stocks, by the way.  Just pointing out it isn't good advice for most people, and there are very real and non-trivial market risks by following his advice.  IMO much greater than the unlikely and hypothetical risks Kennon points out.

All good points. Again, I think we need to remember that Joshua was talking about if someone came into a LARGE amount of unexpected money, and he isn't happy with people suggesting that it should all go into index funds mainly because those people don't understand all of the risks inherent in an index fund. This is a true statement by him, as none of the posters here (besides bacchi) knew of the embedded gains risk (however small it might be) before Brooklyn started the thread

I do agree with you that most people are not suited for individual stock picking though, I just think that there's always more to learn, and I consistently get the sense from these forums (although not from you or posters like brooklyn/bacchi) that any attempt to point out that indexing has flaws that should be taken into consideration (after all, you are outsourcing security selection to the people who dictate the contents of the indices) results in this mob mentality irrationality where you're denounced for no reason

Aphalite

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #43 on: November 05, 2015, 10:14:33 AM »
The Vanguard mining fund doesn't have ETF shares. Honestly, I feel like I'm wasting my time here.

Why would that matter? The mutual fund has the option to do in-kind transfers too:

https://personal.vanguard.com/pub/Pdf/p053.pdf?2210107342
"Potentially disruptive redemptions. Vanguard reserves the right to pay all or part of a
redemption in kind—that is, in the form of securities—if we reasonably believe that a
cash redemption would negatively affect the fund’s operation or performance or that
the shareholder may be engaged in market-timing or frequent trading. Under these
circumstances, Vanguard also reserves the right to delay payment of the redemption
proceeds for up to seven calendar days. By calling us before you attempt to redeem a
large dollar amount, you may avoid in-kind or delayed payment of your redemption.
Please see Frequent-Trading Limitations for information about Vanguard’s policies to
limit frequent trading"

adamwoods137

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #44 on: November 05, 2015, 10:22:04 AM »

Define "considerable."    Remember, in an index fund (which is what we were talking about), there is very little turnover, hence very little actual capital gains exposure. 
 

GAH! The fact that there is very little turnover is PRECISELY the problem!  BECAUSE there is very little turnover there can be a ton of embedded capital gains that will be triggered if outflows start to be larger than inflows.  All Kennon is saying is that if you have the money you should buy the index directly (each stock in the index).  Then you get much lower turnover and you avoid this risk of other people sticking you with a huge tax bill.  He's not selling advisory services here.  He's just pointing out that there are some tax risks with the mutual fund structure that aren't present if you own the exact same securities directly. 

adamwoods137

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #45 on: November 05, 2015, 10:29:43 AM »
One thing I hate is when people claim the sky is falling without proposing a better solution.  Kennon's solution is to simply buy individual stocks.  Great. But we all know the large majority of stock pickers fail to be the market over any reasonable length of time.   Indeed, on average financial advisers actually do worse than random chance would suggest.  In short, they are even shittier at picking stocks than throwing darts.  That is not a criticism of buying individual stocks, by the way.  Just pointing out it isn't good advice for most people, and there are very real and non-trivial market risks by following his advice.  IMO much greater than the unlikely and hypothetical risks Kennon points out.

This isn't at all Kennon's solution.  You are getting a stock index confused with a stock index fund.  He's simply saying that people who index, depending on their situation, might be better off owning the index directly (holding each stock individually) rather than owning them through an index fund.

Cheddar Stacker

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #46 on: November 05, 2015, 10:31:20 AM »
If this is an issue (Interest Compound is making a solid argument that it's not at all), it's minor. Worth knowing about, but not worth using actively managed funds instead as suggested by the article.

I agree that this should be a non-issue once FIRE due to the low tax bracket, but it could be an issue during accumulation due to higher tax rates. Here's what I haven't heard mentioned yet though:


Index returns theoretically should equal actively managed fund returns, gross.
Net of fees, index funds should already be ahead by 1%.
Net of tax drag from churn, index funds should already be ahead by another 1% (or whatever the tax effect of the churn would be).


What this theory is arguing is the tax drag is building up and could potentially burst, rather than the slow leak provided by an actively managed fund. While a lump sum $100K capital gain distribution would have a huge impact on a tax return, likely a bigger impact than $10K/year for 10 years, the difference is likely minor and would be offset if not dwarfed by the 1% advisor fees along the way.

I just don't see this as an issue at all, but if anyone does I believe the solution is not active management, it's diversification into numerous index funds or numerous individual stocks with a portion of your taxable investments.

Interest Compound

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #47 on: November 05, 2015, 10:33:58 AM »
The Vanguard mining fund doesn't have ETF shares. Honestly, I feel like I'm wasting my time here.

Why would that matter? The mutual fund has the option to do in-kind transfers too:

https://personal.vanguard.com/pub/Pdf/p053.pdf?2210107342
"Potentially disruptive redemptions. Vanguard reserves the right to pay all or part of a
redemption in kind—that is, in the form of securities—if we reasonably believe that a
cash redemption would negatively affect the fund’s operation or performance or that
the shareholder may be engaged in market-timing or frequent trading. Under these
circumstances, Vanguard also reserves the right to delay payment of the redemption
proceeds for up to seven calendar days. By calling us before you attempt to redeem a
large dollar amount, you may avoid in-kind or delayed payment of your redemption.
Please see Frequent-Trading Limitations for information about Vanguard’s policies to
limit frequent trading"

This is under a section titled, "Potentially disruptive redemptions." This is not related to embedded capital gains, or taxes. Vanguard created their dual-share structure (and got patent protection) specifically so they can use ETFs to avoid embedded capital gains in their mutual funds which have an ETF counterpart. No point going in circles over this, the evidence is out there.
« Last Edit: November 05, 2015, 10:41:33 AM by Interest Compound »

MrMoogle

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #48 on: November 05, 2015, 10:35:27 AM »
The solution is to buy ETF's.  I don't see how this could affect those.  Granted there's not an ETF for every index fund, but Vanguard has one for all the big ones.

protostache

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #49 on: November 05, 2015, 10:37:48 AM »
If this is an issue (Interest Compound is making a solid argument that it's not at all), it's minor. Worth knowing about, but not worth using actively managed funds instead as suggested by the article.

I agree that this should be a non-issue once FIRE due to the low tax bracket, but it could be an issue during accumulation due to higher tax rates. Here's what I haven't heard mentioned yet though:


Index returns theoretically should equal actively managed fund returns, gross.
Net of fees, index funds should already be ahead by 1%.
Net of tax drag from churn, index funds should already be ahead by another 1% (or whatever the tax effect of the churn would be).


What this theory is arguing is the tax drag is building up and could potentially burst, rather than the slow leak provided by an actively managed fund. While a lump sum $100K capital gain distribution would have a huge impact on a tax return, likely a bigger impact than $10K/year for 10 years, the difference is likely minor and would be offset if not dwarfed by the 1% advisor fees along the way.

I just don't see this as an issue at all, but if anyone does I believe the solution is not active management, it's diversification into numerous index funds or numerous individual stocks with a portion of your taxable investments.

Please quote where Kennon advocates for an actively managed fund. Ever.

Kennon's point, as far as I can tell, is that if one has large taxable holdings then one would lower their overall tax risk exposure by owning the underlying securities directly. I.e. buying the companies that compose the S&P 500 directly, instead of via a mutual fund structure.