Author Topic: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"  (Read 23846 times)

bacchi

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #50 on: November 05, 2015, 10:46:53 AM »
Yes, this would be a problem for someone with multi-millions in the market. There's a tipping point somewhere but let's say it's $10 million. If I had $10M, I'd hire some finance intern twice a year to emulate the S&P 500; better yet, I'd put some in a trust and some in housing credits and some in real estate. For those of us with (or aiming for) $1-2M, it's probably not worth the expense or effort.

adamwoods137

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #51 on: November 05, 2015, 10:47:40 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.

[citation needed]

YoungInvestor

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #52 on: November 05, 2015, 10:49:32 AM »
Kennon simply stated a potential problem and even stated that it doesn't apply to most people.

He even suggested buying the index yourself in such situations, and called index funds a godsend for the rest of us.

What more do you want? Why are you people so aggressive?

Proud Foot

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #53 on: November 05, 2015, 10:58:44 AM »
I think what he says in the article is very good.  And also believe that it does not apply the majority of people.  Obviously if the funds are held within a tax-sheltered account it doesn't have any effect on you at all.  In my opinion the embedded gains is something to be aware of but is also is unlikely to come into effect. 

And if I had the money (winning the lottery like his example) I would do as he suggests, I would purchase the individual stocks to create the index.  Particularly from a buy and hold standpoint. If you followed the S&P 500 and reinvested dividends, I think you could do better than a S&P 500 index fund over the long run.

brooklynguy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #54 on: November 05, 2015, 11:05:58 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.

Isn't the entire problem in need of mitigation in the first place the incurrence of tax liability on "someone else's" gains?  If you buy fund shares with embedded gains already built-in, and then the fund realizes those gains and distributes them to you, then you're effectively left holding the bag for tax liability on gains that accrued before you bought in (and established your own cost basis), while previous investors in the fund were able to cash out with no responsibility for those (then-unrealized) gains.

In any event, your proposed mitigation strategy is to sell the fund shares once the distribution has been reported but before the distribution occurs, correct?  But if you bought the fund shares (with preexisting embedded gains) at $100, then they subsequently rose to $500, then the market implodes, triggering massive redemption requests and, in turn, forcing the fund to liquidate assets and realize gains, and the fund shares are down to $150 when the distribution is reported, what do you do?  If you sell your fund shares to avoid the distribution, you realize a $50 per-share gain on the sale (not a harvestable loss) at a time when all you wanted to do was stay the course and continue to hold.

Telecaster

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #55 on: November 05, 2015, 11:12:05 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.

Now you mention it, I see you're right.  He did say recommend buying the stocks in the underlying index directly.   Let's see, at Fidelity buying each of the 500 stocks in the S&P 500 (the index Kennon mentioned) would cost about $4000 just in commissions, not counting the spreads. 

How much is the tax savings again?   

protostache

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #56 on: November 05, 2015, 11:23:28 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.

Now you mention it, I see you're right.  He did say recommend buying the stocks in the underlying index directly.   Let's see, at Fidelity buying each of the 500 stocks in the S&P 500 (the index Kennon mentioned) would cost about $4000 just in commissions, not counting the spreads. 

How much is the tax savings again?   

Assuming you pay $7.95 per trade (in a real life situation you would be paying less), to replicate VFIAX's 0.05% expense ratio in the first year you would need to invest $7.95mil. If you're ok with a 0.1% expense ratio it drops to $3.97mil.

Remember that, after the first purchase, you don't have to rebalance if you don't want to, which means your initial costs are amortized out across your holding period. Even if you keep up with the index, you're looking at maybe 50 trades a year.

seattlecyclone

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #57 on: November 05, 2015, 11:39:52 AM »
Assuming you pay $7.95 per trade (in a real life situation you would be paying less), to replicate VFIAX's 0.05% expense ratio in the first year you would need to invest $7.95mil. If you're ok with a 0.1% expense ratio it drops to $3.97mil.

Remember that, after the first purchase, you don't have to rebalance if you don't want to, which means your initial costs are amortized out across your holding period. Even if you keep up with the index, you're looking at maybe 50 trades a year.

Very few people want to deal with purchasing 500 individual stocks in just the right ratio, then reinvesting dividends in a way that keeps their portfolio pretty close to the index. I know I sure don't! People who want to do this will generally hire this task out to another entity. Wealthfront will do this for 0.25% annually (as long as you have at least $100k invested). Human advisors will charge more. While these embedded gains do provide some level of risk, I have yet to see an argument that this risk is likely to offset the management fee that you would inevitably need to pay if you don't want to buy or sell 500 different stocks every time you add or remove a substantial amount of money from your portfolio.

bacchi

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #58 on: November 05, 2015, 11:47:42 AM »
Isn't the entire problem in need of mitigation in the first place the incurrence of tax liability on "someone else's" gains?  If you buy fund shares with embedded gains already built-in, and then the fund realizes those gains and distributes them to you, then you're effectively left holding the bag for tax liability on gains that accrued before you bought in (and established your own cost basis), while previous investors in the fund were able to cash out with no responsibility for those (then-unrealized) gains.

In any event, your proposed mitigation strategy is to sell the fund shares once the distribution has been reported but before the distribution occurs, correct?  But if you bought the fund shares (with preexisting embedded gains) at $100, then they subsequently rose to $500, then the market implodes, triggering massive redemption requests and, in turn, forcing the fund to liquidate assets and realize gains, and the fund shares are down to $150 when the distribution is reported, what do you do?  If you sell your fund shares to avoid the distribution, you realize a $50 per-share gain on the sale (not a harvestable loss) at a time when all you wanted to do was stay the course and continue to hold.

Previous investors definitely paid for their gains. They bought at $10 and sold at $100, incurring a $90/share gain. The end result is the same, of course. If you buy at $100 and sell at $150, you have a gain of $50, period. It doesn't matter if there's a distribution or not.

Yes, a fund forcing a taxable event would suck. Given enough shares and enough distribution, the distribution/sale could bump you into a higher tax bracket, forcing you to recharacterize your Roth contributions, etc. It's also very unlikely in this case. There are more important things to worry about, such as advisors charging 1% wrap fees.

JetBlast

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #59 on: November 05, 2015, 01:59:18 PM »

Distribution of capital gains is entirely manageable by an institution like Vanguard for a broad index fund.
This statement should end with the phrase....we hope. We've never seen a run on a large index fund. We haven't seen the market drop 22+% in a day during an era where everyone has instantaneous market quotes on their smartphone. I don't know how people would behave if the Dow was down 4,000 points tomorrow (roughly similar to Black Monday in 1987).

I think we are all in agreement that it is a very unlikely scenario, wouldn't affect tax advantaged accounts, and could be offset with tax loss harvesting. We're discussing a small probability scenario. Joshua Kennon's original point is still valid, as it's referring to a fundamentally different situation than most posters are thinking about. It's about a person that's already won the game and is trying to live the phrase that "you only need to get rich once."  It's someone that is willing to spend the extra money or effort of holding the individual companies to avoid this very, very low probability event.

adamwoods137

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #60 on: November 06, 2015, 02:04:41 PM »
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.

Now you mention it, I see you're right.  He did say recommend buying the stocks in the underlying index directly.   Let's see, at Fidelity buying each of the 500 stocks in the S&P 500 (the index Kennon mentioned) would cost about $4000 just in commissions, not counting the spreads. 

How much is the tax savings again?   

Well, the tax savings is zero if you hold most of your wealth through tax shelters.  Don't be purposefully obtuse though, there are plenty of ways to reduce the commission costs if you're willing to either work a little or think a little.  Some drips are a great way, there's probably something clever you could do with sharebuilder or motif investing, many brokerages give you an embarrassing number of free trades to start out with.  You also save the expense ratio forever.  Even so, if none of that works, there's nothing magic about a specific index.  If you believe in the EMH (and if you don't why are you indexing) most of the benefit from diversification comes from the first 20 or so stocks.  If you choose them randomly (weighted for market cap, or value, or however you prefer to index) and never sell you'll beat a typical index fund on turnover, hidden costs like front-running, and expense ratio, as well as taking all of this other risk completely off the table.  You won't track the index perfectly, but your expected value is the same and you're approximately as diversified, so who cares?  (In fact some small cap index funds do precisely this, they don't buy all of the tiny companies, they buy a randomized representative sample of them.)  Commissions are so low at this point I can't think of any good reasons to buy an index fund as opposed to constructing your own.  (There are plenty of reasons not to "pick stocks" but that isn't what I'm talking about). 

adamwoods137

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #61 on: November 06, 2015, 02:05:52 PM »
Now you mention it, I see you're right.  He did say recommend buying the stocks in the underlying index directly.   Let's see, at Fidelity buying each of the 500 stocks in the S&P 500 (the index Kennon mentioned) would cost about $4000 just in commissions, not counting the spreads. 

How much is the tax savings again?   

Also, is the implication here that index funds don't have to pay the spread!?

seattlecyclone

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #62 on: November 06, 2015, 02:11:08 PM »
Commissions are so low at this point I can't think of any good reasons to buy an index fund as opposed to constructing your own.  (There are plenty of reasons not to "pick stocks" but that isn't what I'm talking about). 

Does "not wanting to mess around with doing dozens of trades each time you want to invest new money or withdraw money" not count as a "good reason"?

adamwoods137

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #63 on: November 06, 2015, 02:13:11 PM »
Assuming you pay $7.95 per trade (in a real life situation you would be paying less), to replicate VFIAX's 0.05% expense ratio in the first year you would need to invest $7.95mil. If you're ok with a 0.1% expense ratio it drops to $3.97mil.

Remember that, after the first purchase, you don't have to rebalance if you don't want to, which means your initial costs are amortized out across your holding period. Even if you keep up with the index, you're looking at maybe 50 trades a year.

Very few people want to deal with purchasing 500 individual stocks in just the right ratio, then reinvesting dividends in a way that keeps their portfolio pretty close to the index. I know I sure don't! People who want to do this will generally hire this task out to another entity. Wealthfront will do this for 0.25% annually (as long as you have at least $100k invested). Human advisors will charge more. While these embedded gains do provide some level of risk, I have yet to see an argument that this risk is likely to offset the management fee that you would inevitably need to pay if you don't want to buy or sell 500 different stocks every time you add or remove a substantial amount of money from your portfolio.

There's no real reason you need to buy the individual stocks at "the right ratio" according to the efficient market hypothesis.  You don't even need to buy all 500 individual stocks.  The reason index funds are market cap weighted isn't because its better, its because when doing science it was mathematically convenient.  The important thing is just that you aren't "picking stocks", but rather that you trust that the market is accurately pricing them and you have a low turnover.  It isn't the weighting that makes magic for index funds, its low turnover, tax efficiency, and humility in the face of a pretty efficient pricing mechanism.  Throwing darts at a board is every bit as good as an index.  It's when you try to outsmart the market that you get in trouble, because you fall prey to cognitive biases, realized taxes, and increased turnover.

adamwoods137

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #64 on: November 06, 2015, 02:14:30 PM »
Commissions are so low at this point I can't think of any good reasons to buy an index fund as opposed to constructing your own.  (There are plenty of reasons not to "pick stocks" but that isn't what I'm talking about). 

Does "not wanting to mess around with doing dozens of trades each time you want to invest new money or withdraw money" not count as a "good reason"?

Oops, that's absolutely right, my elbow was covering up that part of my "cons" list. =-D

protostache

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #65 on: November 06, 2015, 02:24:24 PM »
The reason index funds are market cap weighted isn't because its better, its because when doing science it was mathematically convenient.

Also because other methods tend to cause problems. If you tried to make an equal-weight portfolio that approaches the size of VTSAX most companies would not have the liquidity available to make it happen. Same happens with fundamental weight portfolios, except with more turnover. A market cap weighted index is really the only way to make it happen on that scale because it naturally concentrates most of the money in a small number of companies.

adamwoods137

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #66 on: November 06, 2015, 03:26:40 PM »
The reason index funds are market cap weighted isn't because its better, its because when doing science it was mathematically convenient.

Also because other methods tend to cause problems. If you tried to make an equal-weight portfolio that approaches the size of VTSAX most companies would not have the liquidity available to make it happen. Same happens with fundamental weight portfolios, except with more turnover. A market cap weighted index is really the only way to make it happen on that scale because it naturally concentrates most of the money in a small number of companies.

That's definitely true as well.  The point, however, is that all of these considerations probably have nothing to do with you as an individual investor.  Just because something is easier for a very massive co-op like Vanguard to do, doesn't make it ideal for you.  There's no specific reason that you couldn't define different rules for contributions versus holdings.  You could just say that contributions will be equal weighted, but that you will make no attempt to rebalance.  Anything that lowers turnover seems good in my book.  I always feel a little skeptical that any rebalancing of a portfolio will actually result in better performance after investor bias- spreads- commissions - and taxes are all accounted for. 

Indexer

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #67 on: November 06, 2015, 04:25:47 PM »
With index funds you don't really have to worry about this because they are highly unlikely to spit out those embedded capital gains. Yes a stock index fund should have a lot of embedded gains, and that is because they just keep collecting them instead of forcing them onto investors.

Now it could be an issue for an active mutual fund(including equal weight index funds & smart beta funds). If you looked at an active mutual fund that doesn't trade a lot and has some positions with a lot of appreciation this could very well be a problem. Vanguard Primecap(VPMCX) is actually a prime example of this. It has very low turnover for an active fund, and its unrealized appreciation is 46.97%.

If Primecap sold some of its past winners it could generate a very big capital gain, even to an investor who wasn't in the fund when it was winning.

This also goes hand in hand with the fact that you could own an active fund, lose money, and then still have to pay capital gains.

Aphalite

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #68 on: November 06, 2015, 05:36:52 PM »
With index funds you don't really have to worry about this because they are highly unlikely to spit out those embedded capital gains. Yes a stock index fund should have a lot of embedded gains, and that is because they just keep collecting them instead of forcing them onto investors.

Mechanically, an index has the OPTION to distribute in kind, but the reason you haven't seen any sort of capital distributions in your vanguard funds to date (with the exception of the mining index fund already mentioned previously in the thread) is because inflows have outpaced outflows. NO ONE knows what Vanguard will do if faced with mass redemptions in the main funds (ie total market or sp500). They could, as interest compound has posited, distribute equity holdings in kind, or, if they wanted to and its easier, sell and distribute cash. To place blind faith in Vanguard to do the "right" thing for your suitable interests is to me, naive, particularly because Vanguard does not KNOW what your personal financial situation is

If you're saying that it's highly unlikely BECAUSE a run would have to occur, then maybe. But Vanguard has gotten to where they are because they are a leader in low cost - just like Walmart. Are you telling me that you can't foresee a scenario where a technology company eventually swoops in and offers even cheaper, more customizable services?

Telecaster

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #69 on: November 06, 2015, 06:38:34 PM »
Commissions are so low at this point I can't think of any good reasons to buy an index fund as opposed to constructing your own. 

I can think of a few.   One is that it would be a headache come April 15.  You really want to manage all that?  But another biggie is institutional skill.  That's why sometimes Vanguard funds actually beat the index by a small amount.    A short discussion here:

http://www.efficientfrontier.com/ef/998/indexfun.htm

Another (less dense) discussion here:

http://www.cbsnews.com/news/vanguard-luck-or-skill/

Money shot here:

Quote
Financial markets are not always perfectly efficient and sometimes the price of an S&P 500 futures contract is ever so slightly more attractive than the basket of 500 stocks itself. Vanguard buys the futures with new money when this is the case.

Next, like most large fund families, Vanguard lends out some of its securities to others, taking 102 percent collateral in cash. Vanguard then takes the profits and distributes them to the shareholders in the form of an increased net asset value. The borrowers of these securities need them to cover short positions.

You and I can't do that.  Vanguard can do indexing way better than I can.  I'm not ashamed to admit it.  I am happy as a clam letting them handle my indexing needs. 

Here's my real point, I've been trying to drop hints, but it is time to wrap things up.   Kennon is throwing shade for no reason.   I get the impression he really hasn't been around long enough to know what's up.   We've been through two big market sell-offs in the last 15 years (and a number of minor ones) and the number of index investors hit by this problem is zero.   

The Doomsday scenario could happen, of course.   But lots of other unlikely scenarios could also happen.  I'll mitigate the likely ones and take chances with rest.  This is not a likely problem.   But if it does happen, worst case is potentially a higher tax bill.   But very likely not.    And Kennon is some kind of Guru to point that out? 

And there is a flip side as well.  In the not-so-recent past, Vanguard index funds have had significant negative capital gains exposure for periods of time.  I wonder why Kennon didn't mention that?  I have a couple of guesses why.   



Indexer

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #70 on: November 07, 2015, 02:58:29 AM »
With index funds you don't really have to worry about this because they are highly unlikely to spit out those embedded capital gains. Yes a stock index fund should have a lot of embedded gains, and that is because they just keep collecting them instead of forcing them onto investors.

Mechanically, an index has the OPTION to distribute in kind, but the reason you haven't seen any sort of capital distributions in your vanguard funds to date (with the exception of the mining index fund already mentioned previously in the thread) is because inflows have outpaced outflows. NO ONE knows what Vanguard will do if faced with mass redemptions in the main funds (ie total market or sp500). They could, as interest compound has posited, distribute equity holdings in kind, or, if they wanted to and its easier, sell and distribute cash. To place blind faith in Vanguard to do the "right" thing for your suitable interests is to me, naive, particularly because Vanguard does not KNOW what your personal financial situation is

If you're saying that it's highly unlikely BECAUSE a run would have to occur, then maybe. But Vanguard has gotten to where they are because they are a leader in low cost - just like Walmart. Are you telling me that you can't foresee a scenario where a technology company eventually swoops in and offers even cheaper, more customizable services?

I'm not placing blind faith. As Interest Compound has pointed out they have the option of keeping capital gain distributions to the ETF share class. On that note Interest Compound didn't say the mutual funds would distribute stocks in kind to the investors. He said they would distribute the gains to the ETF share class. These are TOTALLY different things. I'm not sure you fully understand what Interest Compound is getting at. I would read the links he provided. I know you gave the example of the mining fund as a fund that did distribute a capital gain. For starters I would like to know the ticker symbol of that fund because to my knowledge the only Vanguard mining fund is an ACTIVE mutual fund, not an index fund. And as Interest Compound pointed out if that fund didn't have an ETF counterpart it wouldn't be able to direct the gains like that.

Why I do trust them to do the right thing: Vanguard positions the tax efficiency benefits of their index funds. It is a selling point to clients, and a selling point to independent Financial Planners who use their funds/ETFs. Given the option I expect them to keep the funds as tax efficient as possible, and to distribute the gains to the ETFs. I expect them to do this because it has been their selling point. If they had the option, and then they didn't do it they would upset existing loyal customers and the fee only Financial Planners who use their funds. Basically to save a penny today they would cut off future millions. I expect them to be smarter than that...

Vanguard is not comparable to Walmart as a business. Yes they both have low cost in common, and that is where it ends. Walmart has billions tied up in real estate, millions of employees, and a supply network spanning the globe. I would say they are about as agile as a cargo container.... but that cargo container is actually just one tiny cog in their wheel. Vanguard is web based, has essentially no real estate, thousands of employees, and trillions of dollars in assets. IE they can change rather quickly and they have the cash flow to make it happen. If someone found a lower cost more customizable way of doing things and Vanguard saw it as a threat they could easily do something similar and point the bazooka called 'economies of scale' at the problem. The current tech companies trying to get in the investment industry(Betterment/Wealthfront) use Vanguard funds, Vanguard has been rolling out an advice service where you video chat with the advisor(no brick and mortar offices), and I would be really surprised if they weren't working on a Wealthfront equivalent themselves. In this scenario Vanguard isn't Walmart, it is the Amazon stealing Walmart's business.
« Last Edit: November 07, 2015, 03:00:42 AM by Indexer »

Aphalite

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #71 on: November 07, 2015, 04:58:02 AM »
And there is a flip side as well.  In the not-so-recent past, Vanguard index funds have had significant negative capital gains exposure for periods of time.  I wonder why Kennon didn't mention that?  I have a couple of guesses why.

He did mention it:
"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.

FWIW, you can also profit from this in reverse. Benjamin Graham used to talk about this regrading corporations back in the early editions of Security Analysis but it holds true for open-ended mutual funds too. If you are looking at a fund with large embedded losses, and redemptions cause those losses to be realized, you can basically get a tax credit for things you didn't necessarily suffer and use them to offset your own gains.
"
http://www.joshuakennon.com/mail-bag-buying-stock-when-valuations-are-high/#comment-2315926200

I get it, we've all been exposed to plenty of "gurus" who are trying to sell snake oil. Your bullshit detector sensors automatically goes up when it comes to this kind of stuff. But I guarantee you Joshua knows far more than any of us here combined about investing. If you ever take the time to read his site a bit, you'll see what I mean

Aphalite

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #72 on: November 07, 2015, 05:12:56 AM »
I'm not placing blind faith. As Interest Compound has pointed out they have the option of keeping capital gain distributions to the ETF share class. On that note Interest Compound didn't say the mutual funds would distribute stocks in kind to the investors. He said they would distribute the gains to the ETF share class. These are TOTALLY different things. I'm not sure you fully understand what Interest Compound is getting at. I would read the links he provided. I know you gave the example of the mining fund as a fund that did distribute a capital gain. For starters I would like to know the ticker symbol of that fund because to my knowledge the only Vanguard mining fund is an ACTIVE mutual fund, not an index fund. And as Interest Compound pointed out if that fund didn't have an ETF counterpart it wouldn't be able to direct the gains like that.

Do YOU understand how redemptions on ETFs would work? It's not a magical instrument that lets you bypass capital gains entirely just because the fund ends with ETF instead of mutual fund. Here's one more quote from Joshua (emphasis mine):
"The way the VTI shares work (the ones that are structured as an ETF) is this: Unlike the VTSMX, individual investors can't buy or sell (redeem) shares directly with the fund itself. Instead, certain authorized brokerage houses can buy or sell (redeem) in giant 100,000 blocks of "Creation Units". Right now, a single creation unit would cost you $10,369,000.

Most mutual funds have within them the power to do something known as an "in-kind distribution". This means that if liquidity became a problem and you entered a sell order for your shares, Vanguard could say, "Sorry. Times are tough. We're not giving you cash because we can't raise funds in the market by selling the underlying investments. Instead, we are dumping your pro-rata ownership of all of the underlying stocks into a brokerage account you select so you can deal with it yourself. Once that's done, your mutual fund shares are cancelled and you're on your own, sitting on a pile of individual stocks." (In practical terms, funds almost never exercise this power since it's easier and cheaper to sell the stock and forward the cash though I expect that would change quickly the next time we go into a 1929-1933 style meltdown. I imagine a lot of mutual fund investors who eschewed "individual stocks" will find themselves apoplectic because they had no idea this was a possibility - and that they've owned individual stocks all along - and are now holding hundreds or thousands of them directly they can't get rid of easily.)

The ETF creation units are so huge that the theory goes management is far more likely to purposely take advantage of in-kind distributions if it wanted to do so, selecting the shares with the highest embedded gains to kick out the door and hand over to the institution taking the distribution. Goldman Sachs, for example, is probably going to be able to deal with delivery of the underlying stocks rather than cash. This means, at least on paper, the ETFs could serve as a way for the fund to drain off those embedded gains but there is no guarantee it will happen, it's entirely theoretical, and one shouldn't bank on it.

As assets have flooded into passive index-based funds over the past few decades, it's allowed firms like Vanguard to essentially hide this potential time bomb by funding distribution requests with new, incoming funds rather than asset sales when at all possible.
"

The ticker has been mentioned in the thread previously, along with links, it definitely has the ability to direct gains like an ETF would because they have the ability to distribute in kind, which is the ONLY way to avoid massive embedded gains

I personally believe blind trust in any institution, even one as admirable as Vanguard, is dangerous. I think they do a giganticly important service for the public by leading the world towards low cost investing, but you shouldn't drop the "trust but verify" mindset because of the effect of any halo disposition you have towards the institution itself

At the end of the day, it's not a huge risk because 1) the LIKELIHOOD of the scenario happening isn't big, 2) for the posters in the forum, the likely tax bill isn't something that couldn't be managed and 3) what's the alternative if you're a self directed investor who doesn't want to spend too much time on investing? But it IS an embedded risk and I don't understand the massive denial. Index funds have flaws, whether its market cap methodology, float adjustment, whatever, it's not a big deal because at the end of the day, it still represents the best effort-value ratio you can get as an individual investor. The intelligent thing to do is to acknowledge and know those flaws/risks, and, if you have no interest in studying investing any deeper, continue to buy them
« Last Edit: November 07, 2015, 05:20:35 AM by Aphalite »

YoungInvestor

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #73 on: November 07, 2015, 06:26:36 AM »
Correct me if I'm wrong, but:

Vanguard gets some of its cost-cutting through lending its shares to a short seller.

Wouldn't an account for tens of millions get roughly the same treatment and be able to do likewise? I think Interactive Brokers does that, others probably do.

In this case, I think you could fairly consistently beat the index just through these payments.

Not sure what kind of additional yield that would provide, but even while paying a small percentage to someone who handles the account, I think you could match/beat the return obtained by Vanguard.

seattlecyclone

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #74 on: November 07, 2015, 08:12:01 AM »
Here's my real point, I've been trying to drop hints, but it is time to wrap things up.   Kennon is throwing shade for no reason.   I get the impression he really hasn't been around long enough to know what's up.   We've been through two big market sell-offs in the last 15 years (and a number of minor ones) and the number of index investors hit by this problem is zero.   

The Doomsday scenario could happen, of course.   But lots of other unlikely scenarios could also happen.  I'll mitigate the likely ones and take chances with rest.  This is not a likely problem.   But if it does happen, worst case is potentially a higher tax bill.   But very likely not.    And Kennon is some kind of Guru to point that out? 

I couldn't have said it better myself. Of all the things you can worry about, this one is so far down the list that you might as well ignore it. Worst case, there's a run on the fund and your taxes are a bit higher than you were expecting one year. This incredibly insignificant risk is not sufficient reason to abandon mutual funds and try to roll your own.

Caoineag

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #75 on: November 07, 2015, 08:39:19 AM »
Isn't the simple answer just to use ETF's in your taxable account? I know when I was deciding whether to do mutual funds or ETFs in my taxable account, I came across a lot of information on exactly this issue which is why I went with ETFs. The side bonus is that they had expense ratios on par with admiral shares as well without the large minimum.

brooklynguy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #76 on: November 07, 2015, 09:10:05 AM »
Isn't the simple answer just to use ETF's in your taxable account? I know when I was deciding whether to do mutual funds or ETFs in my taxable account, I came across a lot of information on exactly this issue which is why I went with ETFs. The side bonus is that they had expense ratios on par with admiral shares as well without the large minimum.

Potential mitigation of this remote tax risk is not the only consideration to be taken into account, though.  All else is not equal between mutual fund and ETF alternatives for the same underlying fund -- ETFs come with their own set of downsides, such as the existence of a bid/ask spread and inability to transact in fractional shares.

JetBlast

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #77 on: November 07, 2015, 09:38:21 AM »

At the end of the day, it's not a huge risk because 1) the LIKELIHOOD of the scenario happening isn't big, 2) for the posters in the forum, the likely tax bill isn't something that couldn't be managed and 3) what's the alternative if you're a self directed investor who doesn't want to spend too much time on investing? But it IS an embedded risk and I don't understand the massive denial. Index funds have flaws, whether its market cap methodology, float adjustment, whatever, it's not a big deal because at the end of the day, it still represents the best effort-value ratio you can get as an individual investor. The intelligent thing to do is to acknowledge and know those flaws/risks, and, if you have no interest in studying investing any deeper, continue to buy them

I think this really sums it all up very well. Every type of investment has unique risks, some much larger than others, but they all have some kind of flaw. For most people, the flaws in index fund structures are so minor that it is still the best option.

Caoineag

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #78 on: November 07, 2015, 09:46:40 AM »
Potential mitigation of this remote tax risk is not the only consideration to be taken into account, though.  All else is not equal between mutual fund and ETF alternatives for the same underlying fund -- ETFs come with their own set of downsides, such as the existence of a bid/ask spread and inability to transact in fractional shares.

Fair enough, there are pros and cons to each method of acquiring stocks. For me, the efficiency of the ETF's outweighed the cons you mentioned but each person has to decide for themselves.

Interest Compound

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #79 on: November 07, 2015, 11:33:58 AM »
With index funds you don't really have to worry about this because they are highly unlikely to spit out those embedded capital gains. Yes a stock index fund should have a lot of embedded gains, and that is because they just keep collecting them instead of forcing them onto investors.

Mechanically, an index has the OPTION to distribute in kind, but the reason you haven't seen any sort of capital distributions in your vanguard funds to date (with the exception of the mining index fund already mentioned previously in the thread) is because inflows have outpaced outflows. NO ONE knows what Vanguard will do if faced with mass redemptions in the main funds (ie total market or sp500). They could, as interest compound has posited, distribute equity holdings in kind, or, if they wanted to and its easier, sell and distribute cash. To place blind faith in Vanguard to do the "right" thing for your suitable interests is to me, naive, particularly because Vanguard does not KNOW what your personal financial situation is

If you're saying that it's highly unlikely BECAUSE a run would have to occur, then maybe. But Vanguard has gotten to where they are because they are a leader in low cost - just like Walmart. Are you telling me that you can't foresee a scenario where a technology company eventually swoops in and offers even cheaper, more customizable services?

I'm not placing blind faith. As Interest Compound has pointed out they have the option of keeping capital gain distributions to the ETF share class. On that note Interest Compound didn't say the mutual funds would distribute stocks in kind to the investors. He said they would distribute the gains to the ETF share class. These are TOTALLY different things. I'm not sure you fully understand what Interest Compound is getting at. I would read the links he provided. I know you gave the example of the mining fund as a fund that did distribute a capital gain. For starters I would like to know the ticker symbol of that fund because to my knowledge the only Vanguard mining fund is an ACTIVE mutual fund, not an index fund. And as Interest Compound pointed out if that fund didn't have an ETF counterpart it wouldn't be able to direct the gains like that.

Why I do trust them to do the right thing: Vanguard positions the tax efficiency benefits of their index funds. It is a selling point to clients, and a selling point to independent Financial Planners who use their funds/ETFs. Given the option I expect them to keep the funds as tax efficient as possible, and to distribute the gains to the ETFs. I expect them to do this because it has been their selling point. If they had the option, and then they didn't do it they would upset existing loyal customers and the fee only Financial Planners who use their funds. Basically to save a penny today they would cut off future millions. I expect them to be smarter than that...

Vanguard is not comparable to Walmart as a business. Yes they both have low cost in common, and that is where it ends. Walmart has billions tied up in real estate, millions of employees, and a supply network spanning the globe. I would say they are about as agile as a cargo container.... but that cargo container is actually just one tiny cog in their wheel. Vanguard is web based, has essentially no real estate, thousands of employees, and trillions of dollars in assets. IE they can change rather quickly and they have the cash flow to make it happen. If someone found a lower cost more customizable way of doing things and Vanguard saw it as a threat they could easily do something similar and point the bazooka called 'economies of scale' at the problem. The current tech companies trying to get in the investment industry(Betterment/Wealthfront) use Vanguard funds, Vanguard has been rolling out an advice service where you video chat with the advisor(no brick and mortar offices), and I would be really surprised if they weren't working on a Wealthfront equivalent themselves. In this scenario Vanguard isn't Walmart, it is the Amazon stealing Walmart's business.

Exactly. Most people here agree there's a very tiny chance something like this could happen in our lifetime. With that in mind, Vanguard purposely created a unique structure which avoids this, patented it so no one else could copy them, then held it up as a unique selling point of their funds. Am I to worry not only about the tiny chance it becomes an issue, but also that Vanguard went through all that trouble, only to not use the mechanism they specifically created to avoid this? Should I now get an advisor to construct "a directly-held customized index of passive stocks in an individually managed account" as the article tells me to, then call everyone on the forum who still buys Vanguard funds "ignorant", but it's ok because "they'll get what they deserve"?

This is how people new to investing end up with Whole Life Insurance, or paying an advisor a 1-2% ER (yearly fee), not realizing such a "small" fee will consume half of their portfolio over the long-term. This is the type of FUD (Fear Uncertainty and Doubt) that makes it so hard for newbies to make good investment decisions, and it's important to call it out when we see it.

DavidAnnArbor

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #80 on: November 07, 2015, 11:46:39 AM »
brooklynguy :
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. 


Quote from: Josh Kennon
I'd bet 95%+ of investors don't [give any thought to the potential "embedded gain" tax issue.
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. That's almost 45% of the entire capital base!

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

In this New York Times article, "The Ease of Index Funds Comes with Risk"  http://www.nytimes.com/2015/10/11/business/mutfund/the-ease-of-index-funds-comes-with-risk.html

A runup in a Russell 2000 or S&P 500 Index fund could indeed cause valuations of the stocks in these indices to become too high to be justified by actual revenues and profits. The result could be a big sell off of these index funds, which Kennon believes would lead to embedded gains being passed off to investors, hurting those in taxable accounts with whopping capital gains. (Although we didn't see this happen in 2009, one of the worst downturns in stock market history).

The NY Times article suggests one way to avoid the problem of a passive index fund that divorces stock valuations from reality is to buy the Vanguard Total Stock Market Index, which "represents nearly all United States stocks and diversifies market exposure."

Problem solved!!

Telecaster

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #81 on: November 07, 2015, 02:33:06 PM »
I get it, we've all been exposed to plenty of "gurus" who are trying to sell snake oil. Your bullshit detector sensors automatically goes up when it comes to this kind of stuff. But I guarantee you Joshua knows far more than any of us here combined about investing. If you ever take the time to read his site a bit, you'll see what I mean

Heh.  Fair enough.  Salute!

FFA

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #82 on: November 08, 2015, 04:57:59 AM »
just to add from the Australian context : where we have Listed Investment Co's (maybe similar to Berkshire Hathaway). These are closed ended structures (a fixed number of shares issued) and they are required to publicise pre and post tax NAV's. So it kind of highlights the issue. Here is an example from Argo Investments, which has been around for nearly 70 years....

Quote
The Net Tangible Asset backing (NTA) as at 31 October, 2015 was $7.17 per share.

Argo is a long-term investor and does not intend to dispose of its long-term portfolio. However, under current Accounting Standards, the Company is required provide for tax that may arise should the entire portfolio be disposed of on the above date. After deducting this theoretical provision, the above figure would be $6.38 per share.

Unlike open ended ETF's, these LIC's can trade at substantial premium/discount to the NAV. Still it is usually the pre-tax NAV that seems to be the main driver of their value.

This embedded gain issue was a reason I steered clear of these long running LIC's in favour of more recent index ETF's, although yes they still have the tax exposure. I also thought the open ended structure of ETF's reduces/avoids the risk as in practice the price always trades around the pre-tax NAV (but maybe there is some scenario where this is not the case ???).

YoungInvestor

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #83 on: November 08, 2015, 07:15:07 AM »
brooklynguy :
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. 


Quote from: Josh Kennon
I'd bet 95%+ of investors don't [give any thought to the potential "embedded gain" tax issue.
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. That's almost 45% of the entire capital base!

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

In this New York Times article, "The Ease of Index Funds Comes with Risk"  http://www.nytimes.com/2015/10/11/business/mutfund/the-ease-of-index-funds-comes-with-risk.html

A runup in a Russell 2000 or S&P 500 Index fund could indeed cause valuations of the stocks in these indices to become too high to be justified by actual revenues and profits. The result could be a big sell off of these index funds, which Kennon believes would lead to embedded gains being passed off to investors, hurting those in taxable accounts with whopping capital gains. (Although we didn't see this happen in 2009, one of the worst downturns in stock market history).

The NY Times article suggests one way to avoid the problem of a passive index fund that divorces stock valuations from reality is to buy the Vanguard Total Stock Market Index, which "represents nearly all United States stocks and diversifies market exposure."

Problem solved!!

Even if YOU use a total stock market index, if the sp500 fund is still the most popular, a significant portion of your holdings will have this problem.

Heck, given enough money, if everyone uses a total stock market index, equities may come to a point where their valuation makes them suboptimal.

brainfart

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #84 on: November 08, 2015, 07:44:49 AM »
"Embedded Gains"

...and how this problem applies to many European investors without tax advantaged accounts.

"Embedded gains" for us are are taxable events, every year. If there are any, the local European approved funds will publish these numbers and you have to include them when you file your taxes, unless of course they distribute them.

"Embedded gains" are a potential problem for many European investors and one of the reasons why US funds like Vanguard could be dangerous for us. Interestingly, certain Ireland-domiciled iShare funds have been notorious for this in the recent past, too.

To give you an idea what I mean I'll try to piece together an example I saw online a few months ago:

Imagine an investor buying three of the popular iShare funds with embedded gains every month, for 25 years. After 25 years everything is sold at once. A certain amount of capital gains tax is due now which is automatically widthdrawn by the broker/tax authority. At the end of the year a big chunk of these taxes can be reclaimed to avoid double taxation, since the investor already paid taxes on most of the gains many years ago. Ok, let's calculate how much that is.

What paperwork do you need?

12 (months in a year) * 3 (different funds) * 25 (invested years) + 25 (your tax returns) + 3 * 25 (statements for taxes on internal gains already paid by the funds)

So roughly 1000 documents you have to store and finally comb through, to prove how much taxes you already paid in the past and how much you can reclaim. Sounds like a fun way to spend a few weeks of your precious life time and hone your accounting skills. Or pay a professional to do it, I've heard they are cheap....
What are the chances that a) you didn't make any errors and b) your tax authority will accept your calculations as true?
For a small invested 5 figure sum they most likely won't bother checking your numbers and accept your claim. For a large 6 or even 7 figure sum of invested money they certainly will argue with you.

(Funny little iShares fact: they define tax year differently. Government says from january 1st. till dec. 31st. iShares used to disagree, giving other dates. Good luck trying to align the embedded gains with your official tax year)

Someone wrote a letter to the local IRS equivalent with the above example, asking for help. They replied. We have no clue. Too complicated to give advice, we'll decide how do deal with this if and when the need arises.

Now to make things more interesting, imagine said investor rebalanced his portfolio a few times, and doesn't sell everything at once. Ouch. Now you have to account for each individual or even fractional share, when you bought it, how much taxes you paid, and when you sold it!
Alternatively, the investor dies, and now his/her clueless heirs have to do all this.

US funds like Vanguard of course do not cooperate one bit with our European tax authorities. They of course don't pay taxes here and don't supply any information whatsoever about capital gains distributions inside their funds. Since no information is available, taxes due will be guesstimated. One common way to do this in the past in my home country was 6% of the fund value if it goes down, 75% of the gains during any given year. This has been ruled excessive and illegal by the highest European court, after years of legal battle by affected investors. They are still waiting for their money, and nobody knows what the new taxation scheme will look like. Maybe 5%/70%? Who knows, if you don't like it, you are of course free to sue your government and wait a few years.

Anyone knows how US withholding taxes and W-8BEN etc. influence this accounting nightmare? I don't, and don't plan to find out.

FFA

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #85 on: November 08, 2015, 07:29:00 PM »

"Embedded gains" for us are are taxable events, every year. If there are any, the local European approved funds will publish these numbers and you have to include them when you file your taxes, unless of course they distribute them.

just to clarify , do you mean embedded unrealised gains (which is the issue here) ? i'm a bit surprised there would be tax payable on mark-to-market movements of unsold assets.

FFA

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #86 on: November 08, 2015, 07:44:56 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.
I agree with telecaster, the only risk scenarios I can think of are armegeddon ones, in which case the problem is likely to evaporate at the same time.

Anyone who's worried could invest in newly formed etf's which have bought their assets recently. The MER might not be as attractive though !

Indexer

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #87 on: November 09, 2015, 07:43:22 AM »
I'm not placing blind faith. As Interest Compound has pointed out they have the option of keeping capital gain distributions to the ETF share class. On that note Interest Compound didn't say the mutual funds would distribute stocks in kind to the investors. He said they would distribute the gains to the ETF share class. These are TOTALLY different things. I'm not sure you fully understand what Interest Compound is getting at. I would read the links he provided. I know you gave the example of the mining fund as a fund that did distribute a capital gain. For starters I would like to know the ticker symbol of that fund because to my knowledge the only Vanguard mining fund is an ACTIVE mutual fund, not an index fund. And as Interest Compound pointed out if that fund didn't have an ETF counterpart it wouldn't be able to direct the gains like that.

Do YOU understand how redemptions on ETFs would work? It's not a magical instrument that lets you bypass capital gains entirely just because the fund ends with ETF instead of mutual fund. Here's one more quote from Joshua (emphasis mine):
"......"

The ticker has been mentioned in the thread previously, along with links, it definitely has the ability to direct gains like an ETF would because they have the ability to distribute in kind, which is the ONLY way to avoid massive embedded gains

I personally believe blind trust in any institution, even one as admirable as Vanguard, is dangerous. I think they do a giganticly important service for the public by leading the world towards low cost investing, but you shouldn't drop the "trust but verify" mindset because of the effect of any halo disposition you have towards the institution itself

At the end of the day, it's not a huge risk because 1) the LIKELIHOOD of the scenario happening isn't big, 2) for the posters in the forum, the likely tax bill isn't something that couldn't be managed and 3) what's the alternative if you're a self directed investor who doesn't want to spend too much time on investing? But it IS an embedded risk and I don't understand the massive denial. Index funds have flaws, whether its market cap methodology, float adjustment, whatever, it's not a big deal because at the end of the day, it still represents the best effort-value ratio you can get as an individual investor. The intelligent thing to do is to acknowledge and know those flaws/risks, and, if you have no interest in studying investing any deeper, continue to buy them

Do I know how redemptions on ETFs work? First, I was never talking about that, I was talking about mutual funds move gains into the ETF share class. Second, do you know how redemptions on ETFs work?  It is an interesting question because mutual funds have redemptions, ETFs trade on an exchange(they don't normally do redemptions). An average investor is never going to see an ETF redemption. Goldman might, but honestly they would probably have to request it. That is what I'm getting at. Interest Compound, and now myself, are talking about how Vanguard takes the unrealized gains in the mutual fund and moves it to the ETF share class. That way when someone sells the mutual fund... the embedded capital gains are gone!  We aren't talking about the mutual fund or the ETF doing in kind distributions to investors. I'll address that as a second matter.

Step by step in case it isn't clear:
Vanguard 500 index fund admiral shares has a bunch of stocks they bought last week that don't have gains, and they have a bunch of stocks they bought 30-40 years ago with a ton of gains. Shares of AAPL from 1985 would be a good example.
The company that creates the ETF units for VOO comes along and says they need to make more units of VOO.
Vanguard gives them shares to create the new units of VOO.
In a stroke of genius someone at Vanguard said, "Hey, why don't we specifically give VOO the stock shares within VFIAX we bought decades ago that have a lot of appreciation we never want to realize?"
Now those shares of AAPL from 1985 are in VOO which sells like a stock, and doesn't have to do cash redemptions.  Ah ha! The gains can be embedded essentially till the end of time! [Unless a big company(like Goldman) specifically requests an in kind distribution(unlikely).]
Since AAPL use to be a tiny piece of the index there are fewer shares from 1985 than there are from 2014 so VFIAX can get rid of ALL of the shares from 1985 and still keep the allocations right in both VFIAX and VOO. Copy this example for all 500(ish) holdings.
Now the mutual fund VFIAX which does have to do cash distributions has less embedded gains to worry about.

Mission accomplished. The embedded gains have been removed from the mutual fund that has to do cash distributions. Does it remove all of them?  Of course not, but every time this happens there are less embedded gains to worry about in the future. So this isn't something VFIAX would do the day people are requesting distributions. It is something they have been doing for years so that in the event of future redemptions many of the embedded gains have already been removed.

In kind distributions: It seems you are worried they would do this. 1. your link to a prospectus went to the Vanguard Precious metals and mining fund. Again, that is an ACTIVE fund. By design it isn't tax efficient so we should probably be using different examples. 2. Mutual funds aren't going to do in kind distributions to average investors. The investor would need enough money in the fund for the fund to be able to distribute at least 1 whole share of each investment in the proper proportions. In the case of the 500 index that is a LOT of money, and even more with the total stock market index. If a hedge fund or something similar was trying to day trade one of the funds they might do it to them. Otherwise the only way you are going to get an in kind distribution is if you have a ton of money in the fund and you 'request' it. This is really a separate issue from the ETFs. I don't know why this Joshua clickbait guy is trying to drag it all together other than to make it look more confusing than it really is.

In the event of another 1929.  We already had it, it was called 2008... I didn't see mass in kind distributions to investors, did anyone else? Some mutual funds also existed in 1929, and guess what... still didn't do in kind distributions!

Talk about turning an Ant hill into mount Everest. Could the problem Joshua is describing happen?  Yes. Could it happen to a Vanguard index funds that benefits from having the ETF share class? Yes, but it is even less likely than with other index funds. Being worried about this is like buying flood insurance when you live at the peak top of a mountain.

And even if you are super worried about this.... buy the ETF instead of the mutual fund.

brooklynguy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #88 on: November 09, 2015, 08:22:25 AM »
this Joshua clickbait guy

Everyone who keeps denouncing Kennon's comments as "clickbait" may want to take a look at his site before passing judgment.  Keep in mind that all of his blog comments that were quoted in this thread were pulled from the comments section of a blog post describing how different investment approaches react to high market valuations, which, essentially, extolled the virtues of index funds.

My intention in starting this thread was to raise awareness of an issue (representing an admittedly remote risk) of which most of us probably had insufficient (including zero) awareness.  Quoting Kennon's comments in isolation without the broader context may have given the wrong impression about his material -- he puts out some great content, and I would recommend checking out his site.

DavidAnnArbor

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #89 on: November 15, 2015, 01:41:01 PM »
Thank you Indexer for providing a lot of clarity to understanding embedded gains and the way index mutual funds can pass them off to corresponding ETF's.

JetBlast

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #90 on: November 15, 2015, 04:12:49 PM »

Do I know how redemptions on ETFs work? First, I was never talking about that, I was talking about mutual funds move gains into the ETF share class. Second, do you know how redemptions on ETFs work?  It is an interesting question because mutual funds have redemptions, ETFs trade on an exchange(they don't normally do redemptions). An average investor is never going to see an ETF redemption. Goldman might, but honestly they would probably have to request it. That is what I'm getting at. Interest Compound, and now myself, are talking about how Vanguard takes the unrealized gains in the mutual fund and moves it to the ETF share class. That way when someone sells the mutual fund... the embedded capital gains are gone!  We aren't talking about the mutual fund or the ETF doing in kind distributions to investors. I'll address that as a second matter.

Step by step in case it isn't clear:
Vanguard 500 index fund admiral shares has a bunch of stocks they bought last week that don't have gains, and they have a bunch of stocks they bought 30-40 years ago with a ton of gains. Shares of AAPL from 1985 would be a good example.
The company that creates the ETF units for VOO comes along and says they need to make more units of VOO.
Vanguard gives them shares to create the new units of VOO.
In a stroke of genius someone at Vanguard said, "Hey, why don't we specifically give VOO the stock shares within VFIAX we bought decades ago that have a lot of appreciation we never want to realize?"
Now those shares of AAPL from 1985 are in VOO which sells like a stock, and doesn't have to do cash redemptions.  Ah ha! The gains can be embedded essentially till the end of time! [Unless a big company(like Goldman) specifically requests an in kind distribution(unlikely).]
Since AAPL use to be a tiny piece of the index there are fewer shares from 1985 than there are from 2014 so VFIAX can get rid of ALL of the shares from 1985 and still keep the allocations right in both VFIAX and VOO. Copy this example for all 500(ish) holdings.
Now the mutual fund VFIAX which does have to do cash distributions has less embedded gains to worry about.

Mission accomplished. The embedded gains have been removed from the mutual fund that has to do cash distributions. Does it remove all of them?  Of course not, but every time this happens there are less embedded gains to worry about in the future. So this isn't something VFIAX would do the day people are requesting distributions. It is something they have been doing for years so that in the event of future redemptions many of the embedded gains have already been removed.
Do you have any reference to indicate that the fund assets belonging to the ETF share class are separate and distinct from the assets belonging to mutual fund share classes? I can't find any reference that leads me to believe the fund can simply assign highly appreciated assets to newly created ETF shares and thereby remove them from the mutual fund. The mutual fund shares and ETF shares represent an interest in the same investment company.

There are many references online that explain the tax benefits to the mutual fund arising when a block of ETF shares is redeemed in-kind for shares of the underlying stocks. When the Authorized Participant (AP) brings a redemption block to Vanguard (25,000 ETF shares in the case of VOO), Vanguard takes those shares and in return delivers the appropriate amount of stocks making up the fund, with Vanguard choosing the most highly appreciated share lots to exchange. That's how the fund removes highly appreciated assets. It's the reduction of ETF shares in the market, not addition, that is exploited for the tax benefit to mutual fund shareholders.

Here's a video from Vanguard referencing this in-kind redemption process, beginning somewhere around the 1:25 mark.
https://advisors.vanguard.com/VGApp/iip/site/advisor/etfcenter/article/ETF_StandAloneVideo

For anyone interested, here's a google link to the patent application for the type Vanguard ETFs being discussed. Who remembered that Vanguard used to call their ETF shares VIPERs?
http://www.google.com/patents/US6879964

arebelspy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #91 on: November 16, 2015, 01:57:28 AM »
Following.

I agree it's not a big deal, for the most part, though I'm glad I'm aware of it now.

Joshua Kennon is awesome, and I'd be investing in his upcoming fund if it had a lower minimum.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with two kids.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (occasionally) blog at AdventuringAlong.com.
You can also read my forum "Journal."

brooklynguy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #92 on: November 26, 2015, 02:59:11 PM »
Apparently Kennon's incidental comments about the embedded gains issue set off something of a firestorm among his readership.  He made the below comments in a recent (and otherwise unrelated) blog post about a guy who suffered massive losses shorting stock and the lessons that story holds for all of us about the importance of knowing and understanding risks (the comments are long, but only one small part of the much longer overall blog post, which, like most of Kennon's content, is fantastic).  I'm quoting the passage here because it is directly responsive to the direction the discussion in this thread took.

Quote from: Joshua Kennon
Today, you see it [that is, the pointing out of potential risks in a strategy being interpreted by some people a personal attack or evidence of an ulterior motive] most often in index funds, one of my favorite financial market solutions upon which I’ve lavished a lot of praise.  I steadfastly maintain that if you are sitting on a 401(k) plan at work, the smartest move, with a few notable exceptions, is almost always going to be to buy a lower cost index fund that is almost entirely passive in its approach.  Despite this, you wouldn’t believe some of the messages I get on the topic.  Take the recent mail bag response about buying stocks when equity prices are high.  In the comments, I happened to mention off-hand that it is foolish for a wealthy investor who has exhausted his or her tax shelter protections to use large amounts of money to buy index funds due to something known as embedded capital gains (and that the risk inherent in doing so is not mitigated by ETFs once you look at the underlying structure despite the advertising line telling people it solves the problem).  Precisely for the reasons John Bogle wrote in some of his multi-hundred page books, and in which he openly acknowledges it to be the case, it is often far wiser for a wealthy investor in this situation who wants to follow an index approach to construct his or her own index fund directly by holding the underlying stocks outright in a custody account of some sort.  There is no intelligent justification for a taxable investor of significant means taking on a potential, if remote, possibility of being hit with a tax bill while experiencing losses.  None.  Refusal to acknowledge this fact is simply intellectual laziness.

Judging by some of the messages I received, you’d think I’d have suggested throwing puppies off a bridge.  People who do not in any way fit the demographic to whom the problem would apply – you’d need at least several million dollars in a regular, taxable account to worry about this, as well as a decent likelihood of being in an upper tax bracket, which definitely applies to more than a small minority of this community but not the broader general population – thought I was somehow attacking index funds themselves, having ignored everything else I wrote or the context in which the comments were made and the very clear advocation for them within tax shelters and non-profits when the trade-offs in efficiency are worth it and the embedded gains risk is neutralized (many of you know that Aaron and I use them for our family’s charitable foundation due to taking advantage of a donor-advised fund to avoid 990 public disclosures).  The fact that I am aware of the inadequacies and might advocate for them anyway, in certain circumstances, doesn’t compute with these folks.  In their minds, why would I point out the flaws, including the methodology changes that are quietly happening?  They genuinely cannot perceive of a reason a person would otherwise want to know of the shortcomings, let alone publicly discuss them.

Even the objections were evidence that the nature of the problem was misunderstood as the offended had no idea larger investors have entirely different systems and pricing at their disposal.  I had one gentleman write, incredulously demanding how I could justify paying a broker $7,000 to $10,000 in commissions to purchase 500 stocks.  He truly was unaware that 1.) institutional pricing for transactions tends to start at $0.005 per share (half a penny per share), 2.) for a decent-size account, you could almost always negotiate 500 free trades to get it started, and 3.) even if retail rates did apply, they would be both a small overall percentage of the capital base and, unlike an on-going expense ratio, would be amortized over the life of the underlying holdings making them cheaper in the long-run.  Another talked about the stupidity of managing 500 different stock positions, apparently, again, unaware that it’s not difficult at an institutional level because there are software programs that create the necessary trade tickets which you then upload to the broker, often in CSV format after the file is auto-generated to make the necessary adjustments to keep your holdings within the parameters you outlined.  This is not 1965.  You don’t have to get a typewriter, ledger sheet, calculator, and pencil spending hours each month making the necessary modifications as you manually enter trade tickets.  In both cases, they were taking what worked for them – small investors to whom the problem did not apply – and trying to scale it to large amounts.  I’ve repeatedly told you that you cannot do that; always check your underlying assumptions!  The rules are different.  The prices are different.  The systems are different.  The opportunities are different.  The pitfalls are different.  To repeat what I said earlier, you can’t use the same techniques that build a log cabin and apply them to a skyscraper.

In addition, Kennon made some additional insightful comments on the substance of the embedded gains issue in the comments section of that blog post that are definitely worth reviewing for anyone interested in this topic.  I'd quote those here too, but I've probably copied and pasted enough of his content already for one post.

seattlecyclone

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #93 on: November 28, 2015, 09:49:47 AM »
I still think he's laying it on pretty thick there. "There is no intelligent justification for a taxable investor of significant means taking on a potential, if remote, possibility of being hit with a tax bill while experiencing losses. None. Refusal to acknowledge this fact is simply intellectual laziness."

How is "I think the expected impact of this risk is low enough that I don't believe it justifies the management fees required to implement an alternative strategy" not an "intelligent justification"?

protostache

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #94 on: November 28, 2015, 06:33:24 PM »
I still think he's laying it on pretty thick there. "There is no intelligent justification for a taxable investor of significant means taking on a potential, if remote, possibility of being hit with a tax bill while experiencing losses. None. Refusal to acknowledge this fact is simply intellectual laziness."

How is "I think the expected impact of this risk is low enough that I don't believe it justifies the management fees required to implement an alternative strategy" not an "intelligent justification"?

It probably is for you, me, and almost everyone else posting or reading the MMM forum. In the game that Kennon is playing, "taxable investor of significant means" is someone with several million dollars in taxable marketable assets. At that level, trading costs are so low as to have no practical effect, and the management fee pays for so many other services that it's worth it.

Kennon focuses on minimizing wipeout risk above all else, including paying reasonable fees for useful services. When you have less than $1mil in equity assets, none of those services are useful.

I've started thinking of it in terms of D&D levels. I'm a lvl 1 wizard, so magic missile is entirely useful and appropriate against the enemies I face. Kennon is a lvl 9 sorcerer, which makes meteor swarm a more effective tool against his foes. That doesn't make either one of us wrong, it's just that we're at different levels playing different encounters.
« Last Edit: November 28, 2015, 06:39:14 PM by protostache »

brooklynguy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #95 on: November 10, 2017, 11:35:03 AM »
Resurrecting this two-year-old thread to share new information.  Read the whole thread for context and background.

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

At the time of our discussion two years ago, to the knowledge of the participants in this thread, the embedded gain risk it addresses had never actually materialized in the context of an index fund (as opposed to an actively-managed fund).  Today, I came across the following article in the Wall Street Journal, which describes a glaring real-world example of this risk actually coming to pass in the context of an index fund--to wit, according to the article, the PNC S&P 500 Index Fund will be distributing nearly 22% of its current per-share value at the end of this year as a result of excessive net asset outflows due to substantial investor redemptions over the last year, forcing a major taxable event on investors who remain invested in the fund.

WSJ:  "The Rot That Lies Beneath Some Index Funds"

DavidAnnArbor

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #96 on: November 10, 2017, 06:06:32 PM »
It's behind a paywall. Is PNC the bank?

protostache

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #97 on: November 10, 2017, 07:09:12 PM »
Here's a non-paywall link:

https://archive.fo/Wm2iT

The A-class shares are symbol PIIAX, and yes they're sponsored by PNC Bank.

DavidAnnArbor

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #98 on: November 10, 2017, 07:29:53 PM »
Thanks for the article.
I recall from this thread that Vanguard is able to use the ETF's to stash capital gains for the mutual fund equivalent.

Indexer

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #99 on: November 11, 2017, 07:21:38 AM »
Resurrecting this two-year-old thread to share new information.  Read the whole thread for context and background.

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

At the time of our discussion two years ago, to the knowledge of the participants in this thread, the embedded gain risk it addresses had never actually materialized in the context of an index fund (as opposed to an actively-managed fund).  Today, I came across the following article in the Wall Street Journal, which describes a glaring real-world example of this risk actually coming to pass in the context of an index fund--to wit, according to the article, the PNC S&P 500 Index Fund will be distributing nearly 22% of its current per-share value at the end of this year as a result of excessive net asset outflows due to substantial investor redemptions over the last year, forcing a major taxable event on investors who remain invested in the fund.

WSJ:  "The Rot That Lies Beneath Some Index Funds"

I saw this article. I love everything Jason Zweig writes.

Zweig writes, "PNC S&P 500 Index Fund’s 7.2% average annual return over the past decade shrivels to 6.2% after tax, estimates Morningstar."

I did a comparison on morningstar of VFIAX VS PIIAX, and it isn't pretty for PNC. They have had issues managing their capital gains distributions for awhile.

@DavidAnnArbor: You are correct.

If you are concerned about this, just buy the ETF instead of the mutual fund. I use mutual funds in my 401k and IRAs, but my taxable account is all ETFs.