Author Topic: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"  (Read 27471 times)

brooklynguy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #100 on: February 09, 2018, 08:55:12 AM »
A recent Wall Street Journal article has an update to last November's update to this old thread:

WSJ:  "An Index Fund's Sudden Death"

In a nutshell, the PNC S&P 500 Index Fund that was forced to make significant capital gain distributions to its shareholders due to high levels of shareholder redemptions (thereby forcing a major taxable event on the fund's remaining shareholders) is now being liquidated altogether, forcing an even bigger taxable event on the fund's remaining shareholders.

PathtoFIRE

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #101 on: February 09, 2018, 09:07:58 AM »
Thanks for the update, I always dread whenever this thread pops up in my unread list. VTSAX is our largest single stake, which I understand is somewhat protected from these types of events given it's special relationship with VTI, but just over 55% of our after-tax investment accounts are not in VTSAX and this risk has always made me a little nervous.

arebelspy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #102 on: April 09, 2019, 07:45:43 PM »
A recent Wall Street Journal article has an update to last November's update to this old thread:

WSJ:  "An Index Fund's Sudden Death"

In a nutshell, the PNC S&P 500 Index Fund that was forced to make significant capital gain distributions to its shareholders due to high levels of shareholder redemptions (thereby forcing a major taxable event on the fund's remaining shareholders) is now being liquidated altogether, forcing an even bigger taxable event on the fund's remaining shareholders.

Luckily most people redeem when the market crashes, and then there's less gains to pay taxes on. ;)

That would suck though if your holding did get liquidated in a market crash due to other investors redeeming, and you didn't realize, since you buy and hold and ignore the noise, and miss the upswing back. Like what could happen if you use margin, but in reality you're trying to do buy and hold index investing to be safe. Ouch.

Thanks for the update, BG!
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MustacheAndaHalf

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #103 on: April 09, 2019, 09:17:51 PM »
Where's the evidence this occurs?

I find it odd the author provides no examples.  That should have come first, followed by how often this occurs - otherwise it's just a scare tactic.  There are mutual fund databases with decades of history - he can't find any evidence for this?

Notice how the scare tactic turns to insults - no "intelligent" person would do something besides what he says.  Given the chance to respond with evidence, he just says anyone doing otherwise is not intelligent.  The authors I read back up their claims with historical data, not scare tactics.

arebelspy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #104 on: April 09, 2019, 11:22:01 PM »


Where's the evidence this occurs?

How about BG's post 3 up from yours?
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philli14

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #105 on: April 10, 2019, 09:32:39 AM »
I'm definitely one of those investors who are all-in on index funds, but without an extensive knowledge of their inner-workings. I just have a feeling this would be talked about more if it was anything other than a potential black swan?

My understanding is that there are unrealized capital gains in these funds, that would be passed on to the shareholders should the entire fund be liquidated (by the shareholders? by the company who owns the index fund?)? I would hope that the only time something like that would happen is if there are more global economic issues happening, in which case the capital gains would be the least of our concerns. Or maybe this could happen for another reason?

A question.. Would holding a number of index funds from different "providers" be sufficient to mitigate this risk?

For example, instead of holding 100% VTSMX, hold:

33% VTSMX (Vanguard total market)
33% FSKAX (Fidelity total market)
33% SWTSX (Charles Schwab total market)

Might complicate things when keeping track of AA, having to check across multiple companies, etc. But would this effectively reduce risk by owning different index funds of the same variety? Or would an event that sees VTSMX liquidated also see FSKAX and SWTSX be liquidated?

Certainly interesting as I am starting to pour money more into taxable brokerage accounts. Any education/clarification would be very welcomed as this is not my area of expertise, at all.

Indexer

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #106 on: April 10, 2019, 08:02:26 PM »
Resurrected again? 2015, 2017, 2018, and now 2019. Any predictions on whether it comes back in 2020?


Vanguard does 2 very important things to avoid this.

Vanguard total stock distributed a capital gain last year, did anyone notice?

1. Probably not, because it distributed the capital gain to the institutional share class. Investors normally only hold this share class in 401k plans, where no one cares about capital gains distributions. That way the Admiral share class has less embedded gains to worry about in the future.

2. Creating ETF units. I went into detail on this on page 2 of this thread... in 2015. When Vanguard creates new ETF units they purposely push holdings with embedded gains into the ETF. The gains are then trapped there unless someone broke the ETF apart, which is next to impossible for an individual investor. That way the Admiral share class has less embedded gains to worry about in the future.


Vanguard index funds can distribute gains into the other share classes, which includes ETF units, so the admiral share class is highly unlikely to have a capital gains distribution.

I'm not worried about VTSAX distributing a gain, but if you were REALLY worried, just buy the ETF instead.

PathtoFIRE

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #107 on: April 11, 2019, 09:24:22 AM »
Indexer, isn't your points #2 unique to Vanguard, and specifically just VTSAX/VTI? I thought I remember reading that this arrangement was unique and maybe even patented by Vanguard, and therefore wouldn't be applicable outside of Vanguard, or maybe even applicable to the other Vanguard mutual fund / ETF pairings.

MustacheAndaHalf

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #108 on: April 11, 2019, 10:18:18 PM »
Where's the evidence this occurs?
How about BG's post 3 up from yours?
Yes, it happened once - but that doesn't answer how often it occurs.  For example, if I said "make all investment decisions based on 2008! It will happen soon!"... that's using an example, but ignoring the frequency of 2008 type events.  So it's still a scare tactic if it doesn't happen that often.  I think it may also help to categorize where this happens - unpopular funds?  active funds?

SPY (iShares S&P 500) has $180 billion in assets while VFIAX (Vanguard S&P 500) has $157 billion in assets.  Those funds seem like the least likely to experience this - "massive, passive" index funds.  I'm not sure where someone would draw the line between that and the risk of a fund liquidation triggering long-term capital gains.
« Last Edit: April 12, 2019, 07:17:43 AM by MustacheAndaHalf »

arebelspy

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #109 on: April 12, 2019, 10:28:54 AM »


Where's the evidence this occurs?
How about BG's post 3 up from yours?
Yes, it happened once - but that doesn't answer how often it occurs.  ...  So it's still a scare tactic if it doesn't happen that often. 

No, it doesn't answer that.

But that doesn't mean it's a scare tactic.

To raise a concern, say "hey, this could be an issue" and then within a few years, see it actually happen... Well, that's something to look at.

And clearly when people upset about even the idea of it shift the goalposts from "this is theoretical, show me where it's happened" to "okay it happened, but how frequently," it's something one should raise an eyebrow at and consider.
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MustacheAndaHalf

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #110 on: April 13, 2019, 10:21:54 PM »
And clearly when people upset about even the idea of it shift the goalposts from "this is theoretical, show me where it's happened" to "okay it happened, but how frequently," it's something one should raise an eyebrow at and consider.
I didn't change the goalposts - you only quoted the first line from my post.  Note I point out "followed by how often this occurs":

Where's the evidence this occurs?

I find it odd the author provides no examples.  That should have come first, followed by how often this occurs - otherwise it's just a scare tactic.

seattlecyclone

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #111 on: April 13, 2019, 10:45:22 PM »
I don't think the question of "how often has this happened in the past?" is actually all that relevant. We can see that as a fund has been active for a longer period of time, the amount of unrealized gains in that fund will grow. As long as the fund keeps getting a net inflow of cash rather than a net outflow, this is no big deal: they don't need to sell any shares, and so they don't need to distribute any gains. This has been the case for many Vanguard funds for some time. As mentioned earlier in the thread, Vanguard's multi-class share structure allows them to shift lower-basis shares into the ETF and institutional share classes, which minimizes the amount of gains that will need to be distributed to taxable accounts. Even so, some event that caused a large fraction of Vanguard's shareholders to move their money elsewhere would eventually cause the remaining shareholders to have some tax liability from these embedded gains. At this point it's hard for me to envision what such an event could look like, but that doesn't mean it's impossible or even unlikely over the long term.

Indexer

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Re: Potential Tax Risk of Mutual Fund Investing: "Embedded Gains"
« Reply #112 on: April 14, 2019, 11:22:15 AM »
Indexer, isn't your points #2 unique to Vanguard, and specifically just VTSAX/VTI? I thought I remember reading that this arrangement was unique and maybe even patented by Vanguard, and therefore wouldn't be applicable outside of Vanguard, or maybe even applicable to the other Vanguard mutual fund / ETF pairings.

It is only applicable to Vanguard, but should help with all of their big index funds, not just VTSAX. I don't see why VFIAX/VOO, VTIAX/VXUS, etc. wouldn't have the same relationship. I mentioned VTSAX/VTI because it's such a large fund and so many Mustachians own it.

Even so, some event that caused a large fraction of Vanguard's shareholders to move their money elsewhere would eventually cause the remaining shareholders to have some tax liability from these embedded gains.

If you're worried about it call Vanguard and have them convert any shares of VTSAX to VTI tax free.