The Money Mustache Community
Learning, Sharing, and Teaching => Investor Alley => Topic started by: brooklynguy on November 04, 2015, 11:36:22 AM
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In the comments to one of his recent blog posts, Josh Kennon highlighted a potential tax issue lurking under the surface for investors who invest in mutual funds (including index funds) in their taxable accounts: "embedded gains." In a nutshell, the concern is that many mutual funds have unrealized capital gains from appreciation of their underlying shareholdings that could, under the right circumstances, result in a (potentially massive) tax liability for current holders of the mutual fund shares. I've read about this issue before but never really gave it much thought until I read Kennon's (alarmist?) description.
Given the overlap between this forum's membership and Kennon's blog's readership, I was surprised not to have seen his comments (made over a week ago) talked about here. So I just searched the forum and found that, sure enough, someone actually did bring this up:
Another thing regarding index funds' youth : they have never failed, yet. But, at some point in their history, they certainly will. There will be some fraud. Or some unjustified panic. Here in Europe, most index funds aren't invested only in the stocks in the index they are replicating. They handle complicated derivatives that allow them to be less expensive ; some more serious houses (I guess even Vanguard does it) do lend shares for short sellers, here again to reduce costs. I a bad bear market, this can go wrong. And even if you index fund does not fail, even if he was very cautious, panicking investors might try to sell massively their shares. On these hard days, the value of your shares can go far away from the underlying index, or can become very illiquid (which can be a problem if you need the money at that moment).
Joshua Kennon wrote a very salient comment on this (I'll try to dig up a link). His point was that many index funds, Vanguard especially, are massively loaded with unrecognized capital gains. On a normal day to day basis they can fund redemptions with incoming cash flow, but if there was ever a run on the fund they would be forced to sell and recognize part of these gains and passing them on to shareholders. For tax-advantaged accounts this is not an issue, but if you hold index funds in taxable accounts you have to be aware that at some point, you may be forced to pay part of someone else's tax bill because Vanguard forced capital gains on you.
Edit: Link to Joshua's comment (http://"http://www.joshuakennon.com/mail-bag-buying-stock-when-valuations-are-high/#comment-2315661748"). That whole article and the comments are very interesting.
Surprisingly, though, not one person reacted to or commented on protostache's post, perhaps because it got lost in the broader debate occurring in that thread. So I'm starting a new thread on this topic to hopefully generate more discussion, because I think it's a topic worth discussing (or at least being aware of).
Here is the full text of the primary relevant comment from Kennon's blog post:
I'd bet 95%+ of investors don't [give any thought to the potential "embedded gain" tax issue]. It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery. They, quite literally, could be putting a massive amount of their winnings on the chopping block for the IRS to come in and grab it if the stars happen to line up in the wrong configuration. It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.
If you want to see a truly, jaw-dropping example, go back and look at the famous Sequoia Fund report from years past. Here is just one example (http://www.sequoiafund.com/Reports/Annual/Ann05.htm). It was setup by a friend of Warren Buffett following the dissolution of the main Buffett partnership and continued to hold a lot of Berkshire Hathaway stock. In that particular, randomly chosen year (2005), of the $3,772,382,901 in net asset value, $2,345,962,204 represented unrealized capital gains. While the fund was closed to outside investors for decades, management used to outright warn existing shareholders to stop buying it in taxable accounts because the (first world, to be sure) problem had grown so excessive due to their fantastic record they were going to get slaughtered at some point; it was all but an inevitability.
Smaller investors don't have to worry about this sort of thing because almost all of their money is in Roth IRAs or whatnot. That's what I mean when I say they take a rational solution for them (if you don't know what you are doing, have a tiny amount of money, and want good diversification, index funds are a Godsend) and attempt to scale it beyond amounts they can possibly comprehend or understand. It would be like trying to build a skyscraper using the same tools and technology as a log cabin. It's gong to end in disaster because there are complications, rules, regulations, tax quirks, and other things that suddenly become an issue, which they never confronted and don't even know to guard against.
Vanguard's S&P 500 fund is one of the worst in this respect. Of the $198,712,172,000 in assets it had at the end of its fiscal year, a whopping $89,234,130,000 consisted of unrealized capital gains that could someday be triggered. (Take a look at the 2014 annual report in PDF format for yourself (http://www.vanguard.com/funds/reports/q400.pdf).) That's almost 45% of the entire capital base! Stop for a moment and let the horror of that set in. If you're affluent and in a top tax bracket, subject to the 20% rate + the 3.8% Obamacare tax + a state tax on capital gains, we're talking real money that could potentially flow out the door even if you're simultaneously suffering losses (assuming you don't want to sell at a loss to try and offset the gain) as you pick up someone else's tab. What sane person would buy the fund in a taxable account under these circumstances? A 401(k), 403(b), SEP-IRA, whatever ... sure. A brokerage account? No. Absolutely not. Why take on the risk? The generational tax consequences are severe, too. If you held the individual securities, instead, you could potentially pass them on to your children using the stepped-up basis loophole (http://beginnersinvest.about.com/od/estatetax/fl/How-the-Stepped-Up-Basis-Loophole-Works.htm), whereas you can't do it with the underlying appreciated shares of an index fund.
If - if - indexing continues to receive a disproportionate share of asset inflows over the coming few decades and we reach a tipping point where it decouples from underlying intrinsic value due to money flows exerting a bigger influence on market quotations (and therefore market capitalizations), between the potential tax consequences and the silent methodology changes over the past decade and a half that have torn the S&P 500 off its underlying historical hinges, favoring the rich insiders over the mom and pop investors (http://www.joshuakennon.com/sp-500s-dirty-little-secret/), I think there could come a day, under the wrong set of circumstances, John Bogle - a man for whom I have enormous respect - is scapegoated as having unleashed the equivalent of the CDO or sub-prime debt on the world when the real culprit was the fact that so many of the people adhering to his philosophy lacked his common sense. Bogle wouldn't have been buying an equity index fund at 70x earnings or if it had some how gone off the rails. He's too smart. He's got too much Graham in him. Yet, so many of the acolytes have no idea what they own, why they own it, or why indexing works. They worship its form while remaining totally ignorant to its substance. I vacillate between feeling, "they'll get what they deserve" and "maybe they're good people who, though they'll view you as the enemy for pointing this out, don't know better and you should write about it".
(emphasis in original)
Thoughts?
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Interesting. Posting to follow.
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It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery.
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It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.
Honestly, this whole thing reads like click-bait, nothing more than an advisor trying to justify their services in a world where they are growing increasingly less relevant.
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I understand this is more of an issue for managed funds, when the fund manager decides to take some profits after a period of gains. I'm not quite sure I see the problem for index funds, which tend to have low turn over. And the stocks that do turn over,tend to be ones that aren't doing well and therefore get dropped from the index. In that case, you are more likely to benefit from embedded losses than get penalized from embedded gains.
Kennon posits there could be a problem if there is a "run on the fund." Has that ever happened on an index fund?
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I certainly noticed that comment; he's also got a short post on his about.com site about it http://beginnersinvest.about.com/od/capitalgainstax/a/mutual_fund_tax.htm
Naturally, my first thought was "oh no, that's me he's talking about!" I'm certainly plowing tons of money into aftertax mutual funds (VTSAX and VTIAX), and my understanding of the stock market and company valuations is rudimentary. The one thing lacking from throwing me in a further worry though is that he didn't provide any examples of where this has happened. Yes, this rise of giant mutual funds supported by less-sophisticated investors is a relatively new phenomenon, but I began to wonder if this is simply something out of the sphere of my control.
Someone with more knowledge can chime in, but the only fund that I'm aware of that has suffered major outflows in recent years is PIMCO Total Return A (PTTAX) fund, which googling showing went from $293B in April 2013 to less than $100B in September 2015. I don't see reports of major capital gains distributions or other negative effects on investors, but this is a bond fund, so maybe we wouldn't expect as severe of consequences.
So then the question is, what are we to do? Diversifying into alternative but similar funds (substituting Fidelity for Vanguard, or SP500 for Total Stock Market) wouldn't help in the types of scenarios that are envisioned triggering these problems, because every one of these should be facing similar 1) capital gains + 2) records outflows. Individual stocks? Well I'm trying to avoid going down that rabbit hole, I guess my aftertax capital is sufficiently large now that I could try to replicate the SP500, but first I'm going to trigger personal capital gains, and second that will certainly involve a lot more research and work to maintain (I don't think Joshua Kennon would consider that an actual downside). I can't deny that I'm tempted to go in on his new fund that he's creating, but I'd need to liquidate most of my aftertax holdings to meet his minimum, and while he certainly seems like an honest and trustworthy person, I'd be substituting one form of risk for others. At least the potential capital gains bill is a known known, something that I can plan around and attempt to mitigate.
I think my final answer is that his warning won't deter me from continuing the course, but I will have an eye to diversifying my aftertax holdings beyond holding just VTIAX and VTSAX. I already hold a large chunk in DGEIX from my early days using an advisor, and while I have attempted to whittle that down, I think I'll stop and be happy to hold about 1/4 of my aftertax money in that fund, which should be diversified enough (and mostly in the hands of clients with financial advisors who aren't just brokers) from the large Vanguard funds. And maybe at some point, it'll make sense to divert a chunk over to an advisor to maintain a diversified basket of individual stocks.
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Kennon posits there could be a problem if there is a "run on the fund." Has that ever happened on an index fund?
It's buried in my long post above, but that's my question too, how likely is this scenario? I think he would argue that this world of large mutual funds with tons of unsophisticated investors is new and unpredictable, and I can't say that I'd disagree. But the only large run on any large fund that I'm aware of recently is at PIMCO, and I don't hear reports of this, although that is a bond fund, so we wouldn't expect capital gains to be nearly as large.
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The Bogleheads wiki says
Vanguard ETFs are structured as another share class of a mutual fund, like Admiral or Investor shares. This is a process unique to Vanguard, protected by a patent until 2023, with two important consequences for the mutual fund investor:
Tax efficiency: the mutual fund shares benefit from the disposition of capital gains through ETF shares, making Vanguard funds with ETF share classes as efficient as an ETF.
Conversion: mutual fund shares can be converted to ETF shares without a taxable event. This helps when transferring assets to another broker, including charitable donations. Conversion in the other direction is not possible.
Note the tax efficiency bullet. It makes it seem like Vanguard would distribute any capital gains in any of the mutual funds through the ETF versions instead. But I don't know if that's actually true. There's no reference in the wiki for me to follow up on.
EDIT: Since it says protected by patent, I should be able to find such a patent if it exists. But I have not yet done such a search.
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The Bogleheads wiki says
Vanguard ETFs are structured as another share class of a mutual fund, like Admiral or Investor shares. This is a process unique to Vanguard, protected by a patent until 2023, with two important consequences for the mutual fund investor:
Tax efficiency: the mutual fund shares benefit from the disposition of capital gains through ETF shares, making Vanguard funds with ETF share classes as efficient as an ETF.
Conversion: mutual fund shares can be converted to ETF shares without a taxable event. This helps when transferring assets to another broker, including charitable donations. Conversion in the other direction is not possible.
Note the tax efficiency bullet. It makes it seem like Vanguard would distribute any capital gains in any of the mutual funds through the ETF versions instead. But I don't know if that's actually true. There's no reference in the wiki for me to follow up on.
Nice find. Because Vanguard has been so successful with its index funds, it is hard to compete with Vanguard directly. A swarm of rivals now try to compete with things that can be called an "index" and thus benefit from the good reputation of indexing, but do something slightly different so they can be claimed to be better. The result is that there is a drumbeat of critics all saying the same thing: passive indexing with Vanguard sucks. And one of the commonest ways to attack it is to complain about something scary that most people don't know anything about (taxes).
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Any distribution reduces the NAV; in effect, if VTSMX sold everything and distributed 45% as LTCG, it forces the holders to pay taxes on someone else's (Vanguard's) schedule. Of course, the NAV would also be reduced by 45%. If Vanguard were to close VTSMX, there wouldn't be (much of) a difference between selling at your whim or receiving a 45% distribution and selling.
This leads to a mitigation strategy since Vanguard publishes their distributions in early December.
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It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery.
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It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.
Honestly, this whole thing reads like click-bait, nothing more than an advisor trying to justify their services in a world where they are growing increasingly less relevant.
So, I just spent the last few weeks reading basically all of Joshua's blog (except the recipe and family posts). He makes a compelling point, several times, that for a family in the right situation a trusted advisor more than makes up their fee. That situation boils down to having a large amount of assets and a tax profile that doesn't fit the standard mold of self-managed 401(K)/IRA/529 accounts. Once you get to a certain level of assets, an advisor can set you up with things like a charitable remainder trust or a family limited partnership that have a high absolute sticker price to start, but over time save immense amounts in taxes. This is money that then compounds on itself, letting the family leave a bigger legacy than they otherwise would have been able to.
For the majority of people on this forum an advisory service would be overkill, but they're still very much relevant to a certain segment of the population.
edit: Thanks for digging that comment up, brooklynguy!
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It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery.
...
It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.
Honestly, this whole thing reads like click-bait, nothing more than an advisor trying to justify their services in a world where they are growing increasingly less relevant.
So, I just spent the last few weeks reading basically all of Joshua's blog (except the recipe and family posts). He makes a compelling point, several times, that for a family in the right situation a trusted advisor more than makes up their fee. That situation boils down to having a large amount of assets and a tax profile that doesn't fit the standard mold of self-managed 401(K)/IRA/529 accounts. Once you get to a certain level of assets, an advisor can set you up with things like a charitable remainder trust or a family limited partnership that have a high absolute sticker price to start, but over time save immense amounts in taxes. This is money that then compounds on itself, letting the family leave a bigger legacy than they otherwise would have been able to.
For the majority of people on this forum an advisory service would be overkill, but they're still very much relevant to a certain segment of the population.
edit: Thanks for digging that comment up, brooklynguy!
Agreed. The vast majority of people don't need an advisor. Scare-tactics like this, which don't seem to apply to Vanguard funds anyway, can safely be ignored.
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It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery.
...
It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.
Honestly, this whole thing reads like click-bait, nothing more than an advisor trying to justify their services in a world where they are growing increasingly less relevant.
So, I just spent the last few weeks reading basically all of Joshua's blog (except the recipe and family posts). He makes a compelling point, several times, that for a family in the right situation a trusted advisor more than makes up their fee. That situation boils down to having a large amount of assets and a tax profile that doesn't fit the standard mold of self-managed 401(K)/IRA/529 accounts. Once you get to a certain level of assets, an advisor can set you up with things like a charitable remainder trust or a family limited partnership that have a high absolute sticker price to start, but over time save immense amounts in taxes. This is money that then compounds on itself, letting the family leave a bigger legacy than they otherwise would have been able to.
For the majority of people on this forum an advisory service would be overkill, but they're still very much relevant to a certain segment of the population.
edit: Thanks for digging that comment up, brooklynguy!
Agreed. The vast majority of people don't need an advisor. Scare-tactics like this, which don't seem to apply to Vanguard funds anyway, can safely be ignored.
I don't understand why you're stuck on this advisor thing. The main point of the quote, and in fact to Kennon's entire body of work, is that you should be aware of what you're doing. He's a hyper-rationalist and also quite risk-averse. The embedded capital gains inherent in a long-running mutual fund are something to be aware of in a taxable account, since they present a considerable tax risk.
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Following...
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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.
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thanks for sharing.
I love vanguard and I had never considered this perspective.
There is more than one scenario to consider.
1) Yes, I agree that if the total stock market is melting down, then we are talking about a 'black swan' type event.
And in the context of this topic, that's simply not worth trying to insure against.
almost all mutual funds will melt down.
it's a fool's errand to pick the few hedge funds that will outperform the market through a black swan event.
2) But what about a new investment strategy that disrupts vanguard's business model?
vanguard disrupted the traditional asset management business model and has benefited from huge inflows of cash.
Is it reasonable to expect that another company will come along and disrupt vanguard which results in huge outflows in spite of healthy market returns?
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It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery.
...
It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.
Honestly, this whole thing reads like click-bait, nothing more than an advisor trying to justify their services in a world where they are growing increasingly less relevant.
So, I just spent the last few weeks reading basically all of Joshua's blog (except the recipe and family posts). He makes a compelling point, several times, that for a family in the right situation a trusted advisor more than makes up their fee. That situation boils down to having a large amount of assets and a tax profile that doesn't fit the standard mold of self-managed 401(K)/IRA/529 accounts. Once you get to a certain level of assets, an advisor can set you up with things like a charitable remainder trust or a family limited partnership that have a high absolute sticker price to start, but over time save immense amounts in taxes. This is money that then compounds on itself, letting the family leave a bigger legacy than they otherwise would have been able to.
For the majority of people on this forum an advisory service would be overkill, but they're still very much relevant to a certain segment of the population.
edit: Thanks for digging that comment up, brooklynguy!
Agreed. The vast majority of people don't need an advisor. Scare-tactics like this, which don't seem to apply to Vanguard funds anyway, can safely be ignored.
I don't understand why you're stuck on this advisor thing. The main point of the quote, and in fact to Kennon's entire body of work, is that you should be aware of what you're doing. He's a hyper-rationalist and also quite risk-averse. The embedded capital gains inherent in a long-running mutual fund are something to be aware of in a taxable account, since they present a considerable tax risk.
From where I sit, the main point of the article is to scare people into giving his company (he's a financial advisor) their business. It starts with, "It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds..."
and ends with calling people who index with Vanguard "ignorant", saying they will "get what they deserve" but he's fighting the good fight by writing this article anyway and making himself the enemy, so he can cure our ignorance by informing us of his advisory services.
To the numerous new/scared investors of the forum, take note. This is what it looks like when someone's selling you on their product. Remember, there will always be someone who says this time is different, and indexing no longer works. These people come and go. This is why staying the course is so hard. Ignore the noise, stay the course, and 30-60 years later odds are you'll be much better for it.
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The Bogleheads wiki says
Vanguard ETFs are structured as another share class of a mutual fund, like Admiral or Investor shares. This is a process unique to Vanguard, protected by a patent until 2023, with two important consequences for the mutual fund investor:
Tax efficiency: the mutual fund shares benefit from the disposition of capital gains through ETF shares, making Vanguard funds with ETF share classes as efficient as an ETF.
Conversion: mutual fund shares can be converted to ETF shares without a taxable event. This helps when transferring assets to another broker, including charitable donations. Conversion in the other direction is not possible.
Note the tax efficiency bullet. It makes it seem like Vanguard would distribute any capital gains in any of the mutual funds through the ETF versions instead. But I don't know if that's actually true. There's no reference in the wiki for me to follow up on.
Nice find. Because Vanguard has been so successful with its index funds, it is hard to compete with Vanguard directly. A swarm of rivals now try to compete with things that can be called an "index" and thus benefit from the good reputation of indexing, but do something slightly different so they can be claimed to be better. The result is that there is a drumbeat of critics all saying the same thing: passive indexing with Vanguard sucks. And one of the commonest ways to attack it is to complain about something scary that most people don't know anything about (taxes).
I'm not quite sure I understand you.
How would this lend support to critics who say Vanguard sucks?
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It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery.
...
It's tragic when the whole thing could be mitigated by constructing a directly-held customized index of passive stocks in an individually managed account, all bought at cost.
Honestly, this whole thing reads like click-bait, nothing more than an advisor trying to justify their services in a world where they are growing increasingly less relevant.
So, I just spent the last few weeks reading basically all of Joshua's blog (except the recipe and family posts). He makes a compelling point, several times, that for a family in the right situation a trusted advisor more than makes up their fee. That situation boils down to having a large amount of assets and a tax profile that doesn't fit the standard mold of self-managed 401(K)/IRA/529 accounts. Once you get to a certain level of assets, an advisor can set you up with things like a charitable remainder trust or a family limited partnership that have a high absolute sticker price to start, but over time save immense amounts in taxes. This is money that then compounds on itself, letting the family leave a bigger legacy than they otherwise would have been able to.
For the majority of people on this forum an advisory service would be overkill, but they're still very much relevant to a certain segment of the population.
edit: Thanks for digging that comment up, brooklynguy!
Agreed. The vast majority of people don't need an advisor. Scare-tactics like this, which don't seem to apply to Vanguard funds anyway, can safely be ignored.
I don't understand why you're stuck on this advisor thing. The main point of the quote, and in fact to Kennon's entire body of work, is that you should be aware of what you're doing. He's a hyper-rationalist and also quite risk-averse. The embedded capital gains inherent in a long-running mutual fund are something to be aware of in a taxable account, since they present a considerable tax risk.
From where I sit, the main point of the article is to scare people into giving his company (he's a financial advisor) their business. It starts with, "It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds..."
and ends with calling people who index with Vanguard "ignorant", saying they will "get what they deserve" but he's fighting the good fight by writing this article anyway and making himself the enemy, so he can cure our ignorance by informing us of his advisory services.
To the numerous new/scared investors of the forum, take note. This is what it looks like when someone's selling you on their product. Remember, there will always be someone who says this time is different, and indexing no longer works. These people come and go. This is why staying the course is so hard. Ignore the noise, stay the course, and 30-60 years later odds are you'll be much better for it.
So, three things, then I'm done. First, at this point he's an advisor for his family only and as far as I can tell he doesn't charge a fee. The thing he and his husband are building now is going to be some sort of wealth management service, it's true, but they haven't even announced details yet.
Second, you cut off the most important part of the first sentence: "It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery". Self-managed index funds are not appropriate for someone who has no idea what they're doing with a tremendous windfall. Professional advice will literally save them millions of dollars.
Third, the people he's talking about in that article, the people with millions of dollars in taxable accounts, are fundamentally playing a different game than us. They're preserving generational wealth, not accumulating new wealth that they intend to spend down during the course of their lives. Tools useful for one group are not useful for another, because they have different goals.
Also, if you actually took the time to read his work instead of taking a bunch of quotes out of context, you'll see that he's a strong advocate for index funds in tax advantaged accounts for almost everyone. He doesn't say "Vanguard sucks", he in fact says many times that he loves Vanguard because of the transparency and incredibly low fees.
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Second, you cut off the most important part of the first sentence: "It's one of the reasons I shake my head and walk away whenever I hear someone talk about how they'd forego an advisor and invest in low-cost index funds were they to win the lottery".
If I ever win the lottery I'll make sure to look this guy up :)
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In theory, if your index fund is melting down, you could indeed be at risk for an unexpected tax bill. However, why else would an index fund melt down unless it was losing huge amounts of value? If your index fund is melting down, I suspect that you will benefit more from embedded losses than you will lose from embedded gains due to the loss of value. I'm not seeing "considerable tax risk."
Your index fund could be "losing huge amounts of value" as compared to recent history but still be realizing massive capital gains upon liquidating assets because the basis in those assets was created in comparatively ancient history (with a subsequent run-up in market value).
The one thing lacking from throwing me in a further worry though is that he didn't provide any examples of where this has happened.
Kennon provided a few actual historical examples (but none involving index funds):
The best way to understand it is to look at what actually happens in the real world. Go back and pull the Oppenheimer Developing Markets Opportunity fund during the Great Recession. Let's take an extreme example to show how unbelievably ridiculous and unfair the disconnect can be. Imagine you bought it at $57.13 on 10/29/2007 before the world fell apart. You're a good, disciplined buy-and-hold seller so you don't plan on parting with it for a long, long time. On March 3rd, 2009, you are getting ready to file your upcoming taxes, due in April, for fiscal year 2008. You crack open your account. What do you find?
Your shares were at $13.52. You also had $8.88 in cash sitting in the account.
"That's odd", you think. Nope. The fund was forced to liquidate a lot of embedded gains, which occurred in a way that didn't offset perfectly on the way down. Specifically, $0.5583 per share in dividends, $8.0128 per share in long-term capital gains, and $0.3087 per share in short-term capital gains. Depending on the state, you might have owed $2.66 or more in taxes, leaving you $19.74. So, at this point, you've lost almost 35% of your money on paper and you have to write the government a fairly hefty check, picking up the tab for someone else's capital gains.
And if you had happened to buy a bit earlier? It was even worse. You would have had this happen to you two years in a row. Talk about injustice.
If you were willing to time the market - something I think is inherently dangerous - you could have sold some of your shares for a loss and attempted to offset much of the bill, hoping stock prices didn't turn around in the meantime. Who wants to live that way? It's a mess you shouldn't have had to deal with in the first place.
If you're looking for case studies, another example is the Vanguard mining fund - I forgot what it is called, it's the huge one - back around the same time or a few years thereafter. There was one year where it kicked out a big percentage of its NAV to shareholders for taxable gains based on redemptions forcing the managers to sell off holdings to raise cash. Those especially hurt because it turned around and skyrocketed like crazy within the years that followed if I remember correctly, meaning you'd have had to take money out of that which you had invested in the fund at the worst possible time to pay a tax bill that, in reality, wasn't really yours to begin with and is more of a by-product of our broken tax code; money that could have grown by huge amounts as the reversal was sudden and staggering.
There were some other high-profile examples back in 2008-2009. Search for "embedded gains" if you're starting a research file on it as that is what it usually called by the niche contingent of people who bother to worry about these sorts of things. It's almost entirely confined to professional circles. The retail market doesn't seem to care.
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The Bogleheads wiki says
Vanguard ETFs are structured as another share class of a mutual fund, like Admiral or Investor shares. This is a process unique to Vanguard, protected by a patent until 2023, with two important consequences for the mutual fund investor:
Tax efficiency: the mutual fund shares benefit from the disposition of capital gains through ETF shares, making Vanguard funds with ETF share classes as efficient as an ETF.
Conversion: mutual fund shares can be converted to ETF shares without a taxable event. This helps when transferring assets to another broker, including charitable donations. Conversion in the other direction is not possible.
Note the tax efficiency bullet. It makes it seem like Vanguard would distribute any capital gains in any of the mutual funds through the ETF versions instead. But I don't know if that's actually true. There's no reference in the wiki for me to follow up on.
Nice find. Because Vanguard has been so successful with its index funds, it is hard to compete with Vanguard directly. A swarm of rivals now try to compete with things that can be called an "index" and thus benefit from the good reputation of indexing, but do something slightly different so they can be claimed to be better. The result is that there is a drumbeat of critics all saying the same thing: passive indexing with Vanguard sucks. And one of the commonest ways to attack it is to complain about something scary that most people don't know anything about (taxes).
I'm not quite sure I understand you.
How would this lend support to critics who say Vanguard sucks?
It doesn't. The information you provided lends support to ignoring the click-bait scare mongering articles of financial advisors who want your money. This time is not different. Ignore the noise. Stay the course.
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Your index fund could be "losing huge amounts of value" as compared to recent history but still be realizing massive capital gains upon liquidating assets because the basis in those assets was created in comparatively ancient history (with a subsequent run-up in market value).
I too read this with great interest in Joshua Kennon's blog and expected it would pop up over here eventually. It is something many on here would largely avoid in taxable accounts due to the Mustachian lifestyle and low tax brackets many are able to stay in, as there are no long term capital gains if you are in the 15% bracket or below. However it would impact some and is certainly worth consideration by those in higher brackets with mutual funds of any type in a taxable account.
You've hit on precisely the problem that could happen at either an actively managed fund or index fund. The outflows from the fund are offset by inflows, so older shares are retained with excess inflows used to purchase new shares for the fund. If there is a period of excessive net outflows, the fund may not be able to meet redemptions with only recently acquired shares that have little to no embedded gains, and embedded losses may not be high enough to cover the gains either.
I actually wonder if this isn't more of an issue with index funds since they are managed in a mechanical manner, simply trying to maintain the proper ratio of each company in their respective index. Obviously the managers would try to sell shares that create the lowest tax liability, but an actively managed fund has more flexibility in altering their holdings to avoid triggering those capital gains.
Perhaps we've never seen a big index fund run into this problem because indexing tends to promote better investor bahavior. Perhaps it's because so many large index funds have a huge stream of constant inflows from 401k and 403b plans. Perhaps it's just a fluke.
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Searching for "embedded gains" on bogleheads.org hasn't yielded anything too interesting. Which is too bad, because it's fascinating stuff. Has Vanguard ever communicated about this?
@CompoundInterest, please critique Kennon's argument instead of calling him names. There's nothing wrong with pointing out flaws of indexing, no matter how much we all love and embrace it.
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Searching for "embedded gains" on bogleheads.org hasn't yielded anything too interesting. Which is too bad, because it's fascinating stuff. Has Vanguard ever communicated about this?
@CompoundInterest, please critique Kennon's argument instead of calling him names. There's nothing wrong with pointing out flaws of indexing, no matter how much we all love and embrace it.
The term of art, at least in Morningstar's world, is "potential capital gains exposure (http://www.morningstar.com/InvGlossary/potential_capital_gains_exposure.aspx)". You can find it on the "Tax" tab of Morningstar's mutual fund listings. VTSAX is currently 31.56 (http://performance.morningstar.com/fund/tax-analysis.action?t=VTSAX®ion=usa&culture=en-US).
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It is something many on here would largely avoid in taxable accounts due to the Mustachian lifestyle and low tax brackets many are able to stay in, as there are no long term capital gains if you are in the 15% bracket or below.
It would be a bigger problem for most here if it materialized during the (high-income, high-tax-bracket) accumulation phase. And even during (low-income, low-tax-bracket) retirement, it would still be an issue for those of us subject to state and/or local taxes that don't follow the federal regime with respect to LTCGs (like me, unfortunately!), or if the realized embedded gains were significant enough to push you into a higher tax bracket.
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Searching for "embedded gains" on bogleheads.org hasn't yielded anything too interesting. Which is too bad, because it's fascinating stuff. Has Vanguard ever communicated about this?
@CompoundInterest, please critique Kennon's argument instead of calling him names. There's nothing wrong with pointing out flaws of indexing, no matter how much we all love and embrace it.
No one has talked about it on bogleheads, and Vanguard hasn't communicated anything about it, because it's not an issue. This shows how strong click-bait fear marketing really is. He calls Vanguard investors "ignorant" and says they'll "get what they deserve" by not investing with him, but you claim I'm calling him names by pointing out this is a common marketing trick?
No, this time is not different. No, we don't need his "directly-held customized index of passive stocks in an individually managed account" to save us from certain doom. Johnny847 already posted this:
"Tax efficiency: the mutual fund shares benefit from the disposition of capital gains through ETF shares, making Vanguard funds with ETF share classes as efficient as an ETF."
Source: https://www.bogleheads.org/wiki/ETFs_vs_mutual_funds
I'll add some more:
With ETFs, "New investors do not inherit embedded capital gains"
Source: http://www.investopedia.com/articles/mutualfund/05/etfwrap.asp
"Because of the structure of ETFs, embedded capital gains almost never occur."
Source: Predicting the Markets of Tomorrow, page 171 - https://books.google.com/books?id=VWhZ7iMyCw0C&lpg=PT171&dq=ETF%20%22embedded%20capital%20gains%22&pg=PT171#v=onepage&q=ETF%20%22embedded%20capital%20gains%22&f=false
"When an ETF experiences redemptions, it can hand over a basket of the fund’s underlying securities instead of cash. It can also pick which shares to hand over, ridding itself of tax lots with the greatest embedded capital gains. Because the trade is conducted in-kind, no capital gains are realized."
Source: http://www.morningstar.com/advisor/t/54272084/untangling-etf-tax-efficiency-myths.htm
Ignore the noise. Stay the course.
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My mental model for how mutual funds work is that the fund buys shares with investor money, these shares have a cost basis just like if you purchased them yourself, and if the fund sells some shares then any tax on the gain over the cost basis is paid by the mutual fund shareholders in proportion to their ownership in the fund.
These capital gains are commonly a major expense for people holding actively managed funds that would make lots of trades within the fund. So far this has not been an issue for most Vanguard funds because indexing is gaining in popularity and the funds have a net inflow of investor cash. Most of their transactions are then buying new shares, not selling old ones. They would basically only sell shares in the relatively rare circumstance where a company leaves the index, in which case they're likely recognizing a capital loss on those shares anyway. The net result of all this has been that most Vanguard funds only rarely have capital gains distributions that are taxable to shareholders.
The worry here is that as Vanguard grows and holds its portfolio for longer and longer amounts of time, they're accumulating lots of unrealized capital gains that must be realized and distributed to shareholders at some theoretical point in the future. As we've already acknowledged, the funds aren't likely to make many transactions where they swap their Company A stock for Company B stock in search of better returns. That's not Vanguard's business model. No, any large transactions will happen as a result of existing investors moving their money out of the fund faster than new investors come in. Maybe Schwab starts offering a line of index funds with half the expense ratio and people start to leave Vanguard. Maybe the economy experiences a serious meltdown, nobody is willing to invest new money, and many of the existing investors need to take their money out to put food on the table. Hypothetical scenarios abound.
Even in these scenarios it does look like Vanguard has some mechanisms available to help mitigate the damage. The ETF thing that johnny847 mentioned above is something I've heard mentioned before. It sounds like they have a mechanism whereby they can shift low-basis shares off of the mutual fund books by creating and selling new ETF shares. It's an impressive-sounding bit of financial engineering, albeit one that I don't fully understand. When they do sell shares, they can start with the shares that have higher cost basis. In the case of a market crash, a lot of the shares Vanguard holds will be underwater, so they wouldn't need to pass on any gains until a very high percentage of investors (50%? More?) liquidates their shares.
All in all, I view this as a relatively minor risk, especially for those of us who plan to retire in lower tax brackets.
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Vanguard hasn't communicated anything about it, because it's not an issue.
I wouldn't say that, it's right there on the Distributions tab of the fund overview, with a link talking about exactly the unrealized gains/losses scenario that Kennon is discussing (https://personal.vanguard.com/us/content/Funds/FundsVGFundsAboutGainsLossesJSP.jsp).
For example, VTSAX has unrealized gains equal to almost 30% of NAV (https://personal.vanguard.com/us/funds/snapshot?FundId=0585&FundIntExt=INT#tab=4). Which seems to imply that their ETF escape hatch is at least not 100% effective at avoiding the problem - though maybe if there were a lot of ETF redemptions that would help?
It seems to me that what he's talking about is something that could happen. It's a low probability, but if it did happen it would be an annoying expense at a very bad time.
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Any distribution reduces the NAV; in effect, if VTSMX sold everything and distributed 45% as LTCG, it forces the holders to pay taxes on someone else's (Vanguard's) schedule. Of course, the NAV would also be reduced by 45%. If Vanguard were to close VTSMX, there wouldn't be (much of) a difference between selling at your whim or receiving a 45% distribution and selling.
This leads to a mitigation strategy since Vanguard publishes their distributions in early December.
I didn't follow this - what exactly is the proposed mitigation strategy?
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The reason a lot of his stuff doesn't get posted here is because there's an almost heretical standard towards indexing here - because indexing works fairly well, and much better than picking actively managed mutual funds, the posters in this forum have collectively (for the most part, there are exceptions) decided that they now know all there is to know about investing, and that there is little to no downside to indexing. You can already see Interest Compound stubbornly suggesting that there's nothing to be learned because Joshua is launching an asset management business. And just look at cyclone's post:
All in all, I view this as a relatively minor risk, especially for those of us who plan to retire in lower tax brackets.
the point posters don't see is that runs on a fund doesn't happen when it's convenient for you and your tax bracket, it can hit you when you're at your highest earning capacity. All the talk about ETF structure minimizing taxes and little to no turnover doesn't understand that for this to scenario to happen, YOU GET STUCK WITH THE CONSEQUENCES OF OTHER INDEXER'S ACTIONS. People here are confusing distributions of small sales (companies that have left the index) and dividends with a run on the index fund itself.
GRANTED, this scenario has very little chance of happening because it would require such a massive amount of indexers to sell, AND Vanguard could possibly issue the shares in kind instead of liquidating if such a run occurs. This means that a lot of the posters in this forum probably doesn't have to worry about such a scenario - sometimes ignorance is bliss, and indexing IS the best time/effort for value tradeoff when it comes to investing small amounts of money
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The structure of Vanguard funds with ETFs certainly gives managers an opportunity to reduce the impact during a run on the fund as they can use the in-kind transfer mechanism to exchange the shares with the lowest purchase price with redeeming ETF shares. But there appears to me to be a limit to that ability and it's the number of ETF shares being redeemed in relation to total outflows.
For example, Vanguard's site shows the Total Stock Market Index Fund has net assets of $371.5 billion, with the ETF shares responsible for $52.3 billion, or a little more that 14% of the total. In the event of a market crash with major redemptions in the fund, will the authorized participant be able to buy up enough shares to exchange and allow the fund to avoid the capital gains? The events of 2008 seem to indicate yes, but I honestly don't know.
As an aside, it looks a lot tougher for managers to use the ETF exchange mechanism during a run on the Total International Stock Index Fund. VXUS has net assets of $4.4 billion out of a fund total $174.6 billion. That's 2.5% of net assets held by the ETF.
I'm sure someone at Vanguard much smarter than myself has thought this through and modeled scenarios to find out how bad it has to get before the ETF can't absorb all the capital gains.
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I understand this is more of an issue for managed funds, when the fund manager decides to take some profits after a period of gains. I'm not quite sure I see the problem for index funds, which tend to have low turn over. And the stocks that do turn over,tend to be ones that aren't doing well and therefore get dropped from the index. In that case, you are more likely to benefit from embedded losses than get penalized from embedded gains.
Kennon posits there could be a problem if there is a "run on the fund." Has that ever happened on an index fund?
It's not about the turnover, because you're right, turnover usually only occurs when securities move in and out of indices. Joshua is talking about runs on the fund, where redemptions > cash held by the index fund. This results in forced sales, even if you're an index. When you buy an open ended index fund, you're not buying fresh shares of the underlying securities, you're buying the mutual fund as it is that day - the passive mining fund Brooklyn posted is VGPMX, and if you go to the distribution link and go back a few years, you can see all of the LT and ST (which is even worse, since it's taxed at ordinary tax rates) Capital Gains: https://advisors.vanguard.com/VGApp/iip/site/advisor/investments/price?fundId=0053#state=0
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1) Yes, I agree that if the total stock market is melting down, then we are talking about a 'black swan' type event.
And in the context of this topic, that's simply not worth trying to insure against.
almost all mutual funds will melt down.
it's a fool's errand to pick the few hedge funds that will outperform the market through a black swan event.
The answer is holding the underlying securities within the index yourself, or constructing a similar basket of safe blue chip securities that you hold. That way it doesn't matter what other investors do, their sales of the index fund doesn't affect you because YOU don't have to follow the herd and sell the securities yourself
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Any distribution reduces the NAV; in effect, if VTSMX sold everything and distributed 45% as LTCG, it forces the holders to pay taxes on someone else's (Vanguard's) schedule. Of course, the NAV would also be reduced by 45%. If Vanguard were to close VTSMX, there wouldn't be (much of) a difference between selling at your whim or receiving a 45% distribution and selling.
This leads to a mitigation strategy since Vanguard publishes their distributions in early December.
I didn't follow this - what exactly is the proposed mitigation strategy?
When there's a large fund loss, such as in the example ($53-$13), sell the shares, which will counter any distributed LTCG and taxes due. Since distributions at Vanguard are announced ahead of time, this can be done pre ex-div in 2008; or it can be done in 2009, per the example, moving the losses to the 2009 tax return.
In other words, this is easily solved with a little end of year planning.
1) See that Oppenheimer is going to make a large distribution at the end of December.
2) Realize that this will increase personal taxes due to LTCG, even though the market is doing poorly.
3) Look at the fund NAV and see how awful it's doing.
4) TLH the fund, taking a ~$30/share loss.
There's no need for individual stocks or an advisor or a managed fund.
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In other words, this is easily solved with a little end of year planning.
1) See that Oppenheimer is going to make a large distribution at the end of December.
2) Realize that this will increase personal taxes due to LTCG, even though the market is doing poorly.
3) Look at the fund NAV and see how awful it's doing.
4) TLH the fund, taking a ~$30/share loss.
There's no need for individual stocks or an advisor or a managed fund.
While true, the fact that there's no discussion on this topic at bogleheads and with seemingly none of the posters here except for you knowing about embedded gains before Brooklyn started this thread, what are the chances of indexers actually knowing/thinking up a strategy such as what you suggested?
It's a great strategy if adoption is minimal, I'm just questioning actual utility as you would have to really broadcast it loudly across the internet space, which, if the desired effect is reached, would result in even MORE redemptions - plus, you'd have to convince all of the dyed in the wool indexers that their 30 year habit of "dollar cost average in, never sell" is wrong for only this instance at this point in time and they should sell now. How many people on the boards would accuse you of fear mongering then?
EDIT: Brooklyn had posted this above, but Joshua already mentioned your strategy in his comment response:
"If you were willing to time the market - something I think is inherently dangerous - you could have sold some of your shares for a loss and attempted to offset much of the bill, hoping stock prices didn't turn around in the meantime. Who wants to live that way? It's a mess you shouldn't have had to deal with in the first place."
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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.
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Vanguard mutual fund shares benefit from the disposition of capital gains through ETF shares. Because the trade is conducted in-kind, no capital gains are realized. Remember, Vanguard mutual funds can be converted to ETFs without realizing capital gains, but not the other way around.
This is a non-issue.
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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.
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Vanguard mutual fund shares benefit from the disposition of capital gains through ETF shares. Because the trade is conducted in-kind, no capital gains are realized. Remember, Vanguard mutual funds can be converted to ETFs without realizing capital gains, but not the other way around.
This is a non-issue.
They have the CHOICE to conduct in kind distributions. But it's cheaper for Vanguard to just stick you with capital gains, which is what they did with the mining index fund from 2005 through 2012
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In other words, this is easily solved with a little end of year planning.
1) See that Oppenheimer is going to make a large distribution at the end of December.
2) Realize that this will increase personal taxes due to LTCG, even though the market is doing poorly.
3) Look at the fund NAV and see how awful it's doing.
4) TLH the fund, taking a ~$30/share loss.
There's no need for individual stocks or an advisor or a managed fund.
While true, the fact that there's no discussion on this topic at bogleheads and with seemingly none of the posters here except for you knowing about embedded gains before Brooklyn started this thread, what are the chances of indexers actually knowing/thinking up a strategy such as what you suggested?
It's a great strategy if adoption is minimal, I'm just questioning actual utility as you would have to really broadcast it loudly across the internet space, which, if the desired effect is reached, would result in even MORE redemptions - plus, you'd have to convince all of the dyed in the wool indexers that their 30 year habit of "dollar cost average in, never sell" is wrong for only this instance at this point in time and they should sell now. How many people on the boards would accuse you of fear mongering then?
Oh, yeah, most index funders wouldn't do this. It's not the end of the world if nothing is done but, in the Oppenheimer case above, it would suck come April 15.
But the chances of a run are very unlikely. We have to balance the risk vs the time and effort of managing 75+ stocks vs. paying a manager 1%.
EDIT: Brooklyn had posted this above, but Joshua already mentioned your strategy in his comment response:
"If you were willing to time the market - something I think is inherently dangerous - you could have sold some of your shares for a loss and attempted to offset much of the bill, hoping stock prices didn't turn around in the meantime. Who wants to live that way? It's a mess you shouldn't have had to deal with in the first place."
Eh, it's standard TLH strategy. At most, you're out of the market for 31 days. At best, you take the tax loss and switch the money to a similar but not-the-same investment.
If he's a financial advisor and doesn't do TLH, then he's not much of a financial advisor.
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The reason a lot of his stuff doesn't get posted here is because there's an almost heretical standard towards indexing here - because indexing works fairly well, and much better than picking actively managed mutual funds, the posters in this forum have collectively (for the most part, there are exceptions) decided that they now know all there is to know about investing, and that there is little to no downside to indexing. You can already see Interest Compound stubbornly suggesting that there's nothing to be learned because Joshua is launching an asset management business.
And another reason is that a large number of posters here are financially literate and are able to rationally and unemotionally evaluate financial risks.
As you point out, for this scenario to come true a series of several unlikely events must first happen. And if all those things do happen, the worst case scenario is your tax bill might be larger than you thought. And of course remember that those capital gains can be offset by capital losses, and then capital gains receive favorable tax treatment anyway. In short, the worse case scenario really doesn't sound very scary to me. If something of this magnitude really does happen, I suspect our tax bills will be the very least of our problems.
One thing I hate is when people claim the sky is falling without proposing a better solution. Kennon's solution is to simply buy individual stocks. Great. But we all know the large majority of stock pickers fail to be the market over any reasonable length of time. Indeed, on average financial advisers actually do worse than random chance would suggest. In short, they are even shittier at picking stocks than throwing darts. That is not a criticism of buying individual stocks, by the way. Just pointing out it isn't good advice for most people, and there are very real and non-trivial market risks by following his advice. IMO much greater than the unlikely and hypothetical risks Kennon points out.
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Vanguard mutual fund shares benefit from the disposition of capital gains through ETF shares. Because the trade is conducted in-kind, no capital gains are realized. Remember, Vanguard mutual funds can be converted to ETFs without realizing capital gains, but not the other way around.
This is a non-issue.
They have the CHOICE to conduct in kind distributions. But it's cheaper for Vanguard to just stick you with capital gains, which is what they did with the mining index fund from 2005 through 2012
The Vanguard mining fund doesn't have ETF shares. Honestly, I feel like I'm wasting my time here.
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As you point out, for this scenario to come true a series of several unlikely events must first happen. And if all those things do happen, the worst case scenario is your tax bill might be larger than you thought. And of course remember that those capital gains can be offset by capital losses, and then capital gains receive favorable tax treatment anyway. In short, the worse case scenario really doesn't sound very scary to me. If something of this magnitude really does happen, I suspect our tax bills will be the very least of our problems.
One thing I hate is when people claim the sky is falling without proposing a better solution. Kennon's solution is to simply buy individual stocks. Great. But we all know the large majority of stock pickers fail to be the market over any reasonable length of time. Indeed, on average financial advisers actually do worse than random chance would suggest. In short, they are even shittier at picking stocks than throwing darts. That is not a criticism of buying individual stocks, by the way. Just pointing out it isn't good advice for most people, and there are very real and non-trivial market risks by following his advice. IMO much greater than the unlikely and hypothetical risks Kennon points out.
All good points. Again, I think we need to remember that Joshua was talking about if someone came into a LARGE amount of unexpected money, and he isn't happy with people suggesting that it should all go into index funds mainly because those people don't understand all of the risks inherent in an index fund. This is a true statement by him, as none of the posters here (besides bacchi) knew of the embedded gains risk (however small it might be) before Brooklyn started the thread
I do agree with you that most people are not suited for individual stock picking though, I just think that there's always more to learn, and I consistently get the sense from these forums (although not from you or posters like brooklyn/bacchi) that any attempt to point out that indexing has flaws that should be taken into consideration (after all, you are outsourcing security selection to the people who dictate the contents of the indices) results in this mob mentality irrationality where you're denounced for no reason
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The Vanguard mining fund doesn't have ETF shares. Honestly, I feel like I'm wasting my time here.
Why would that matter? The mutual fund has the option to do in-kind transfers too:
https://personal.vanguard.com/pub/Pdf/p053.pdf?2210107342
"Potentially disruptive redemptions. Vanguard reserves the right to pay all or part of a
redemption in kind—that is, in the form of securities—if we reasonably believe that a
cash redemption would negatively affect the fund’s operation or performance or that
the shareholder may be engaged in market-timing or frequent trading. Under these
circumstances, Vanguard also reserves the right to delay payment of the redemption
proceeds for up to seven calendar days. By calling us before you attempt to redeem a
large dollar amount, you may avoid in-kind or delayed payment of your redemption.
Please see Frequent-Trading Limitations for information about Vanguard’s policies to
limit frequent trading"
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Define "considerable." Remember, in an index fund (which is what we were talking about), there is very little turnover, hence very little actual capital gains exposure.
GAH! The fact that there is very little turnover is PRECISELY the problem! BECAUSE there is very little turnover there can be a ton of embedded capital gains that will be triggered if outflows start to be larger than inflows. All Kennon is saying is that if you have the money you should buy the index directly (each stock in the index). Then you get much lower turnover and you avoid this risk of other people sticking you with a huge tax bill. He's not selling advisory services here. He's just pointing out that there are some tax risks with the mutual fund structure that aren't present if you own the exact same securities directly.
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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.
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If this is an issue (Interest Compound is making a solid argument that it's not at all), it's minor. Worth knowing about, but not worth using actively managed funds instead as suggested by the article.
I agree that this should be a non-issue once FIRE due to the low tax bracket, but it could be an issue during accumulation due to higher tax rates. Here's what I haven't heard mentioned yet though:
Index returns theoretically should equal actively managed fund returns, gross.
Net of fees, index funds should already be ahead by 1%.
Net of tax drag from churn, index funds should already be ahead by another 1% (or whatever the tax effect of the churn would be).
What this theory is arguing is the tax drag is building up and could potentially burst, rather than the slow leak provided by an actively managed fund. While a lump sum $100K capital gain distribution would have a huge impact on a tax return, likely a bigger impact than $10K/year for 10 years, the difference is likely minor and would be offset if not dwarfed by the 1% advisor fees along the way.
I just don't see this as an issue at all, but if anyone does I believe the solution is not active management, it's diversification into numerous index funds or numerous individual stocks with a portion of your taxable investments.
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The Vanguard mining fund doesn't have ETF shares. Honestly, I feel like I'm wasting my time here.
Why would that matter? The mutual fund has the option to do in-kind transfers too:
https://personal.vanguard.com/pub/Pdf/p053.pdf?2210107342
"Potentially disruptive redemptions. Vanguard reserves the right to pay all or part of a
redemption in kind—that is, in the form of securities—if we reasonably believe that a
cash redemption would negatively affect the fund’s operation or performance or that
the shareholder may be engaged in market-timing or frequent trading. Under these
circumstances, Vanguard also reserves the right to delay payment of the redemption
proceeds for up to seven calendar days. By calling us before you attempt to redeem a
large dollar amount, you may avoid in-kind or delayed payment of your redemption.
Please see Frequent-Trading Limitations for information about Vanguard’s policies to
limit frequent trading"
This is under a section titled, "Potentially disruptive redemptions." This is not related to embedded capital gains, or taxes. Vanguard created their dual-share structure (https://www.bogleheads.org/wiki/ETFs_vs_mutual_funds#Vanguard_funds) (and got patent protection) specifically so they can use ETFs to avoid embedded capital gains in their mutual funds which have an ETF counterpart. No point going in circles over this, the evidence is out there.
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The solution is to buy ETF's. I don't see how this could affect those. Granted there's not an ETF for every index fund, but Vanguard has one for all the big ones.
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If this is an issue (Interest Compound is making a solid argument that it's not at all), it's minor. Worth knowing about, but not worth using actively managed funds instead as suggested by the article.
I agree that this should be a non-issue once FIRE due to the low tax bracket, but it could be an issue during accumulation due to higher tax rates. Here's what I haven't heard mentioned yet though:
Index returns theoretically should equal actively managed fund returns, gross.
Net of fees, index funds should already be ahead by 1%.
Net of tax drag from churn, index funds should already be ahead by another 1% (or whatever the tax effect of the churn would be).
What this theory is arguing is the tax drag is building up and could potentially burst, rather than the slow leak provided by an actively managed fund. While a lump sum $100K capital gain distribution would have a huge impact on a tax return, likely a bigger impact than $10K/year for 10 years, the difference is likely minor and would be offset if not dwarfed by the 1% advisor fees along the way.
I just don't see this as an issue at all, but if anyone does I believe the solution is not active management, it's diversification into numerous index funds or numerous individual stocks with a portion of your taxable investments.
Please quote where Kennon advocates for an actively managed fund. Ever.
Kennon's point, as far as I can tell, is that if one has large taxable holdings then one would lower their overall tax risk exposure by owning the underlying securities directly. I.e. buying the companies that compose the S&P 500 directly, instead of via a mutual fund structure.
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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.
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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]
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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?
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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.
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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.
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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?
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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.
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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.
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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.
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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.
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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).
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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!?
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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"?
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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.
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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
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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.
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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.
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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.
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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?
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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:
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.
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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.
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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
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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
(http://www.joshuakennon.com/sp-500s-dirty-little-secret/)
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!!
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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!
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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....
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 ???).
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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.
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
(http://www.joshuakennon.com/sp-500s-dirty-little-secret/)
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.
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"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.
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"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.
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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 !
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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.
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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.
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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.
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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
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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.
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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 (http://www.joshuakennon.com/how-joe-campbell-found-himself-106445-56-in-debt-to-his-broker-in-a-matter-of-minutes-because-he-didnt-understand-the-risks-of-shorting-stock/) 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.
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 (http://www.joshuakennon.com/mail-bag-buying-stock-when-valuations-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 (http://beginnersinvest.about.com/od/wealthmanagement1/fl/How-Does-Global-Custody-Work.htm) 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 (http://www.joshuakennon.com/mail-bag-still-hold-index-funds-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 (http://www.joshuakennon.com/sp-500s-dirty-little-secret/)? 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 (http://www.joshuakennon.com/assumptions-are-the-enemy-of-the-rational-thinker/)! 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.
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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"?
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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.
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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" (https://blogs.wsj.com/moneybeat/2017/11/10/the-rot-that-lies-beneath-some-index-funds/)
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It's behind a paywall. Is PNC the bank?
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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.
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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.
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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" (https://blogs.wsj.com/moneybeat/2017/11/10/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.
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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" (https://www.wsj.com/articles/an-index-funds-sudden-death-1517799661)
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.
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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.
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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" (https://www.wsj.com/articles/an-index-funds-sudden-death-1517799661)
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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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.
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Where's the evidence this occurs?
How about BG's post 3 up from yours?
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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.
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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.
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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.
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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.
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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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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.
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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.
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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.