With exchange-traded funds rapidly becoming more mainstream investment vehicles, a debate has emerged over how to maximize their tax-efficiency capabilities.

Fund investors looking for a low-cost, tax-efficient alternative to mutual funds have two different ETF models available to them. Vanguard Index Participations Equity Receipts, or VIPERs, are an ETF class of some of the fund giant's existing conventional mutual funds. The Valley Forge, Pa.-based fund manager launched 14 VIPERs last year to leverage its brand in the burgeoning ETF market.

The company now plans to unveil dual share classes for most of its other index funds including 10 new sector funds. Vanguard is expected to exclude small investors from the conventional share class of its new sector funds, a decision that it hopes will drive investors to the ETF class

Other firms have opted to use separate funds as part of their ETF initiatives, with one conventional mutual fund and one ETF, but each tracking the same benchmark. For example, Fidelity Investments has licensed the Fidelity Nasdaq Composite Index for two such separate funds. The holdings of each fund will be similar, but their portfolios will not be linked in any way.

In order to capitalize on their tax benefits, an ETF redeems its outstanding shares making "in-kind" transactions or swapping fund shares in 50,000 share blocks called creation units. Instead of having to sell stock to generate the cash to pay redemptions like a traditional mutual fund, an ETF doles out its lowest-priced stocks first, thereby enabling the fund to increase the average-cost basis of its remaining portfolio holdings. More importantly, this type of security-for-security swap reduces or even completely wipes out capital gains realized within the fund.

Gastineau Blitzes Vanguard

The allure of the ETF is its capital gains tax-deferral feature, found in a majority of equity ETFs. Provided that an ETF share class is large and actively traded, in terms of in-kind redemptions, investors will reap the tax benefits that it boasts. However, one industry expert suggests that the Vanguard model may be inferior to the stand-alone model used by Barclay's Global Investors' iShares, SPDRs and the QQQs.

Gary Gastineau, managing director of ETF Consultants, Summit, N.J., said the Vanguard Total Market Fund has only 6% of its assets in the ETF share class while the remainder resides in the conventional share class. If an ETF is not actively traded and does not have many in-kind redemptions, it is less likely to be tax efficient, Gastineau explained. While the Total Market Fund may be the most clear-cut example of this scenario, all other existing Vanguard funds will be forced to cope with similar obstacles.

"If the ETF share class is small or, more specifically, if in-kind redemptions are a small fraction of the fund's total redemptions, the fund will exhibit little of an ETF's characteristic tax efficiency," Gastineau said. "The bottom line is you're not likely to see a significant number of in-kind redemptions in these multi-share class structures," he said.

He believes that if an investor does not value the ability to trade intraday, then they would be better off going into the conventional share class. And for those who are interested in active trading and tax efficiency, those features are widely available through ETFs that are not encumbered by a conventional share class diluting the benefits of in-kind redemptions. Vanguard's new sector index funds will also carry the same hybrid structure, but both will be starting from the same asset base.

Another criticism of the Vanguard model is that it goes in one direction in that only the conventional share class is exchangeable into the ETF class. An investor cannot convert from the ETF share class to the conventional share class. Ultimately, Gastineau believes that a taxable investor would be better off choosing the Fidelity model and that Vanguard faces some difficult challenges in bringing their ETFs to the masses.

"They're approaching the problem of this two-class fund with one hand tied behind their back," he said. "A pure ETF manager has a much simpler life."

Gastineau further stipulated that the tax benefits of the investment depend on what the market does. If the market hugs the flat line for three or four years, you're not going to see any effect because there won't be any significant net capital gains to be realized. However, if the market goes up or if there's rapid turnover in the positions that have been successful in some these indexes, then you'll have a situation where you realize capital gains inside the fund. Then there's a much higher probability that these hybrid funds with two share classes are going to be less tax-efficient than a pure ETF, Gastineau said.

Gus Sauter, Vanguard's chief investment officer and manager of the $98 billion Vanguard 500 index fund, argues that Gastineau doesn't take into account some of the other things an open-end mutual fund can do, such as using cash flow to realize losses.

Although ETFs redeem on an in-kind basis, conventional funds can sell their highest-cost shares to meet redemptions. In turn, this can yield the positive effect of realizing capital losses for the funds, which can be used to offset any gains. Sauter believes that ETF share classes of these funds can benefit from the losses enabled by the cash flows related to conventional share classes.

"We see no clear evidence that ETFs structured as share classes of conventional funds should necessarily be materially less tax-efficient than stand-alone ETFs tracking the same index," said Christopher Traulsen, an analyst at fund research firm Morningstar.

Gastineau concedes that the Vanguard ETFs will offer tax benefits for investors, but maintains that in order to achieve optimal tax efficiency, investors are better served going with the pure ETF play. He concluded that only superior performance and dominance of a very actively traded ETF share class for some of the smaller Vanguard funds, including its new index funds, will make for an attractive tax-efficient vehicle for the ETF investor.

Gastineau also noted that a different share class within an ETF might be worth exploring, one in which investors are able to enter and exit through the ETF class. In the end, allowing some redemptions to be swapped for cash diminishes tax efficiency for exchange-traded funds, he said.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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