The tax implications of mutual funds and ETFs can make the tax code look simple. Unlike investing in individual stocks, mutual funds can generate capital gains even when you haven’t sold any shares of the fund. These distributions make asset location–whether to hold certain investments in taxable or retirement accounts–critical.
To help us sort through this issue is James Rowley, Senior Investment Analyst at Vanguard. In this interview we cover not only asset location, but also the nuts and bolts of dividends and capital gains generated from mutual funds and ETFs.
Mutual Funds vs. ETFs – Why Asset Location Matters
Jim starts out by discussing the differences between mutual funds and ETFs. Apart from some legal distinctions, he make it clear that the two investment vehicles have a lot in common. From an investment standpoint, one of the most notable differences is that most mutual funds are actively managed – about 85% – while most ETFs – about 90% – are index funds.
That of course circles back to the asset location issue. Index funds, whether in the form of a mutual fund or ETF, have very little turnover that would create capital gains. As a result, index funds are generally a better fit in taxable accounts than actively managed funds.
Jim also recommends that income paying funds, such as corporate bond funds, be held in tax advantaged accounts.
So what about other asset classes, like equity index funds, real estate investment trusts (REITs), municipal bonds and individual stocks? Jim provides valuable insight in the interview, as well as a wider discussion on both capital gains and tax efficient investing.
Transcript of Interview with James Rowley of Vanguard:
Rob: Jim, welcome to the show.
Jim Rowley: Thank you very much Rob.
Rob: I’m always happy to have someone from Vanguard join us. You guys always bring us great information for folks. I know today we’re going to talk about mutual funds an ETFs and taxes,— dividends, capital gains and how all that works in the context of mutual funds and ETFs. Before we get to all that fun stuff though, why don’t you give folks an idea of who you are and what you do at Vanguard?
Jim Rowley: Sure. My name is Jim Rowley and I’m the senior investment analyst in Vanguard’s investment strategy group. Our group is largely responsible for answering the question of what Vanguard thinks about a lot of different investing topics. I’ve been at Vanguard for nine years but most of my work in the group tends to focus on matters related to portfolio construction, indexing and ETFs.
Rob: What did you do before Vanguard?
Jim Rowley: I worked at a couple of different firms but I’ve been in investments sales and I’ve done investment banking and mutual fund analysis. So I’ve seen a pretty good different array of what goes on in the financial services industry.
Rob: Before we get to taxes and mutual funds, I’ve got to ask you probably the most important question of the interview which is, who are you rooting for tonight, Ohio State or Oregon?
Jim Rowley: Maybe to the dismay of many football fans who may be listening, I watch my football on Saturday mornings from England and I happen to be a diehard fan of Arsenal FC.
Rob: I have no idea what you just said, Jim.
Jim Rowley: English soccer.
Rob: Okay. [Laughter]. So where are you located?
Jim Rowley: Just outside of Philadelphia in Valley Forge, Pennsylvania.
Rob: So you’re just outside of Philadelphia. I know there’s a team there, what’s it called—the Eagles, right?
Jim Rowley: The Eagles will not be appearing—
Rob: [Laughter]. Well, that’s true. Are you going to watch the game tonight?
Jim Rowley: I will probably watch some of it, yes.
Rob: Okay. But you don’t really care who wins, right?
Jim Rowley: I’m not a big college football fan but that doesn’t mean I have no interest.
Rob: That’s okay, that’s okay. I’m just thrilled that Ohio State made it this far. I guess we’ll see what happens. Okay, well, let’s… The reason I wanted to talk to you is because I’ve got a lot of email from folks who have taxable accounts and wonder how mutual funds and ETFs can affect our tax liability whether it’s through dividends or capital gains. It can be a little confusing because you can buy a mutual fund and not sell anything, not sell any shares and still have capital gains taxes, for example. And that can be confusing. I know it’s been confusing for me at times so I though, sort of just a primer for folks, maybe you can walk us through the differences between mutual funds and ETFs first. Then we’ll slowing weigh in to the tax issues?
Jim Rowley: Sure. Ironically, most of the press headlines we tend to see is what makes mutual funds different from ETFs or mutual funds versus ETFs so to speak. At Vanguard we like to point out that it’s really about mutual funds and ETFS. We start from that standpoint because we think they’re overwhelmingly similar. We think they have far more in common with each other than they have differences. If you take the technical legal prospective, mutual funds and the overwhelming number of ETFs are regulated as investment companies under the Investment Company Act of 1940. So this is the regulatory framework that governs investment guidelines, permissible activities. These funds have to have a board of director or an investment advisor, matters related to financial statements and disclosures so the way they’re set up— the way they’re organized and regulated, they’re very much the same. ETFs generally come with these two differences if you really think about it… And for all similarities, you can group the differences down to two points. One, is that ETFs are bought and sold on an exchange, meaning the shares of an ETF… Rob, if you and I are a buyer or seller, we execute that trading through a brokerage window and the shares are traded on an exchange. Whereby, when we buy and sell our shares of a mutual fund, it’s done directly with that fund. The second difference is, with shares of an ETF, if we trade them on an exchange, the price that we get at that moment is an executed traded market price. Whereas, when we buy and sell share of a mutual fund, we get that, end-of-day, net asset value as our price.
Jim Rowley: So that’s really the two main difference because when you look at it from the 30,000 foot view, they’re overwhelmingly similar.
Rob: For your typical investor (and I would put myself in this category) where you’re saving for retirement and/or for a child’s education in an IRA, 401k or maybe taxable accounts, does it matter? If you’re at Vanguard, how do you decide whether to buy the mutual fund version of this investment or the ETF version?
Jim Rowley: Number one, start with your investment strategy. With any investment strategy, what you want to do is sit down and think about what your strategy is and what your allocation is, first and foremost. If you start with that and think about what the your right mix of stocks versus bonds, that should be the first stop when thinking about that. Another avenue where the differences between mutual funds and ETFs comes from is if you look at the mutual fund universe— I think off the top of my head it might be 85 percent of the assets in mutual funds are actively managed funds. On the ETF side it’s probably closer to 90 percent that are actually index. So now is where we’re going to get into a little bit of those differences that are dictated. Not because one’s a mutual fund or ETF, but because mutual funds are overwhelmingly actively managed products and EFTs are overwhelmingly index products. This is where the discussion starts to come into play, when investors are making decisions about whether they want to go the index vehicle route or the actively managed route.
Rob: Right. Well, if you’re investing with Vanguard, like I do, I’m going to pick an index passive investment, regardless. If I’m assuming an index fund, does it matter ETF versus mutual fund?
Jim Rowley: It still matters from the standpoint of what is the index that product is tracking. No ETFs are all alike, but not all index providers are alike either. Investors want to make sure that you have comprehensive, diversified (and when you pick the product) low cost, exposure to broad-based equity indexed and broad-based fixed income indexes. Assuming you come to Vanguard because our share class structure is such that the ETF is a share class alongside our conventional mutual fund shares, you’re getting to the same portfolio. And that portfolio is tracking the indexes that you’re looking for. A lot of your decisions at this point come down to taking a look at the cost of transacting.
Rob: Okay. And I know at Vanguard, at least for mine— but I guess part of it depends on if you’re an investor share or admiral share. But I’m pretty sure that at an admiral share the costs are the same, aren’t they? At least between most of the mutual funds Vanguard offers and the corresponding ETF?
Jim Rowley: For index funds, yes. The expense ratio of our ETF share class is equivalent to that of its corresponding admiral share class.
Rob: Yeah, okay. I know the focus today is taxes— when it comes to Vanguard ETFs and mutual funds, do taxes come into play at all as to what an investor might want to choose? Are the tax ramifications different or the same between the ETFs at Vanguard and the comparable mutual funds?
Jim Rowley: Because the ETF is simply a share class alongside the conventional share and because they’re therefore both part of the same portfolio, the taxes that might be generated by the fund itself are equivalent.
Rob: Okay. Let’s get into that more. I want to make sure I’ve got the universe here, correct. When it comes to a mutual fund in a taxable account, it’s my understanding there are two things that trigger taxes. One is dividends and the other is capital gains. That’s sort of the universe we’re dealing with. Do I have that right or am I missing other events that trigger taxes? Obviously you could sell but that would be a capital gain I guess?
Jim Rowley: Yeah. Actually, you bring up a good point with number three. I think it is important when we talk to investors, noting there’s taxes where the source may be the fund itself. And as you mentioned, the portfolio generates dividends and/or capital gains due to activities at the portfolio level. But there’s still may be taxes caused because the investor sells shares that trigger some type of gain from that standpoint as well.
Rob: Right. I guess if probably is good to keep those two types of capital gains separate. At least for the purposes of our discussion. Let’s walk through those. Let’s start with dividends. Walk us through how dividends work inside a mutual fund and how they ultimately come to generate tax liability for investors?
Jim Rowley: Sure. If you think of a portfolio that the fund itself represents, right? As you mentioned, these funds are organized as an investment company and they have any number of stocks or bonds in the portfolio. Their activities is to acquire, dispose of and hold different securities. And as those underlying securities pay dividends (in the case of stocks or coupon payments if it’s a bond fund) they come into— they’re created by the portfolio and held by the fund. Really, the best way of explaining it is, if the fund isn’t coming up on one of its near-turn dividend distribution payments, it takes those stock dividends or bond coupons and reinvests them back into the portfolio.
Rob: Okay. So when dividends are paid, I’m looking at my— Among other things, I own the Vanguard Small Cap Value Index Admiral Share (VSIX). So when companies within that fund pay a dividend, Vanguard takes that cash and reinvests it into shares of the companies that are held in that index?
Jim Rowley: That is correct. For some funds it might be an annual payout, some might be quarterly. As the fund comes towards one of those payout times, whether it’s new cash coming into portfolio and/or the portfolio managers might have to raise some cash by selling some underlying securities. That’s what helps to generate the dividend that is then paid out by the fund.
Rob: Okay. And when you say paid out by the fund, paid out by the fund to folks like me that own shares of the fund?
Jim Rowley: Correct. So you, as a fund shareholder, would be receiving that funds payment of its dividend.
Rob: Okay, so I know in my case, at least for the most part, the vast majority of the dividends that I see paid out are in December. What’s so magical about December? That seems to be the case regardless of whether Vanguard or someone else. December seems to be a big month for dividend payouts. Why is that?
Jim Rowley: By the time the fund gets to year-end, there are rules related to making sure that it pays out a certain amount of its dividend investment income that its received over its previous 12 months. So a lot of it is making sure that what it has gathered over the course of the year meets the requirements of what it’s supposed to pay out by its year-end.
Rob: So effectively— and I guess this kind of gets into the nuts and bolts of it, but does the mutual fund— obviously it keeps track of all of the dividends it’s received from the various companies that are held in the mutual fund. Does that keep track of that throughout the year? Then at the end of the year (December in this case) distribute that based on the amount of shares that each individual investor owns? At the end of the day is it a somewhat involved math problem to figure out how much each investor gets?
Jim Rowley: You can think about it because going back to some of my earlier phraseology, we’re talking about investment companies. Like many companies, they keep track of their accounting if you want to think about it that way. As they bring in dividend income from the underlying companies, it’s a process by keeping track of exactly how much income comes in. When it comes the time for that to be paid out then, yes, those fund shareholders sort of receive their equivalent, their pro rata amount of all the income that has been received by the fund itself from all of its underlying securities.
Rob: Okay. Now in the case of the small cap value index fund, I actually bought that at the beginning of last year. I think on the third. I’m trying to remember why and I can’t remember why that date. But, I basically held it for all of 2014. If I had bought it at the beginning of December last year, instead, the dividend transaction that I’ve see—and I’m literally looking at my account online while we talk, was December 19. It was when the dividend that was paid out last year, the main one that hit my account. Let’s say, if I had invested December 1, last year, instead of January, would that have affected the dividend payment I received?
Jim Rowley: Without seeing the dates in front of me, much of it depends upon if you’’re a holder of record date. Meaning investors who wish to receive a dividend on a fund need to have the shares settled in their account by a certain date to become eligible to receive payment of that fund’s dividend. That’s known in advance from an investor’s standpoint.
Rob: So, if you’’ve held those shares on that date, you’’re going to get your percentage of the dividend regardless of whether you’’ve owned that fund for 10 years or you bought it three months ago?
Jim Rowley: Right, depending upon if you own them as of the record date. Which means, for some funds it could be a matter of couple of days. But maybe the bigger point, I think, if I understand you is, it doesn’’t necessarily mean you have to have owned the fund for eleven months and two weeks to get that. It might just be a matter of days prior to that last dividend payment.
Rob: Yeah. And I’’ve read this before, that if you’’re looking to buy into a mutual fund, invest in a mutual fund in a taxable account, you might want to consider when they’’re going to be distributing dividends and capital gains because you could buy, again, depending on the record date as you said—. But let’’s say it’s a few days before December 19 that you invest $100,000, you may get hit with taxable dividends and perhaps capital gains even though you’’ve only held the fund for a few weeks.
Jim Rowley: This probably may be a good opportunity to share some of the tax-efficient strategies that we talk about with clients here at Vanguard. The phrase that we like to put out there is what we call, asset location. What asset location suggests is— think about using the space in your tax-advantaged accounts for those investments that might be less tax-efficient, right? At the same time for your taxable accounts, use that space for your more tax-efficient investments. Here’s a good example of that… If I think about my taxable accounts, muni bonds make sense in my taxable accounts. As do (when it comes to equities) my index-based products. And why is that? Because with index funds, you are typically looking at very low turnover portfolios. And you’’re typically looking at funds that pay very little in the way of capital gains. And I can link together here, you know, come back to the ETF mutual fund story is, you know the fact that many ETFs don’t pay much in the way of capital gains, has more to do with— they happen to be indexing strategies. The majority of them are indexing strategies. And most mutual funds are active. So when you think about tax-efficient investing in this concept of asset location, for your taxable accounts, try to use index-based products whether they’’re traditional mutual funds or index ETFs and your muni’s. In your tax-advantaged accounts, here’s where you might to consider using things like corporate bond funds which have very big income payments and your actively managed equities. Because actively managed equities tend to pay more in the way of capital gains. And when you use those products in your tax-advantaged accounts, the fact that they pay capital gains really doesn’t matter.
Rob: Right, and you know I’’ve heard too, of keeping REITs in a tax-advantaged account. I know I certainly try to do that in my taxable accounts. I have muni. In fact, it’’s a Vanguard municipal bond fund and index products and some individual stocks too. So that’’s very helpful. I still wonder, though, if someone’’s going to invest in a taxable account, even if it’’s an efficient fund like as you mentioned— an equity index fund, should they be at all mindful as to when the dividend payments are going to hit in relation to when they’’re buying it? Or do you think that’s just not a worthwhile evaluation?
Jim Rowley: Well, if the dividend payment comes, it’s still income you receive.
Jim Rowley: From our standpoint, another way to think about tax efficient investing is maximizing your after-tax return. It’’s about keeping what you have, not necessarily avoiding a payment.
Rob: Right, right. Okay, well we’’ve talked about dividends, what about capital gains? Let’‘s talk about capital gains generated by the funds. Let’s say I own a mutual fund for 12 months. I didn’t sell any shares, yet, at the end of the year I can see capital gains triggered. What causes that in a mutual fund?
Jim Rowley: You can have activities that are caused by, it might be a manager decision or it could be underlying shareholder activity. Manager decision might be on the active side. You have a fund manager and they have a particular favorite stock and they borrowed a while ago and let’’s say it goes up in value and it reaches the price point they were looking for and they have the next best idea so they sell shares of that stock that they had bought. If they sell it for more than they acquired it for, they have caused the gain to the fund. So they have incurred a capital gain. If it is matters related on index fund, let’’s say, you might have things like index rebalancing, where an index fund manager isn’’t picking his or her favorite stocks like an active manager might be. But in the course of trying to make sure they’’re holding the securities that are found in the index, they may be forced to buy or sell securities along the way and they could also trigger something in the way of a capital gain. What happens is, at year’s end, to the extent that the fund is still sitting with those gains on the books, they might be required to account for that or publish that.
Rob: And that would then get pushed down to the investors and they would have that capital gain to recognize on their taxes?
Jim Rowley: They would. And just in case anybody’’s thinking, “What if everything keeps going up, that’s a lot of gains?” You know keep in mind, the same thing happens on the reverse where if a stock goes down it gets sold and a loss is realized, and the losses can be offset against the gains over the course of that year.
Rob: Yes. And that’’s a big tactic that mutual fund managers use to try to offset gains with losses that they may have generated as well.
Jim Rowley: It’s a good way to work toward tax-efficient investing from a portfolio manager’s standpoint.
Rob: So in the context of Vanguard, how do we— and I guess I can use the same small cap fund, this VSIX. How does someone looking to invest in this, or any other mutual fund, its history with capital gains and what kind of capital gains it’s experienced over last year or in the last few years?
Jim Rowley: Most fund websites, including us at Vanguard, have ways for investors to go and take a look at the history of the amounts that get paid out. But I would say to investors who are starting out that way and they’’re thinking about what they might see, just keep in the back of your mind that you should expect (on a relative basis) your actively managed funds in the world are typically going to have higher capital gains payouts than index funds are. You should have an expectation. I don’’t really know if there’s a magical number about what’s high or low, but just the relative looking at one versus the other. You should expect to see index funds having very little in the way of capital gains payouts.
Rob: Yeah, I know for Vanguard you have a page, dividends and capital gains distributions. I’’m looking at that in my account right now and you have divided it between taxable accounts and non-taxable. Obviously, I’’m focused on taxable accounts. The thing that kind of amazes me is for your index fund, there are almost no capital gains distributions. How do you guys manage that?
Jim Rowley: Going back to maybe some of the earlier points, indexing is a very tax-efficient strategy to begin with. I think that gets a little bit overlooked. Indexing itself is tax-efficient. Maybe there’s a way to use a simple example. Let’’s just think if we had one stock in the portfolio, you have investors place their assets with that fund. That security is one of many where the portfolio manager might be buying shares of it every day. So you know, round numbers, maybe one day they buy it at $10 a share and the next day $11, $12, $13. And maybe the market dips the next day and they buy it at $12, then $11. So, you can kind of see that over time you build up different tax lots. And when it comes time that the portfolio manager might have to sell particular shares of that stock, they can actually go identify the stocks that have the highest purchase price or the highest tax slot.
Jim Rowley: In other words, trying to sell something that might either be at a loss or might minimize your gain.
Rob: Yeah. Well, I’’ll tell you… I’m looking at both my mid-cap index fund and my small cap index fund which are both in my taxable accounts. Zero, short or long-term gains last year. So, well done. In terms of tracking error on these funds, how often are purchases made in order to keep an index fund tracking the index? Are there daily transactions in these funds?
Jim Rowley: Everyday there’s transactions in the funds. As investors are looking to acquire shares of our fund, portfolio managers are putting that money to work every day.
Jim Rowley: And the beauty of market cap weighted indexing is that it’s a self-rebalancing strategy. All market cap weighting means is there’’s a certain number of shares for every given stock and it trades at a particular price every day. So the number of shares outstanding times that price is that company’s total value in the universe (if you will). And every day that changes. So if you’’re a portfolio manager and you need to buy shares of the stock to match the index, it’s self-rebalancing because all the shares you own, its price is reflected every day, now and going forward. So it tends to be a very tax-efficient strategy because traditional indexes, those that are market-cap weighted, it’s a self-rebalancing strategy.
Rob: Okay. I guess the third and final one which I think is the easiest to understand, is capital gains— when the investor decides on his or her own, to sell an investment. You’ve got short and long-term gains. One of the things that I like about Vanguard is that I can go into my account and you guys show me exactly what my gains are for each investment. So that if I decide to sell, I can figure out for myself what the tax implications are going to be. I found that to be extremely helpful. In terms of taxes, we’’ve kind of covered dividends and capital gains, am I missing anything?
Jim Rowley: I would say when it comes to taxes, I would hope investors remember that tax-efficient investing is about your after-tax return. Tax-efficient investing is not avoiding gains. That’s not what it’s about. It’s about making sure whatever you invest in, you’’re keeping as much of that as possible on an after-tax basis. That after- tax basis might be because of the fund itself, right? Index funds, for example. Even if you own an index fund that does have a capital gains payout, to extent that that index (with the low cost) is tracking its index very closely, even after you might pay a capital gains on it, there’’s still a possibility that you do better than a different index fund that lags its index by a significant amount but still doesn’’t pay a capital gain… if that makes sense. It’s not about avoiding payments. It’s about keeping as much as you possibly can. That’s on the fund side. Then on the other side, think about the asset location. The investor can control some of their own tax-efficient policies by taking those steps. By putting index funds or the more tax-efficient vehicles in their taxable accounts and thinking about putting the less tax-efficient vehicles in their tax-advantaged accounts.
Rob: Right. That’s a great point. Just listening to you, you mentioned asset location a number of times. Does Vanguard have any white papers on asset location and the value of tax-efficient investing?
Jim Rowley: We actually have several principles on portfolio construction as well as those on asset location.
Rob: I’ll get some links to those from you later so I can include those in the blog post that will go with this interview so folks can check that information out?
Jim Rowley: Absolutely.
Rob: Okay, that’d be great. I appreciate your time today. It’s an important topic. Kind of like eating your broccoli. Maybe it’s not the sexiest thing, but it’s good for you. I appreciate you taking the time to talk with us. Before I let you go, I always like to ask folks that come on the show about their favorite books. Books about money, investing, money management or whatever. What are some books that have resonated with you that you think could help folks concerning personal finance and investing?
Jim Rowley: I’m a big fan of David Swenson, who’s the Chief Investment Officer at Yale. He has a very good and straightforward book on portfolio construction for investors. He has an institutional version and maybe a more retailed version. I think it’’s very straightforward and simple to understand. Maybe for a little higher level, more technical reading, there’’s a pretty good book called Against the Gods. I believe it’s referred to as “the remarkable story of risk” and it just goes to show, investing, not just in modern times but several hundred years prior to us, the concept of risk has lived and is a very important consideration when investing.
Rob: Okay. Now the David Swenson book, is that Unconventional Success?
Jim Rowley: Yes.
Rob: Okay. Yeah, that’’s a good one. Against the Gods, I’’ve not read. I will definitely get that. I’’m curious though… The remarkable story of risk— I don’t want to go down a whole other path here, but I know in the context of modern portfolio theory and all that sort of thing, risk is generally evaluated on beta or volatility. Do you think that’s the right way to look at risk? Or is that like a whole other podcast and interview if we go down that path?
Jim Rowley: Maybe that technical path is a whole separate one. But the simple way to think about it is, no matter what investment strategy you look at, no matter what product, there are two sides to every coin. I would urge investors, that when they’’re looking at the prospect of return or potential return— that does not come without the other side of the coin. There is some form of risk, however you wish to measure it.
Rob: Okay, good. Hey I appreciate those recommendations. Against the Gods, is one that I’’ve not read. I’’ll definitely check that out. Jim, again, I appreciate your time with us today.
Jim Rowley: Thank you very much, Rob. It’s been my pleasure.