Morningstar Advisor - April/May 2012 - (Page 63)

The gap can be significant. IShares’ EEM beats Vanguard’s VWO by 23 basis points on the one-year measure. The irony is the ETF is a share class of Vanguard Tax-Managed International. Across the board, iShares ETFs lead Vanguard ETFs in tax efficiency. However, iShares’ desired narrative of Vanguard’s ETF investors paying the price for other investors’ behavior doesn’t hold up to scrutiny, at least in this case. Vanguard seems to be a victim of its success. To see why, consider how an ETF gains its tax efficiency. Much of it comes from the in-kind redemption process, which allows the ETF to dole out the most appreciated tax lots without triggering a taxable event. However, strong inflows reduce an ETF’s opportunities to rid itself of appreciated tax lots. This is likely what’s happening with Vanguard’s ETFs. Looking at estimated net flows for the year as a percentage of starting assets, in every single year, for every ETF, Vanguard’s asset growth beat iShares’ by huge margins. Vanguard ETFs’ growth advantage over iShares ETFs’ averaged 92 percentage points over the past four years. It’s also worth looking at Vanguard’s mutual fund flows. Over the past five years, the volatility of flows was modest. Even during the depths of the financial crisis, Vanguard shareholders didn’t engage in destructive liquidation that could have resulted in capital gains for ETF share-class owners. We think Vanguard’s emphasis on asset allocation and passive investing has resulted in a mutual fund clientele less prone to portfolio churning, mitigating concerns that ETF shareholders will be left with the bag when it comes to taxes. Granted, there was at least one example of Vanguard ETF shareholders paying for other share-class investors’ behavior. In November 2008, Vanguard Extended Duration Treasury had three share classes: EDV with $50 million in assets, VEDTX (an institutional share class) with $253 million, and VEDIX (which virtually had no assets). The fund’s year-to-date return through November was 22%. Through December, it was 55%. In December, the fund had a $108 million outflow, or 32% of the fund, all of which came from the mutual fund, not the ETF. This resulted in an $11 capital gains distribution, 11% of the net asset value at the start of the year. It seems the biggest tax risk to Vanguard ETF investors is when the ETF share class is tiny compared with the mutual fund class, allowing a handful of investors redeeming shares to trigger capital gains. With the biggest Vanguard ETFs, this should not be much of a risk. Tax Efficiency Is Only Part of Efficiency since the SPDR’s SPY inception in January 1993, the Vanguard 500 open-end mutual fund has superior pretax and aftertax performance despite being a stodgy old mutual fund. Perhaps the most efficient aspect that ETFs have brought to the indexing landscape isn’t related to taxes at all. It is their unfettered distribution across platforms: No longer do index investors have to settle for subpar index funds that charge egregious fees. Now that the competition is available to all investors, no matter your brokerage, perhaps it is time to eliminate 150 or more of the “platform filling” S&P 500 index mutual funds with poor tracking, high fees, and more frequent capital gains distributions in favor of the more efficient mutual funds and ETFs that are delivering on indexing promises. K Paul Justice is Morningstar’s director of North American ETF research and a contributing editor of Morningstar Advisor. Samuel Lee is an ETF analyst with Morningstar. We find it hard to credit concerns that Vanguard’s dual-share-class structure poses a significant risk to ETF investors. Granted, a couple of Vanguard’s ETFs have been less tax-friendly than iShares’ in 2011, but the funds’ massive inflows explain most of the difference. Looking forward, we expect the potential for spillover taxes to fall along with the share of total assets held by Vanguard’s mutual fund share classes. That said, the risk of spillover taxes will always be there. But if Vanguard mutual fund holders continue to exhibit tendencies to redeem funds less often than other fund families, then the dual-class structure has several benefits over both stand-alone mutual funds or newly launched ETFs. Dual-class-structure ETF investors have thus far been compensated by the built-in liquidity and improved ability to fully replicate the index a pre-existing asset base provides. These factors have attributed to their ETFs demonstrating strong overall performance from the day of their launch. Success begets success in passive, market-cap-weighted index funds. Investors have shown skill in selecting good index funds and ETFs, and scale generally begets lower fees and more efficient tracking in index funds. This may also help explain why, MorningstarAdvisor.com 63 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2012

Morningstar Advisor - April/May 2012
Contents
Contributors
Letter From the Editor
We’re Too Smart
How Do You Use Alternatives?
Taking the Lead
How to Find Economic Moats
The Beauty of Currencies
No Clarity on Bonds
Four Picks for the Present
Investment Briefs
Performance Chasing, Evaluated
Technology’s Slim Pickings
How Much Is Enough?
The Fear Bubble
Three Traits of a Successful Long-Short Equity Manager
Why Absolute-Return Funds Fail to Deliver
An Economist’s Response to Crises
Undiscovered in Plain Sight
Untangling ETF Tax- Efficiency Myths
Central Banks Driving the Gold Rush
U.S. Industrials Could Add Some Magic to Europe-Weary Portfolios
No-Hesitation Allocation Funds
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Greatest Story Ever Told

Morningstar Advisor - April/May 2012