By: Larry MacDonald

The tax efficiency of Vanguard exchange traded funds (ETFs) may be different than other ETFs. That’s because they are actually a special share class of Vanguard’s Index Mutual Funds, as Preet Banerjee notes on his wheredoesallmymoneygo.com blog.

According to Preet, index funds face the risk of having to sell shares to meet redemption requests, which could trigger capital gains that are distributed to unitholders (and become taxable in their hands). ETFs don’t face this same risk because they “can simply redeem ETF units on an in-kind basis to fund the request.”

The table below, from Sigma Investing, might be interesting to consider in this context. It shows the capital gains distributed by the Vanguard 500 Index and SPDR S&P 500 (SPY) from 1993 to 2006. The bottom of the table shows that the Vanguard 500 distributions are, on average, higher than SPY. But this is due to the early years. For the seven most recent years of the period, there are no distributions.

The SPY has capital distributions because it has to update its holdings whenever its index changes. So do the Vanguard index funds, I believe. The latter have ways to offset capital gains, which Preet mentioned. ETFs also have ways to offset capital gains.

The Sigma Investing website has some tables containing “average tax drag” for a number of Vanguard index funds. The Vanguard Total Market Index Fund (VTI), for example, is reported to have an “average tax drag” of 0.33%. The site doesn’t say what period the data covers or provide the data source, etc. I sent them an email and hope to get this info.

Capital Gains Distributed by Vanguard 500 Index and SPY