The Cutting Edge

January 01, 2004

Fund issuers now use at least two different fund models to deal with the fact that some investors prefer exchange- traded funds (ETFs) while others prefer conventional funds. These models are likely to lead to very different results for taxable investors. To state the difference in the simplest possible terms, tax efficiency in an ETF depends on the frequency of inkind redemptions. Allowing some redemptions to be for cash, at the option of the investor, diminishes tax efficiency.

The more 'established' of the two models is epitomized by Vanguard's VIPERs. Vanguard Index Participations Equity Receipts are an exchange-traded share class of some of Vanguard's existing conventional index funds. Vanguard's Total Market Fund, and more recently, its Extended Market Fund, have these ETF share classes. Vanguard will offer similar exchange-traded share classes for most of its other index funds and for ten new sector index funds.

In contrast to the Vanguard model, Fidelity Investments uses separate funds, one conventional and one ETF, that will track the same index. Specifically, Fidelity has licensed the Nasdaq Composite Index for two such separate funds. The two fund portfolios are similar in composition, but the portfolios will not be linked in anyway.1

We believe there are important advantages in Fidelity' s two-fund structure. To understand these advantages fully, we need to look at the tax characteristics of conventional funds, ETFs and combinations of the two types.

An ETF generally redeems its outstanding shares by delivering out portfolio securities in-kind in a large transaction, typically 50,000 fund shares or some multiple of 50,000 shares. The ETF delivers out its lowest-cost securities first in these untaxed in-kind redemptions, letting the fund increase the average cost basis of its remaining portfolio securities and reducing or even eliminating capital gains realized inside the fund. The key to the widely touted ETF 'tax efficiency' is really capital gains tax deferral (from the step-up of average basis inside the fund) until a shareholder sells the ETF shares. Inkind redemptions are harder to implement in a conventional fund, making eventual taxable capital gains distributions much more likely in conventional funds.

The Vanguard-type structure is based on a single pool of portfolio securities underlying both share classes, in contrast to the Fidelity-type's two separate funds, each with either ETF or conventional shares. Any tax efficiency produced by the ETF share class in the Vanguard-type structure is diluted by the presence of the other share class. Barring possible in-kind redemption in the conventional fund to create shares in the ETF, tax efficiency from in-kind redemption in the Fidelity-type products will be concentrated in the separate exchange-traded fund.2 In the Vanguard-type structure, an investor can enter through either the exchange-traded share class or the conventional share class, but only the conventional share class is exchangeable into the other class. An investor in the exchange-traded share class cannot convert into the conventional share class. The Vanguard-type share class conversion process can go in only one direction.

It is useful to consider why someone might select one share class over another, or one structure over another. Three fund characteristics are likely to determine an investor's preference for conventional versus ETF share classes. They are:

(1) Cost

(2) Ability to trade a fund's shares on an intra-day basis and

(3) Tax efficiency


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