The Cutting Edge

May 01, 2005

From the forthcoming book, Someone Will Make Money on Your Funds - Why Not You? - A Better Way to Select Mutual and Exchange-Traded Funds, John Wiley & Sons, available in September 2005.

Capital Gains Overhang

Few investors fully appreciate the significance of the tax efficiency that the exchange-traded fund (ETF) structure provides. Table 1 offers an arresting comparison of the capital gains tax status of the Vanguard 500 Index Fund (Vanguard 500) and the Standard and Poor's Depository Receipts Trust ETF (SPDR), two funds tracking the S&P 500 Index that have been in existence for a number of years - over 12 years for the SPDR and over 25 years for the Vanguard 500. Both funds have had high rates of asset growth in a generally rising equity market. To make the comparisons as clear as possible, the relationships in the table are stated as percentages, with each fund's net assets set at 100 percent.

Table 1

Capital Gains Overhang/(Underhang), Vanguard 500 vs. SPDR

    Ajusted to  
Date of Fund Report 9/30/2004 12/31/2004* 12/31/2004
Fund SPDR SPDR Vanguard
Net Assets 100.00% 100.00% 100.00%
Unrealized Gains (Losses) (20.73%) (11.04%) 27.32%
Accumulated Net Realized Losses** (7.29%) (6.70%) (4.17%)
Capital Gains Overhang (Underhang) (28.02%) (17.74%) 23.16%
S&P 500 Index Level 1115 1212 1212
Actual Fund Assets ($ billions) $45.7 $55.9 $106.6

* Adjusted for appreciation in the S&P 500 from 9/30/2004 through 12/31/2004. This adjustment reduces realized and unrealized losses as a percent of adjusted net assets for the SPDR. The adjusted net assets for the SPDR as of 12/31/2004 would have been $49.7 billion.

Sources: Fund Annual Reports, Standard & Poor's

** Realized losses in a fund may be carried forward for up to eight years.

The dates of the latest available annual reports for the two funds are different - September 30, 2004 for the SPDR and December 31, 2004 for the Vanguard 500. To make the tax positions comparable, I adjusted the relevant realized and unrealized loss figures for the SPDR forward to 12/31/04. In making this adjustment, I assumed that the SPDR had no losses or gains during that quarter other than an increase in net assets and unrealized appreciation from the rising market in the final quarter of 2004. The appropriate columns for the capital gains overhang comparison, then, are the adjusted SPDR column for 12/31/04 and the Vanguard 500 column for the same date. The striking difference between the funds is that the SPDR investor is protected from a capital gains distribution by unrealized losses while the Vanguard 500 shareholder eventually faces capital gains distributions if accumulated gains have to be realized.

Vanguard's response to the vaunted tax efficiency of ETFs has been that conventional funds have the ability to realize losses in the fund to offset gains that might be realized on stocks sold at a profit. In fact, the accumulated net realized losses as a percent of the fund's projected 2004 year-end net asset value were greater in the SPDR (6.70 percent) than in the Vanguard 500 (4.17 percent). Vanguard also notes that mutual funds can redeem fund shares in kind, just as ETFs do. Vanguard did succeed in redeeming shares in-kind to "shelter" an impressive $372 million in capital gains during 2004. However, this amount pales in comparison to the $2.6 billion in unrealized gains that the much smaller SPDR "redeemed out" in its 2004 fiscal year.

The most important difference between the two funds is in the level of unrealized gains or losses. The Vanguard 500 had unrealized gains of 27.32 percent of net asset value on 12/31/04, whereas the SPDR had 11.04 precent of net assets in unrealized losses after adjusting the 9/30/04 portfolio forward to 12/31/04. The SPDR's accumulated book losses provide a cushion against any possible capital gains distribution. To use standard terminology, the Vanguard 500 had a capital gains overhang of 23.16 percent at the end of 2004, while the SPDR had a capital loss overhang (or a capital gains "underhang") projected at 17.74 percent of net assets as of that date.


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