The Hidden Advantage of Vanguard's New ETFs


Savvy investors know that it’s not what you make, it’s what you keep. That’s why the apparently ho-hum news about Vanguard Group’s new exchange-traded funds is actually worthy of note. The key benefit could be tax savings.

On June 24 Vanguard announced it is seeking regulatory approval for 20 new ETFs. That’s good news for Vanguard investors who like to keep everything in the family, especially as Vanguard now offers commission-free trading on its in-house ETFs.

But why should anyone else care? After all, there are hundreds of ETFs already, plenty of them in the sectors Vanguard has targeted.

Vanguard touts its low fees, but ETF fees are already so low they hardly matter. Among the three ETFs tracking the Standard & Poor’s 500, Vanguard’s will charge 0.06% a year compared to 0.09% on its two competitors, the SPDR 500 (Stock Quote: SPY) and the IShares S&P 500 (Stock Quote: IVV). On a $100,000 investment, the Vanguard ETF will charge $30 less a year than the other two. Hardly earth shattering.

But Vanguard may have a bigger edge in tax efficiency, which determines how much the investor keeps after taxes are paid, according to Morningstar Inc. (Stock Quote: MORN). The reason is that the Vanguard ETF will be offered as a share class of the firm’s Vanguard 500 Index mutual fund (Stock Quote: VFINX). While most index funds are tax efficient compared to actively managed funds, Vanguard has worked hard to squeeze a little extra efficiency into this one.

That can be done with various techniques. When the fund must sell stocks to raise cash for investor redemptions, for example, it can select blocks for which it had paid the most. That minimizes profits that have to passed on to shareholders in year-end distributions, or it produces losses that can offset other taxable gains.

Because the Vanguard fund is so big, with $91 billion in assets, it can do the extra work to minimize taxes without threatening its low expense ratio.

“We anticipate that now having an ETF linked to the fund will only provide further opportunities for Vanguard to keep the fund even more tax efficient,” Morningstar said in an analysis.

Tax efficiency shows up in Morningstar’s figure for tax-adjusted return, which shows how much an investor in the highest bracket would actually earn after paying taxes. Over the past 10 years, investors in the Vanguard fund lost 1.26% a year compared to average annual losses of 1.36% in the SPDR ETF and 1.48% in the IShares ETF.

Granted, these are not enormous differences. But if all else is equal, why not go with the investment that will earn a smidgeon more? Especially as conscious efforts to improve tax efficiency could produce bigger results in a rapidly rising market.

The biggest benefit from Vanguard’s announcement: by expanding its lineup of low-fee, tax-efficient ETFs, Vanguard puts more pressure on competitors to keep these costs low.

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