A little known fact (it seems) is that the Vanguard lineup of ETFs are not stand-alone products to the same extent as other ETF manufacturers’ ETFs. Rather, Vanguard ETFs are simply a special share class of Vanguard’s Index Mutual Fund lineup. While on the surface this might not sound like an important distinction, it is important to note the implications.
There are certain tax advantages of the ETF structure over and above the mutual fund open-ended trust structure. All other things being equal, suppose we have an index fund which has had a strong performance since inception. Further, let us assume a large investor redeems half the fund. An open-ended mutual fund trust will be forced to sell stocks at a realized gain in order to fund the redemption request. This creates a taxable event in which all the remaining unit-holders are subject to. A traditional ETF, on the other hand, can simply redeem ETF units on an in-kind basis to fund the request, thereby potentially sparing the remaining unit holders from any capital gains distributions.
So, it is important to note that Vanguard funds do not offer this one advantage of other ETFs from a tax efficiency perspective since they are, again, just a separate share class of the open-ended mutual fund trust index funds. If there were large redemptions causing realized capital gains, these could flow through to the Vanguard ETF holders.
However, it is also important to note open-ended mutual fund trusts have one advantage over traditional ETFs in that they can harvest capital losses to offset future capital gains. In this case, Vanguard ETFs have an advantage over other ETFs because they participate in the benefits of tax loss harvesting that is normally reserved for the mutual fund structure.
So at the end of the day, are Vanguard ETFs better or worse from a taxation perspective compared to other ETFs? Long term it’s close enough to a wash for me that it wouldn’t impact my decision to purchase Vanguard ETFs on a retail basis.