Under the hood – Vanguard US stock index funds in 2017


Vanguard issues annual reports for the firm’s US stock index funds on December 31 of each year. The reports provide information that can highlight some of the underlying conditions affecting a fund’s future capital gains distribution outlook; the level of security lending in each fund;  a means of measuring investor turnover in the funds; and a look at how mutual fund trading techniques reduce transaction costs.

Tax implications

Capital gains

Mutual funds are legally structured as pass-through conduits of investment income. The income usually comes from dividends and interest received from securities or by profits realized by selling securities. By law, the fund must distribute income and gains to shareholders or else pay tax on retained income. Funds cannot, however, pass realized losses on to shareholders. These losses are retained by the fund, and can be used to offset future gains.

Taxable shareholders are no doubt pleased when they open their 2017 annual reports and see that none of the following Vanguard US stock index funds has distributed a capital gain over the past five fiscal years.

While not distributing gains, the funds at times realize net gains during a given fiscal year. Often a fund will offset any realized gains with realized losses, or use retained loss carryovers to offset gains, thus providing shareholders zero capital gains distributions.

In addition Vanguard index funds contain both mutual fund share classes and exchange-traded fund share classes. The exchange-traded funds frequently realize in-kind redemption gains. Because in-kind redemption gains are not taxed to the fund or its shareholders, the fund manager will usually select shares with the lowest tax basis for redemption baskets.

Although these gains are not taxed, they are nonetheless included in a fund’s reported annual realized gain. Netting out these non-taxable gains produces the actual taxable gain or actual realized loss. The table below shows the 2017 reported gain or loss realized for each Vanguard US stock fund, the in-kind redemption gain or loss, and the actual net realized gain or loss. Note that in 2017,  the Vanguard Large Cap Index Fund and the Vanguard Small Cap Index Fund used loss carryover losses to offset net realized gains.

As an accounting entry, in-kind redemption gains become a part of the fund’s paid in capital.

Fund Gain/Loss In-kind redemption Net Gain/Loss
Total market 4,548,286,000 5,768,376,000 (1,220,090,000)
S&P 500 6,306,391,000 6,646,264,000 (339,873,000)
Extended 1,935,143,000 2,570,553,000 (635,410,000)
Large cap 217,973,000 193,166,000 24,807,000
Large growth 2,678,539,000 2,805,087,000 (126,548,000)
Large value 1,593,601,000 1,789,646,000 (196,045,000)
Mid cap 2,275,996,000 2,770,245,000 (494,249,000)
Mid growth 196,999,000 345,983,000 (148,984,000)
Mid value 336,923,000 484,277,000 (147,354,000)
Small cap 4,116,255,000 3,828,096,000 288,159,000
Small growth 1,104,663,000 1,325,381,000 (220,718,000)
Small value 1,187,494,000 1,325,381,000 (137,887,000)

More on loss carryovers

As noted, realized losses cannot be distributed to shareholders. Surplus losses can be “carried over” to subsequent years when they can be used to offset future gains. Prior to 2010, these carryover losses where subject to expiration dates.

The passage of the Regulated Investment Company Act Modernization Act of 2010 stipulated that mutual fund losses could be carried over indefinitely, but these losses must be used before taking any expiring loss carryovers.

The table below shows each fund’s loss carryover and shows both the amount and percentage of unexpiring carryovers.

Fund Total loss carryovers 2011 forward unexpiring % unexpiring
Total Market 1,660,426,000 1,660,426,000 100.00%
S&P 500 1,161,462,000 1,161,462,000 100.00%
Extended 1,163,440,000 1,138,856,000 97.89%
Large cap 118,637,000 94,460,000 79.62%
Large growth 1,138,498,000 1,138,498,000 100.00%
Large value 558,094,000 558,094,000 100.00%
Mid cap 3,437,989,000 3,143,021,000 91.42%
Mid growth 613,501,000 540,287,000 88.07%
Mid value 634,867,000 630,830,000 99.36%
Small cap 1,770,542,000 1,166,393,000 65.88%
Small growth 1,439,318,000 1,178,200,000 81.86%
Small value 763,172,000 374,398,000 49.06%

The considerable level of  historical unexpiring carryover losses in most of the funds has resulted in these carryover losses expiring without being used. The last expiration date will occur on December 31, 2018.

If a carryover loss expires, it becomes a part of the fund’s paid in capital.

Fund 2017 expired 12/31/2018 expiring
Total Market
S&P 500
Extended 49,578,000 24,584,000
Large cap 24,177,000
Large growth 300,177,000
Large value 333,377,000
Mid cap 294,968,000
Mid growth 73,214,000
Mid value 4,037,000
Small cap 342,008,000 604,149,000
Small growth 243,082,000 261,118,000
Small value 487,808,000 388,774,000

 The exchange-traded fund

Given that in-kind redemption helps improve a fund’s tax basis, it is somewhat helpful to examine a fund’s share class distribution. Most Vanguard index funds have mutual fund share classes (investor shares, lower cost admiral shares, and institutional shares) as well as exchange-traded fund shares. The following table shows the ratio of exchange-traded fund share class assets to total fund share class assets.

Fund Total assets ETF assets ETF/Total assets
Total market 662,577,171,000 91,862,048,000 13.86%
S&P 500 391,434,606,000 83,640,332,000 21.37%
Extended 63,145,552,000 5,711,226,000 9.04%
Large cap 18,586,692,000 11,612,841,000 62.48%
Large growth 73,116,654,000 31,398,987,000 42.94%
Large value 65,048,747,000 36,559,620,000 56.20%
Mid cap 94,732,666,000 21,936,798,000 23.16%
Mid growth 11,284,072,000 3,575,811,000 31.69%
Mid value 17,170,847,000 8,354,828,000 48.66%
Small cap 84,634,838,000 21,605,204,000 25.53%
Small growth 21,215,439,000 6,980,645,000 32.90%
Small value 29,635,904,000 12,649,548,000 42.68%

Security lending

Vanguard US stock index funds earn additional income by lending securities to qualified institutional borrowers. The firm allocates 100% of after expense security lending earnings to the fund.

A fund’s expenses are paid out of fund earnings. Given that the US tax code gives a tax preference to dividends that qualify for lower tax rates, it is prudent for fund managers to allocate non-qualified income to fund expenses. The table below shows the amount of security lending income earned by each fund in fiscal year 2017 and calculates its percentage ratio to total annual fund expenses.

Fund Net security lending income Total expenses % of expenses
Total Market 109,770,000 320,589,000 34.24%
S&P 500 4,231,000 151,221,000 2.80%
Extended 56,247,000 37,220,000 151.12%
Large cap 624,000 8,465,000 7.37%
Large growth 5,761,000 34,936,000 16.49%
Large value 244,000 29,703,000 0.82%
Mid cap 4,560,000 43,894,000 10.39%
Mid growth 764,000 7,490,000 10.20%
Mid value 249,000 11,423,000 2.18%
Small cap 40,717,000 40,542,000 100.43%
Small growth 13,173,000 15,280,000 86.21%
Small value 10,157,000 21,361,000 47.55%


The annual report documents the rate of annual turnover of its assets by the fund manager. In addition, the reports also document the sales and redemption of fund shares by shareholders. This data allows us to compute a redemption to average net assets ratio (R/ANA) that corresponds to a shareholder annual turnover rate. In addition the redemption to sales ratio ( R/S ) shows net shareholder purchase or net shareholder redemption in a fund. A ratio less than one shows net purchase; a ratio greater than one shows net redemption. For the 2017 fiscal year all of the funds documented below experienced net investor inflows.

The R/ANA and R/S ratios, viewed together, can signal market timing activity within a fund. For example a fund showing an R/ANA ratio of 400% and an R/S ratio of 1 (equal buys and sells) is likely being market timed by fund shareholders.

Fund Turnover R/ANA R/S
Total market 3% 9% 0.64
S&P 500 3% 13% 0.49
Extended 11% 38% 0.91
Large cap 3% 9% 0.47
Large growth 8% 19% 0.76
Large value 9% 16% 0.61
Mid cap 14% 19% 0.83
Mid growth 23% 20% 0.57
Mid value 17% 21% 0.62
Small cap 15% 23% 0.82
Small growth 19% 27% 0.88
Small value 19% 23% 0.75


One of the main arguments for investing in passive index funds is the relative assurance of reaping a fair share of market returns. But as market benchmarks bear no costs, an index fund manager needs to reduce frictional costs in order to better attain the market return. Costs include not only the fund expense ratio, but also the fund’s transaction expenses for buying and selling securities.

While mutual fund managers rarely provide specific details concerning proprietary trading techniques, there are certain trading mechanisms that clearly reduce transaction costs. For example, mutual fund managers can reduce transaction expenses through the use of cross trading securities and by making in-kind transactions when buying and selling securities.

A cross trade takes place when an investment manager “swaps” a security between separate funds that he or she manages. These types of transactions are regulated by section  17 CFR 270.17a-7  of the Investment Company Act of 1940 and, for plans governed by ERISA, the Statutory Exemption for Cross-Trading of Securities. The manager must prove a fair market price for the transaction and record the trade as a cross for proper regulatory classification.

An example will let us see how a cross trade eliminates transaction costs. Suppose our manager operates both a small cap growth index fund and a mid cap growth index fund. When the tracker indexes reconstitute, a small growth company is reclassified as a mid cap growth company. If the manager uses market transactions to sell the stock from the small cap index fund, and then buy the stock for the mid cap index fund, the funds will pay brokerage commissions and spread costs on both the sale and purchase. Alternately, with a cross sale transaction, the manager will trade internally between the funds. There will be no commission expense for this trade and there is no need for a bid ask spread.

In-kind transactions are permitted for both mutual funds and exchange-traded funds. In-kind purchases and sales of securities are specifically used by exchange-traded funds. With securities being transferred in-kind, there are no brokerage commissions or bid ask spreads incurred since there are no sales or purchases of the transferred shares.

The following table shows both the separate and the combined percentage of cross trades and in-kind transactions in US stock index  funds.

Fund Cross purchase In-kind purchase Total purchase Cross sale In-kind sale Total sale
Vanguard Total Market 0.00% 20.11% 20.11% 0.00% 31.40% 31.40%
Vanguard Large Cap 2.86% 59.96% 62.82% 11.11% 37.86% 48.97%
Vanguard Growth 7.24% 45.48% 52.73% 20.89% 49.09% 69.99%
Vanguard Value 12.66% 55.23% 67.89% 16.02% 47.06% 63.08%
Vanguard Mid Cap 3.03% 30.30% 33.33% 16.92% 30.21% 47.13%
Vanguard Mid Growth 8.84% 31.08% 39.91% 24.27% 25.07% 49.33%
Vanguard Mid Value 10.30% 34.89% 45.19% 24.61% 32.97% 57.58%
Vanguard Small Cap 11.01% 36.01% 47.02% 6.99% 38.05% 45.04%
Vanguard Small Growth 7.92% 35.84% 43.76% 22.58% 40.63% 63.21%
Vanguard Small Value 24.05% 35.85% 59.90% 12.65% 31.19% 43.84%


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