The ETF creation-redemption mechanism which provides for the vehicle’s capital gains tax efficiency has a corresponding negative impact on the vehicle’s efficiency at realizing qualifying dividends, which are taxed at lower tax rates. Regulations require that shares meet holding period requirements (for both sales and purchases of shares around the dividend distribution date) to qualify for the tax preference. Institutional ETF creation-redemptions often violate these holding period requirements, generally resulting in lower dividend tax efficiency for an ETF in comparison with a similar Index Mutual Fund. Both ETFs and Index funds can apply non-qualifying dividend income for expenses, leaving the maximum amount of qualifying dividends for distribution to shareholders.
The following table shows 2004 qualifying dividend data for Vanguard index and tax-managed funds with similar asset class Barclay I shares. To the extent that Small Value indices contain sizeable allocations to REITS (the dividends from REITS are non-qualifying dividends), qualifying dividend percentages will be reduced.
Table 1 Qualifying Dividends-2004 Vanguard Qualifying Dividend I shares Qualifying Dividend Total Market Index 100.00% Total Market 91.77% Tax Managed 1000 100.00% S&P 1500 82.18% Large Cap 100.00% R3000 97.66% S&P 500 100.00% R1000 81.46% Tax Managed S&P500 100.00% S&P 500 85.13% Growth Index 100.00% Growth 89.23% Value Index 100.00% Value 81.01% Mid Cap Index 86.89% Mid Cap 73.11% Small Cap Index 70.09% R2000 61.30% Tax Managed Small 100.00% S&P 600 81.13% Small Growth 100.00% Small Growth 85.59% Small Value 63.84% Small Value 73.60% Emerging Markets Index 68.41% Emerging Markets 84.40%
Vanguard has also announced estimated qualifying dividends for 2005. One should note that VIPER shares of corresponding index funds share the qualifying dividend status of the underlying fund. Also one should note that the Tax-managed funds, as part of their tax efficiency mandate, maximize both capital gains and dividend components of investment return. Thus, the Tax-Managed International fund qualifies for the foriegn tax credit, as well as providing for 100% qualifying dividend status. The Total International Index, as a fund of funds, does not qualify for the foriegn tax credit, nor are all of dividends qualifying (58.16% in 2004; 80.19% in 2005); thus the fund is more suitable for location in tax-preferenced accounts.
Table 2. Estimated Qualifying Dividends-2005 Vanguard Fund Qualifying Dividend Total Market Index 100.00% Tax Managed 1000 100.00% Large Cap 100.00% S&P 500 100.00% Tax Managed S&P500 100.00% Growth Index 100.00% Value Index 100.00% Mid Cap Index 90.74% Small Cap Index 76.66% Tax Managed Small 100.00% Small Growth 100.00% Small Value 68.83% Tax Managed International 100.00% EAFE 82.42% Total International 80.14% Europe 83.19% Pacific 79.47% Emerging Market 65.73%
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