Strategies

Specific share identification mutual fund redemption at Vanguard

Background

Many investors are aware that when they sell a mutual fund or stock with a gain, they have to pay capital gains taxes for it. On the other hand, if they sell with a loss, they can claim a tax loss on it, as long as the transaction does not run foul of the wash sale rule. Fairmark has an extensive section “Capital Gains and Losses 101” that covers this in detail.

Unless an investor is selling the entire holding, it is usually best to identify specifically which shares are being sold. However, the identification part is somewhat confusing. The following paragraph from Fairmark explains why this is so:

The traditional way to specify the shares you’re selling is in the form of an instruction to your broker:

Sell 50 shares XYZ from the lot purchased on March 12, 2005.

This makes it sound like the broker has to do something special — possibly locate those specific shares, or at least make a record of some kind indicating what shares you sold. Some brokers will tell you “we don’t offer that service.” But in reality the only thing the broker has to do, besides executing the sale transaction in the normal way, is send you a written confirmation that you specified shares from the lot purchased on March 12, 2005.

This post is a review of my experience with specific share identification mutual fund redemption with Vanguard.

The Process

Prior to the day of redemption, I created a list of the tax lots I wanted to sell. These are basically the tax lots which have the highest cost basis and which will give me the maximum capital gain loss which I can claim on my tax return next year.

I then created the following message (which is a variant of the message, as suggested by seugene, from reference [1])

Subject: Specific Identification Sale of Mutual Fund

Dear Vanguard,

This is to inform you that for the following trade(s) placed today in my taxable joint account, I want to use the specific share identification method for capital gains calculation.

(A) Vanguard Total Stock Market Index Admiral Fund VTSAX, redeeming XXX.YYY shares from the following lots:

1) MM/DD/YY XX.YYY shares
2) MM/DD/YY XX.YYY shares

I understand that I am responsible for tracking my cost basis.

Please acknowledge that you have received this message.

Thank you.

Dated MM/DD/YYYY.

On the day of the redemption, I sent the above message via a secure email to Vanguard and then placed the sale of the specified number of shares online as per usual.

A few days later, I received the following confirmation:

Dear indexfundfan:

Thank you for your e-mail regarding your desire to use the specific share identification method (as defined in the Internal Revenue Code) for purposes of determining your cost basis. I am responding on behalf of your Flagship representative, XXX.

We acknowledge receiving your specifications, identifying the particular shares purchased on several dates to be redeemed from your Vanguard Total Stock Market Index Admiral Fund in the account #XXX. To assist you in making an adequate identification of such shares, we are confirming your specifications as outlined below in accordance with federal regulation section 1.1012-1(c)(3) of the Internal Revenue Code.

You are redeeming XXX.YYY shares from the following lots purchased on the following dates:

1) MM/DD/YY XX.YYY shares
2) MM/DD/YY XX.YYY shares

In the event you were using a different method to determine cost basis (for example, average cost method), you may need written consent from the Internal Revenue Service (IRS) to change to the specific share identification method. Consult your tax adviser if you have any questions concerning tax reporting methods or for additional assistance.

Please be advised that Vanguard’s recordkeeping systems support the average cost basis method of basis determination, not the specific share identification method. Therefore, it is your responsibility to keep sufficient records to support your basis determination under the method you have chosen, including but not limited to tracking the cost and related gain or loss of shares [exchanged, redeemed] for purposes of reporting that information to the IRS.

Additionally, since you are using the specific share identification method for tax reporting, any average cost basis statement that you may receive from Vanguard for this fund and account should be disregarded.

I have forwarded a copy of this e-mail to your representative. If you have any further questions, you may contact your Flagship Representative at 1-800-XXX, extension XXX. If your representative is unavailable at the time of your call, the next available trained representative will be happy to assist you. If you prefer, you may ask to be transferred to his voice mail. He will promptly return your call.

Flagship’s business hours are Monday to Friday from 8 a.m. to 10 p.m. and Saturdays from 9 a.m. to 4 p.m. Eastern time. You may also feel free to visit our website at www.vanguard.com, 24 hours a day, 7 days a week.

Sincerely,

XXX
Registered Representative
Vanguard Flagship Services

I printed a copy of the above to PDF and save it together with the secure email I had sent out a few days earlier.

That’s it. I now have a written confirmation that the brokerage had received my instructions to redeem specific shares of my mutual fund.

PS. The Fairmark article linked above has a brief section discussing the “legality” of whether an email confirmation (versus a paper confirmation) is sufficient. For my personal records, I am inclined to think that the secure email is sufficient, but another person’s situation could be different.

Reference

[1] Boglehead forum discussion.

Is it worthwhile to pay the ETF conversion fee?

Based on my previous post on whether to convert my VEIEX (Vanguard Emerging Market Index Fund) holding to VWO (ETF class), I thought it would be a good exercise for me to try to build a simple calculator to compute the breakeven investment amount for investors who need to pay the $50 conversion fee.

The calculator below will find the breakeven point which will make it worthwhile to perform the mutual fund to ETF conversion. The calculator inputs are as follows.

  1. The conversion fee, currently $50. Enter 50.
  2. The ETF expense ratio saving. For example, VEIEX ER=0.37% and VWO ER=0.25%. The difference is 0.12%, enter as 12.
  3. The investment horizon in years.
  4. The expected annual return. If the expected annual return is 8%, enter 8.

When the investment amount to be converted is higher than that calculated, a conversion would be worthwhile (assuming the assumptions are true). Note that as mentioned in the previous post, taxes are not considered in the computations.

ETF Conversion Decision Calculator

Conversion fee (in $)
Expense ratio saving (in bps; 100 bps = 1%)
Investment horizon (in years)
Expected return a year (in %)
 
Investment should be at least (in $)

Should I convert VEIEX to VWO ETF?

Vanguard has been offering ETF classes of several of their conventional mutual shares for some time now. One of the most interesting feature, which is unique to Vanguard as far as I know, is the ability for an investor to convert shares in the mutual fund to ETF shares for a fee of $50 (free for Flagship clients if done directly at Vanguard). This conversion is one-way only — you cannot convert ETF shares into mutual fund shares.

Why convert?

  1. The main reason why an investor would want to convert mutual fund shares to the ETF class is because the expense ratios of ETF shares are lower than the investor class mutual fund shares. For example, the Vanguard emerging markets index mutual fund VEIEX charges 0.37% annually while the ETF version VWO charges only 0.25% a year.
  2. A second reason is the possibly better tax efficiency in terms of capital gains distributions.
  3. The third reason is the redemption fees savings. For certain mutual funds with redemption fees (most notably VEIEX and VTMGX), converting mutual fund shares to the ETF class and then selling the ETF shares would save a bundle on the redemption fees (0.5% for VEIEX and 1% for VTMGX shares owned for less than 5 years), especially if the amount is substamtially more than $1000.

Why not to convert?

  1. If an investor already owns admiral shares of the mutual fund, there is little (if any at all) saving in the expense ratio. For example, the admiral class of Vanguard’s emerging market index fund VEMAX and VWO both charges the same 0.25% expense ratio a year.
  2. ETFs could trade at a premium or discount, in addition to a trading spread (trading spread is the difference between the bid and asking prices). A person investing in mutual fund shares does not have to be concerned with purchasing or selling shares trading at a premium or discount, nor be concerned with the cost associated with the trading spread. Mutual funds shares are bought and solt at NAV (net asset value).
  3. If an investor is contributing regularly, purchasing the mutual fund “generally” has no transaction fee while purchasing an ETF would normally entail a brokerage commission charge (unless the investor is using a free-trade broker). The brokerage fees could add up quickly to a substantial amount. Note: I say “generally” because one mutual fund exception is VEIEX, which charges a 0.5% purchase fee.

The case for VEIEX to VWO conversion

After looking at the pros and cons, let’s examine the specific case for VEIEX to VWO conversion.

Expense ratio saving. If an investor is holding a substantial amount of VEIEX (say from the low four digit range onwards), there is definitely a saving when the holding is converted to VWO. The current expense ratio saving is 0.37% – 0.25% = 0.12% or 12 bps (bps = basis points) per year. This difference, compounded over many years, could become substantial.

To see if this expense ratio saving really does make a difference in the performance numbers, let’s look at the historical performance of VEIEX and VWO for the years ended Oct 31, 2006 and 2007 (values taken from the prospectus):

  2006 2007
VEIEX (investor shares, ER=0.42% in 2006, ER=0.37% in 2007) 32.55% 69.59%
VWO (ETF, ER=0.25%) 32.74% 69.78%
VEMAX (admiral shares, ER=0.25%) N.A. 69.82%

Clearly, VWO outperformed VEIEX by 0.19% in both 2006 and 2007, the first two full years of its existence.

Trading spreads. There could be a trading spread cost in selling VWO in the future during the withdrawal phase. However, from my observations, the trading volume and liquidity of VWO has been improving through the months. The impact of trading spread cost should be relatively low. Furthermore, a 12 bps expense ratio difference a year would turn into (1.0012^20)-1 = 2.43% difference in 20 years time. This should mitigate any trading spread cost.

Redemption fee. Converting the mutual fund shares to the ETF class is one way to avoid the 0.5% redemption fee.

Conversion fee. As already mentioned, Vanguard charges a $50 conversion fee unless the investor is a Flagship client. Below, we will briefly look at how this fee would affect the conversion decision.

In the analysis, assume that the $50 fee to pay for the conversion comes out from the original VEIEX investment (tax consequences not considered for simplicity). Let R be the approximate investment return a year, X be the original investment amount and N be the number of years the investment is held.

Then the value of the investment after N years, would be given by

  • X*(1+R-0.0012)^N for VEIEX
  • (X-50)*(1+R)^N for VWO

For VEIEX, the compounding rate is reduced by the expense ratio difference of 0.0012 a year. For VWO, the original investment amount is reduced by $50 due to the conversion fee.

For the conversion to be worthwhile, we require (X-50)*(1+R)^N to be larger than X*(1+R-0.0012)^N. For example, if R = 0.1 (10% return a year), N = 10 years, solving the inequality gives X > 4606. This means that given the assumptions, it is better to convert if the original investment amount X is at least $4606.

Other scenarios are given in the table below.

2008-04-12-etfconversionbreakeven.png

Summary

It appears that for my situation, it makes a lot of sense to convert my VEIEX holding to VWO. This is especially so given that the investment is in the mid five digit amount and the conversion will be free for me. For investors who have to pay the conversion fee, the table above may help to decide if paying the $50 fee is worthwhile.