ETF Turnover and Tax Cost Ratio

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masheen
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Joined: Sat Apr 17, 2021 1:17 pm

ETF Turnover and Tax Cost Ratio

Post by masheen »

I apologize if this is reposted. I searched for etf, turnover, capital gains, etc. It was a long list of results, but didn't see a clear explanation for my question.

The context for the question is holding Schwab's high yield dividend fund, SCHD, in a taxable account.

Are the only tax consequences the long-term capital gains on the distributions (ignoring fees, tracking error, etc)? My primary concern is being taxed due to the high turnover. After learning about authorized participants and creation units, I still wasn't sure if it creates taxable events when the underlying index updates SCHD's constituent stocks. If I'm wrong there, could that create short term capital gains as well?

With all the digging I've done, I felt good enough to start buying a bit of SCHD, then I saw fidelity's tax cost ratio estimates for SCHD and VYM. One website reported they both distribute 99.8%+ qualified dividends. If that's true, with my current understanding I'd assume Fidelity made a mistake here.

I'm just a bit turned around. Please help me understand this, and thanks in advance!

------------- Yield --- Expense Ratio - Tax Cost Ratio - Turnover Ratio
VYM ------ 2.82% ------ 0.06 --------------- 0.71% ------------ 8%
SCHD ---- 2.90% ------ 0.06 --------------- 1.22% ------------ 46%

Edit: Just noticed taxes in fine print of the personal finance forum. My mistake - I did look before posting but missed it.
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grabiner
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Re: ETF Turnover and Tax Cost Ratio

Post by grabiner »

The creation-redemption process allows most ETFs to avoid capital gains caused by index turnover. This is not perfect, but close. In the history of Vanguard ETFs, only three times has a diversified stock ETF distributed a capital gain.

Vanguard FTSE All-World Ex-US Small-Cap started near the 2009 market bottom, and doubled in value in its first year. It had so few shares with losses that it distributed small capital gains in 2009 and 2010. It has not distributed a gain since then.

Vanguard International High Dividend Yield Inde distributed a 6% capital gain in 2021; I believe this was related to changing to a different index, which forced more turnover than usual.
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alex_686
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Re: ETF Turnover and Tax Cost Ratio

Post by alex_686 »

Another advantage with ETFs is that the Authorized Participants (AP) normally bear the cost trading. So having a high turnover might not be a disadvantage.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
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masheen
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Re: ETF Turnover and Tax Cost Ratio

Post by masheen »

It's amazing that the creation-redemption filters enough of the shares to (mostly) eliminate capital gains. It sounds like that tax cost ratio estimate is simply erroneous then.

Thanks for clarifying!
vtsnowdin
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Re: ETF Turnover and Tax Cost Ratio

Post by vtsnowdin »

Do those funds reinvest dividends as a drip or periodically pay them out to your cash account?
sycamore
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Re: ETF Turnover and Tax Cost Ratio

Post by sycamore »

masheen wrote: Thu Jan 27, 2022 12:55 am It's amazing that the creation-redemption filters enough of the shares to (mostly) eliminate capital gains. It sounds like that tax cost ratio estimate is simply erroneous then.

Thanks for clarifying!
Can you explain why the tax cost ratio estimate is erroneous? Usually vendors give an estimate of how much a person (*) would pay in taxes on the distributions of all types. If the fund has no cap gains distributions, the tax cost ratio would only reflect the tax cost of dividend distributions.

* the person may be defined as someone in the highest federal ax bracket. Check the fine print under the estimate to see what their assumptions are; it may not match your tax situation.
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grabiner
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Re: ETF Turnover and Tax Cost Ratio

Post by grabiner »

sycamore wrote: Thu Jan 27, 2022 7:25 am
masheen wrote: Thu Jan 27, 2022 12:55 am It's amazing that the creation-redemption filters enough of the shares to (mostly) eliminate capital gains. It sounds like that tax cost ratio estimate is simply erroneous then.

Thanks for clarifying!
Can you explain why the tax cost ratio estimate is erroneous? Usually vendors give an estimate of how much a person (*) would pay in taxes on the distributions of all types. If the fund has no cap gains distributions, the tax cost ratio would only reflect the tax cost of dividend distributions.

* the person may be defined as someone in the highest federal ax bracket. Check the fine print under the estimate to see what their assumptions are; it may not match your tax situation.
The tax cost ratio comes from Morningstar, which doesn't always know about qualified dividends. Tax data from the fund provider would be more reliable. (It is also possible that the funds might actually have different fractions of qualified dividends.)
Wiki David Grabiner
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