Updated Mar, 2022

How is VDHG tax-inefficient?

How is VDHG tax-inefficient?

To answer the question of how is VDHG tax-inefficient, we need to look at two things:

  1. The structural difference between managed funds and ETFs
  2. How currency hedging gains and losses are taxed in Australia

Managed funds vs ETFs

What is an ETF and a managed fund?

ETFs, managed funds, LICs, investment bonds, trusts, companies, and superannuation are all investment vehicles or legal structures that hold investments. A structure is not defined by the investments in them, and they can all hold a variety of assets such as stocks, bonds, real estate, infrastructure, commodities, cash, or any combination. What is important is that each structure has different tax consequences. We will stick to ETFs and managed funds in this article.

What is the difference in structure between an ETF and a managed fund?

In a managed fund, the entire fund is a single pool of assets, so if there are more outflows from the fund requiring selling assets from the pool, it triggers capital gains for all of the fund’s investors. So even if you don’t sell any units yourself, you are still forced to realise some capital gains along the way. Realising gains means you cannot defer paying tax until you sell, which would otherwise allow you to earn returns on the delayed tax owed. The ability to earn money on delayed tax payments (and earnings on those earnings, and so on) is one of the biggest advantages of capital growth over income-focused investments.

This triggering of capital gains for all investors does not occur with ETFs due to the unique tax structure of ETFs. Instead, you defer these capital gains until you sell your ETF shares. The reason for this is that unlike units of managed funds that are bought and sold at the end of the trading day when the stock market is closed, units of ETF shares are — as the name Exchange Traded Fund implies — able to be traded on the stock market throughout the trading day.

As a result of being able to trade ETF shares on the stock market, to make sure ETFs are trading close to the underlying net asset value (NAV) of the basket of shares it holds, a market participant called a market maker is appointed by the company offering the ETF to provide liquidity (liquidity refers to the ability to be converted into cash without affecting its market price).

When there is no one in the market selling parcels of an ETF near the NAV, a market maker will effectively buy and package up the underlying individual securities, convert them into ETF parcels and offer them at NAV (plus a small spread to pay the market maker for their job). This provides liquidity to the ETF market. I.e., it ensures there are always ETF shares available to buy that are in line with the NAV.

It works the other way too. When there is no one buying parcels of ETFs near the NAV, a market maker will effectively buy ETF shares at NAV (minus a small spread) and convert them to the underlying individual securities and sell them off. Again, this provides liquidity to the market, ensuring you can always sell your ETF shares at NAV.

They are called market makers because when there is no market (i.e. nobody buying or nobody selling), they make (create) a market for people to buy and sell.

How does this affect tax efficiency?

When a market maker converts a basket of the underlying individual shares into an ETF share, there are no capital gains embedded in the ETF share in the same way there are no capital gains embedded in individual shares you buy.

And when a market maker buys an ETF share to convert to the underlying individual shares, any capital gains that are generated from this redemption are distributed directly to the market maker and do not impact other ETF investors.

This constant creation and redemption of ETF units wash away the embedded capital gains, and the result is that ETFs are much more tax-efficient than managed funds.

VDHG is an ETF, so how is VDHG tax-inefficient?

While VDHG itself is an ETF, the seven funds held within VDHG are managed funds rather than ETFs. So even though VDHG itself is an ETF, the underlying funds result in tax inefficiency.

Real examples of the problem with managed funds occuring

This tends to occur during market selloffs as people panic-sell and there are more redemptions than purchases, with the pool of funds having net outflows. The result is capital gains liabilities for all investors holding units in the managed fund.

A recent example was during the coronavirus market downturn where VGAD (the ETF) had no mid-year distribution (due to currency hedging), yet the managed fund version had a distribution due entirely to other investors selling their units. This is even despite the two funds having the same base fund because they’re two different pools of money and are managed according to the fund structure.

Here are a couple of threads with people complaining about the managed fund version of Vanguard’s funds which are pooled (as opposed to the equivalent ETFs, which were not).

Further reading

Currency hedging

To explain how hedged ETFs are taxed in Australia, we first need to explain how an ETF or other managed fund actually does currency hedging.

These funds want to execute the hedging in the cheapest way possible. This turns out to be through the use of currency exchange contracts known as ‘currency forwards‘. They are called ‘forwards’ because the agreement is for a theoretical exchange of currencies is at a set date in the future. There is a relatively deep market for these forward contracts, so the transaction costs are very low.

So if a fund has shares denominated in US dollars, but its investors have invested in Australian dollars and want to remove currency risk, the fund will enter a forward contract to exchange USD for AUD in, say, a month’s time. As the exchange time approaches, the fund enters into an opposite contract, and the two contracts cancel each other out. So there is never an actual exchange of currencies. At the same time, a new forward contract is entered into to run for another month. This constant rolling of the contracts turns out to be the way to minimise transaction costs.

During the period the first contract was held, the exchange rate between the two currencies will have moved. If the exchange rate movement increases the value of the US shares, the value of the forward contract will have an offsetting loss. If the exchange rate movement decreases the value of the US shares, the value of the forward contract will have an offsetting profit.
   
However, unlike capital gains, where tax is not paid until the shares are sold, under the primary tax rules, the forward contracts are not capital gains tax assets. They are taxed as income. That means gains from hedging through forward contracts cannot offset capital losses, and losses from hedging cannot offset capital gains. The result is the inability to delay paying tax on the currency hedging return when the AUD rises or wiping capital gains when there are losses from the AUD falling. So even though you have not sold any shares, you are forced to realise profits on your investment beyond the income component of the underlying assets.

The government has addressed this problem and created a solution called the ‘hedging election’ in the ‘Taxation of Financial Arrangement rules’, also known as the ‘ToFA rules‘ (pronounced like ‘tofu’ but ending in an ‘a’).

The effect of this is that the gains or losses on the shares and the gains or losses on the forward contracts can offset each other under the tax rules.

The problem is that there is a lot of analysis and a lot of record-keeping that has to be done for the Tax Office to accept that the fund is using the option properly. And unfortunately, most funds find the option too difficult and don’t use it.

Vanguard is one of those fund managers that does not use it in their currency-hedged equity funds (although they use it in their currency-hedged fixed income funds).

As a result, when the AUD falls, there are zero distributions (with losses unable to offset capital gains), and when the AUD rises, there are very high distributions (which you must pay tax on in that year and cannot defer as with capital gains). You can see these lumpy distributions in Vanguard’s currency-hedged shares fund as well as in the ETF equivalent (VGAD) under ‘distribution history‘ where there are multiple quarterly distributions in a row, often for years, which are zero (where the AUD had fallen), followed by multiple quarterly distributions, often for years, that are very high (where the AUD had risen).

I emailed Vanguard requesting they consider using ToFA, since at the enormous size of the currency-hedged fund they have, even raising the cost to investors of just 1 basis point (0.01% or $1 p.a. per $10,000 invested) would result in $800,000 per year to manage the administrative work, which would be a huge win to investors in terms of financial return through tax-efficiency, but they didn’t even respond to my email, and in response to a question in a Vanguard webinar, they were not interested in even looking at it.

What can you do about it?

1. Accept that not everything in life is perfect.

VDHG and Vanguard’s other diversified funds, while imperfect, are excellent. Their asset allocation has been created as a result of extensive research and is the standard by which everything else is (and, in my opinion, should be) measured against. They also do all the work for you so you can focus on your income, savings, family, and general quality of life.

These funds will certainly be superior to the many advisers who try to sell you on their ability to create a portfolio that will outperform — and which will cost you thousands of dollars a year in unnecessary ongoing management fees eating away at your nest egg. This is not to say you should avoid advisers — but you want an adviser whose focus is on strategic advice, not on product selection.

2. Go for an all-in-one that doesn’t suffer from these problems

The only other all-in-one that I’m aware of that doesn’t suffer from these issues is DHHF. The funds it holds inside are ETFs rather than managed funds, and they decided not to use any currency-hedged equities. Additionally, it is the only all-in-one that is 100% equities, which gives you the option of leaving out bonds entirely if that matches your risk tolerance. Although, there is still some tax inefficiency in DHHF due to using US-domiciled funds.

3. Split it up and buy the ETF equivalents and manage it yourself

You can split your portfolio up and use the equivalent ETFs that invest in the same securities instead of the managed funds. To make it simpler, you can leave out small caps. And if you use VDHG (as opposed to the other diversified funds with more defensive assets), you will notice very little difference leaving out the two fixed interest funds since they make up only 10%.

This will reduce the number of funds to manage from 7 to 4, and they have been explained on this page on equity funds if you want more information.

That still leaves the question of whether to include the currency hedged equities fund. This is a tough one because, without it, you are left with two potential problems:

  1. If you replace it with Australasian equities, you have a lot of concentration risk in your portfolio.
  2. If you replace it with (unhedged) global equities, you have more currency risk.

I try to moderate all three of these downsides (concentration risk, currency risk, and cost of inefficient hedging) by combining some Australian equities, some currency-hedged global equities, and the rest in global (unhedged) equities.

There is very little work in managing a portfolio of 4 broad market index funds. If you want a spreadsheet that tells you in an instant which one to purchase at your next regularly contribution, you can download the portfolio tracking spreadsheet I use.

Alternatively, you can use Pearler, which offers an autoinvest feature that automatically purchases the ETF most below your target asset allocation, and there is nothing more to do.

Final thoughts

I hope this has answered the question of how is VDHG tax-inefficient so you can make a more informed decision for your investments. In the US, where the retirement structure (401k) is taxed at 0%, and instead, tax is paid as capital is withdrawn (the reverse of the way superannuation works), all-in-ones are seen as an excellent investment in their 401k zero-tax environment. Yet it is often mentioned that it is something to be avoided in their taxable account (i.e. investments outside the zero-tax environment where they must pay tax along the way). I think that’s something worth chewing on.