A Cushion of Tax Efficiency

Index mutual funds are considered highly tax-efficient investments. Because they rarely sell stocks, they rarely “realize” or lock in capital gains. That means there’s little in the way of taxable capital gains distributions to pay out to shareholders each year.

But what would happen if a stock market swoon caused shareholders to bail out of index funds en masse? Would those funds’ tax efficiency unravel?

Not immediately, says Gus Sauter, who heads the index fund operations at the Vanguard Group in Valley Forge, Pa. A large index fund such as Vanguard’s flagship Index-Trust 500 Portfolio, which tracks the Standard & Poor’s 500-stock index, could handle more redemptions in a tax-efficient manner than many people think.

If the stock market went through a flat period, Sauter says, Vanguard Index-Trust 500 could handle $1.25 billion in net redemptions before having to pay out taxable gains. If the market dropped 10%, the fund could redeem about $5.75 billion without having to pay out taxable gains. Here’s why: The fund would have more short-term losing positions, which would be used to meet the initial redemptions, thereby postponing the need to sell any profitable positions. If the market swooned, losing, say, 20%, the fund could sell off about $12.75 billion without unraveling its tax efficiency, Sauter figures.

Two related problems that would crop up in a period of massive shareholder redemptions are increased trading costs brought on by fund managers’ being forced to bail out of stocks, and overall selling pressures that could push down the prices of stocks in the index.

But Sauter says those problems are no great cause for worry. He points out that S&P; 500 index funds captured just 8% of the $200 billion of new money that flowed into stock mutual funds in 1996.

“People think index funds are moving the market,” Sauter says. “But it’s hard to think that that 8% dominated the other 92%.”