ETF Perspectives Vanguard insights for financial advisors

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1 ETF Perspectives Vanguard insights for financial advisors Winter 2015 Understanding the affluent investor: Trends, insights, opportunities George Walper Jr. is president of Spectrem Group, a financial industry leader in primary research and analysis of the affluent investor market. In this interview, he discusses his firm s recent research findings on investor attitudes, behaviors, and relationships with advisors. Vanguard: What s weighing on the minds of affluent investors? George Walper Jr.: Top national concerns remain focused on the political environment, legislative gridlock, and fear of a prolonged economic downturn. Most recently, with the hope that midterm results may break the long-standing partisan standstill, we asked affluent investors what Congress should focus on in the coming year. Predominant responses included corporate tax reform, immigration reform, and modification of the Affordable Care Act. Investors are still skittish about the financial markets. During any dramatic dip in the markets even one lasting only a few days some investors immediately move assets to cash. Any potentially negative market driver is seen as justification for moving to or maintaining cash assets, despite very low interest rates. So investor confidence still lags behind the relative market stability of recent years. What factors most influence investors satisfaction with their advisors? GW: Responsiveness and frequency of proactive contact consistently top the list. We ve found that anything less than quarterly contact results in a significant decline in client satisfaction and also in a client s overall assessment of an advisor s abilities. Broadly speaking, investor satisfaction with advisors has returned to prerecession levels. And yet, there s one surprising exception: Younger investors are significantly less satisfied than older investors. For instance, among investors with more than $25 million in assets, 90% of those over 65 are highly satisfied with their advisors. For those under 55, however, that number drops to 60%.¹ While this is most pronounced in the highest-wealth segments, the trend persists at all asset levels. (continued on next page) 1 Spectrem Group, The $25 million plus investor. Lake Forest, Ill.: Spectrem Group. In this issue 10,000 hour rule of skill mastery applies to trading too Page 5 Not alpha, not beta. Is it smart? Page 7 Tax year over, now what? Page 10

2 Understanding the affluent investor: Trends, insights, opportunities (continued) Wealth segment snapshot Net financial assets* Mass affluent Millionaire Ultra-highnet-worth $100K $1M $1M $5M $5M $25M Households 29.0 million 8.4 million 1.2 million Average age 59.0 years 63.0 years 65.5 years Percentage in retirement 39% 57% 59% *Not including primary residence. Source: Spectrem Group, in partnership with Vanguard, Today s affluent investors: Insights and opportunities. Valley Forge, Pa.: The Vanguard Group. Our research indicates that younger investors tend to be more demanding, which may explain why they feel less satisfied with their advisors. We re also finding that younger investors expect a broader range of services than many advisors are used to providing. What trends have you seen in the ownership of ETFs versus traditional mutual funds? GW: It s important to keep in mind that ETFs still need to be sold as opposed to purchased. In other words, many investors still don t know what an ETF is. Therefore, a significant level of education is required to sell the idea of investing in them. So ETFs are primarily used by professionals or by investors who have been educated by their financial advisors. The highest levels of ETF ownership are in the upper-wealth segments. For example, our research from 2009 to 2013 found that the number of ultra-high-net-worth (UHNW) investors who owned ETFs more than doubled, while the increase among millionaires was far less pronounced, and mass affluent investors barely increased their ETF ownership at all. Wealthier investors may be a tad savvier, but they also tend to have more in-depth discussions with their advisors. As a result, they re more likely to understand ETFs and be able to weigh ETFs potential advantages. What about domestic and international investments? GW: Similar to the use of ETFs, the tendency to hold international investments correlates with the level of sophistication and education of the investor. Therefore, the prevalence of international holdings is primarily wealth-driven. Nonetheless, any time an international issue dominates the headlines, investors react with a strong inclination to invest in the United States only. Our research reveals a persistent and surprisingly prevalent home bias, where respondents actually say they re unwilling to invest outside the United States at all. To a certain degree, this aligns with risk-tolerance levels, which are higher in upper-wealth segments. But clearly there s an additional lack of investor awareness and also a lack of education, even on something as basic as the trade-off between the risk mitigated by global diversification and the risk added by including non-u.s. investments in a portfolio. So investors with global investments tend to be those who work with advisors to get the guidance that helps them avoid emotional decisions and the education that helps them understand where and how global investments might best fit in their portfolios. 2

3 Resistance to international investing reveals need for education and guidance I am not willing to invest outside the United States Mass affluent Millionaire UHNW 74% 58% 49% Spectrem Group, in partnership with Vanguard, Today s affluent investors: insights and opportunities. Valley Forge, Pa.: The Vanguard Group. How do investors feel about active versus passive investing? GW: Individual investors don t spend a lot of time thinking about investment categories, such as active or passive, as advisors do. Investors do, however, consider risk carefully. When we ask them if they re willing to take significant investment risk on a portion of their investments in order to earn a higher return, a sizable majority say no. Most are willing to perform in line with the market, which suggests comfort with passive strategies. You ve previously suggested that advisors should take a more holistic approach with clients? What do you mean? GW: Advisors most often focus their efforts on investing and retirement planning. However, clients, especially those aged 40 to 55, want an advisor who understands their entire financial picture, including life goals and extended family circumstances. For instance, they want guidance on life issues such as health concerns, living in retirement, eldercare, and generational planning. We ve seen a certain amount of frustration from investors dealing with advisors unprepared for more outside-the-box discussions. For instance, clients may want information on annuities or long-term care insurance, and some advisors are unwilling or ill-equipped to help them. Yet advisors who understand the bigger picture and support clients with noninvestment needs will have deeper client relationships. Younger investors are becoming increasingly important to advisors both as clients and as clients heirs. What should advisors keep in mind when working with Generation X and Millennial investors? GW: Many advisors don t realize that their clients are quite willing to introduce them to their children. We ask investors at what age their children or grandchildren should meet their advisor, and the most common response is 18 to 25. So advisors should be initiating these meetings. Meeting heirs through their own families is an incomparable way to develop personal, long-standing relationships with future clients. (continued on next page) Advisors who understand the bigger picture and support clients with noninvestment needs will have deeper client relationships. George Walper Jr. 3

4 Understanding the affluent investor: Trends, insights, opportunities (continued) Client satisfaction: Responsiveness and communication trump performance Top 5 Which of the following would cause you to change financial advisors? Not returning phone calls in a timely manner Not being proactive in contacting me Not giving me good ideas and advice Not returning s in a timely manner Underperformance compared with market Mass affluent Millionaire Ultra-high- net-worth 59% 61% 63% Source: Spectrem Group, in partnership with Vanguard, Today s affluent investors: insights and opportunities. Valley Forge, Pa.: The Vanguard Group. There are a few things advisors should consider when trying to relate to youngergeneration investors. First, investors under 44 tend to be disproportionately confident about their investment knowledge. This may be due to the confidence of youth or younger investors facility with online research. Regardless, this means advisors need to demonstrate their added value to younger prospects, and they need to be careful to respect the perceived knowledge of younger clients. Second, the younger generation lives in a fast-paced, highly personalized, and mobile environment, which has led to higher expectations for responsiveness, flexibility, and accessibility. Investors under 44 are far more open to different methods of communicating with their advisors, such as texting, which most older investors don t see the need for or aren t comfortable with. Third, social media is important, and it s not going away. Advisors need to be conversant on these platforms and knowledgeable about the culture of younger investors. They should understand where younger clients get information and engage in discussion. Of course, advisors also need to understand their own regulatory restrictions. In the future, advisors will be increasingly expected to have a social media presence or at the very least, an in-depth knowledge of relevant social media discussions. Note: George Walper Jr. is not affiliated with Vanguard, and Vanguard does not make any representation regarding his views. Source: Unless otherwise noted, Spectrem Group, in partnership with Vanguard, Today s affluent investors: Insights and opportunities. Valley Forge, Pa.: The Vanguard Group. 4

5 FROM THE ETF CAPITAL MARKETS DESK 10,000 hour rule of skill mastery applies to trading too I m a runner. I say that loosely because I took up running a little more than a year ago after having been out of competitive sports for about two decades. Over the last year I ve experienced some significant improvement, probably because I was so out of shape to begin with. But with practice I ve gotten better. So how does that relate to capital markets and trading? Well, as the saying goes, if you want to get better at something, you have to practice. Brandon Clark is head of the ETF Capital Markets Team at Vanguard. His team works with Vanguard sales executives to help advisors obtain best execution on large orders. The team also works with market makers to ensure they understand Vanguard ETFs. For anyone who read the book Outliers, you ll recall that Malcolm Gladwell suggested it takes 10,000 hours of practice to master a field. The idea is pretty simple: The more you practice, analyze your results, learn from your mistakes, and make improvements, the better your results become. The reality is that is a lot of practice, and it requires years to master something. So, again, how does that relate to trading? As an industry, we have talked for years about best practices when it comes to trading ETFs. We ve developed ideas about how to maximize trading efficiency by using well-defined rules of the road. We base these rules on our knowledge of how the products work and on common mistakes we see people make. From not only our practices but also our observation of others practices, we ve come up with these trading best practices. This may take several articles to work through, but I m going to try to get us to a collective 10,000 hours by leveraging the practices of others to make us all better at trading ETFs. It s been said that experience is the most effective teacher, and our observations seem to bear this out: For most investors, until they make similar mistakes on their own, they won t heed the missteps of others. Nonetheless, I ll present a couple of mistakes others made lessons that I hope will add to your 10,000 hours (at least vicariously). Best practice: Not using market orders The most frequent mistake people make is using market orders, and it s an error that can cost investors money. Market orders, when combined with other market events, can have a significant impact on your client s investment The all-too-common market order mistake This intraday snapshot from October 30, 2014, of Vanguard Extended Duration Treasury ETF shows how a sharp price decline can be triggered by an ill-considered market order. $ :30 a.m. 10:46 a.m. 11:30 a.m. 12:40 p.m. 1:35 p.m. 2:01 p.m. 2:26 p.m. 3:58 p.m. experience. It is interesting to hear investors resistance to the preferred alternative, using limit orders. The most common excuse I hear is, What if I use a limit order and the market moves away from me to the point the order isn t executed? If you re worried about the market moving away from your order, set your limit high enough to ensure it will be executed. A small bit of extra effort can mean the difference between a wellexecuted and a poorly executed trade (and, thus, big money for the clients on whose behalf you re trading). As you ll see in the examples that follow, using market orders when buying securities can be a game of Russian roulette. As an example, let s look at a market order to sell Vanguard Extended Duration Treasury ETF (EDV) (see chart left). Upon hitting the market, (continued on next page) Source: Vanguard. Past performance is no guarantee of future results. 5

6 10,000 hour rule of skill mastery applies to trading too (continued) the order caused the ETF to trade down several percentage points nearly $5 off from its earlier levels. The investor could have averted the dramatic dip and realized a better sale price by setting a limit order; in all likelihood, the order still would have been executed. In addition, when a trade like this happens, the price movement could trigger any stop-limit orders clients have on the security. In this example, I know of several client stop orders that were triggered because of this initial trade. This is yet another reason that using limit or stop-limit orders is important. Let s take a look at one more best practice and a quick example. Best practice: Not trading at the open, especially market orders Trading at the open is probably the most costly mistake made by investors every day across the ETF universe. We often talk about the reasons you should avoid doing this: lack of liquidity, higher volatility, and so on. But here is a real-life example to demonstrate the point. While the amounts may not be dramatic, they reinforce the importance of some best practices. See the chart at right for an example of what happens when Vanguard Mortgage-Backed Securities ETF (VMBS) trades at the open. In the first minute of trading, VMBS dropped by nearly $2, or almost 4% of its opening price. Extrapolate that over a sizable trading block of several thousand shares, and you can easily see why this is not the time you want to be trading. This particular illustration might be a bit extreme, but these types of trades happen across the ETF universe more often than people might think. Again, this is all part of our 10,000 hours to master trading. (By the way, I used a couple of Vanguard ETFs in these examples merely for illustrative purposes. In truth, the manner of market reactions depicted here can and do happen with the funds of sponsors throughout the market.) Avoid the trap of trading at the open Lack of liquidity and higher volatility offer two compelling (and sometimes expensive) reasons to avoid trading at the open, as this October 13, 2014, example with VMBS illustrates. $ :30 a.m. 10:11 a.m. 11:23 a.m. 1:38 p.m. 2:22 p.m. 2:51 p.m. 3:10 p.m. 3:44 p.m. Source: Vanguard. Past performance is no guarantee of future results. The path to trading mastery So how do you get better at trading for your clients? Allow me to refer back to my running experience. Every time I go for a run, I wear a watch that tracks a significant amount of data. When I get home, I analyze the data to see how I could do better, where I lost time, and so forth. When you trade a security, you should want to see if you made any mistakes, if there s something you could do better, and, hence, if you could achieve better results. 6 In other words, as with any skill, the way to strengthen your performance is to study it and identify changes likely to bring about your desired outcome. Whether your goal is shaving a few minutes off a favorite run or saving large sums when trading on behalf of clients, you position yourself much better for success when you take a learner s approach. Looking to ensure your execution is as close to net asset value as possible when making ETF trades for your clients? Call your Vanguard sales executive at to arrange to speak with someone on the ETF Capital Markets Team about your individual situation. 7

7 Not alpha, not beta. Is it smart? Smart beta investments could follow a strategy as simple as equally weighting the stocks in an index or as complex as using a set of rules based on multiple factors, such as value or volatility metrics. Much of the recent debate over smart beta investments centers not on how well those products perform but on what to call them. Confusion over the name may indicate confusion over the product line. Is smart beta indexing, a new form of investing, or active management? Clifford S. Asness, cofounder of a quantitative analysis investment firm, summed up his view on the what is it? controversy in the Financial Analysts Journal.¹ People should call a bet a bet, Asness wrote. If you own something very different from the market, you re making a bet and someone else is making the opposite bet. Many contend that the smart beta label is misleading, since a robust body of work has shown that the strategy is neither smart nor beta. But even if another name is applied strategic investing, alternatively weighted investing, or something else advisors should understand why they might use it, what it really is, and what it isn t, said Christopher Philips of Vanguard Investment Strategy Group. Why use smart beta? What it is Despite the proliferation of products and the growing interest, investor confusion abounds over what these strategies are and are not, largely because smart beta cannot be singularly classified. For example, some strategies depend on a single criterion, such as dividends, GDP, or volatility. Others use multiple criteria. The common denominator, however, is that each reflects a deviation in some respect from a market-cap-weighted benchmark. These alternative weighting schemes display characteristics that should result in performance that differs from the market s risk-return characteristics (or market beta). As shown in the figure below, one way to see the active management risk of these strategies is to look at the active share to measure how much they differ from the broad market. Smart beta strategies (blue) are represented throughout the spectrum, demonstrating not only their variety but, more important, also proving they are not (continued on next page) Where does smart beta fall in the spectrum of investment options Advisors can be attracted to smart beta for several reasons. They may have heard about the historical outperformance of some alternative indexes used by smart beta products, or they hope to take advantage of supposed market inefficiencies. Advisors may also like the idea that smart beta can replace traditional high-cost active management at a lower cost, an argument that, Philips indicated, may have some validity. Philips added, however, that replacing traditional high-cost active with traditional low-cost active is also an option. But whatever the reason, advisors should understand why they want to use a product. Have clarity of understanding and purpose, Philips said. If you as an advisor believe in dividend investing, value investing, or the ability of managers to add alpha, that s fine. Then we have to approach the question of whether smart beta can meet those objectives. 1 Clifford S. Asness, My top 10 peeves. Financial Analysts Journal 70(1): Number of stocks 4,000 3,500 3,000 2,500 2,000 1,500 1, Active share to Russell 3000 Index (%) Vanguard Total Stock Market Index Fund Smart beta ETFs and index funds Traditional actively managed equity funds Vanguard 500 Index Fund; Vanguard Russell 1000 Index Fund ETFs focused on a specific risk factor Source: Vanguard, based on data from Morningstar, Inc. As of June 30,

8 Not alpha, not beta. Is it smart? (continued) substitutes for achieving the U.S. stock market beta (red), just as one would not presume that the S&P 500 Index or the Russell 1000 Value Index (orange) are the best proxies for the U.S. stock market. Typically, smart beta strategies favor smallercapitalization and value stocks, but not always. Depending on how the products are structured, style and size characteristics may shift, Philips said. The designers don t go in, for instance, as value-oriented. It s just an outcome of their portfolio selection process, Philips said. Then those exposures are dynamic over time. It is not always one static allocation. Because of that, Philips said, smart beta allocations more closely resemble active management. Because they are active in their design (as opposed to their implementation), their exposures to market risk factors should be expected to change over time. The figure below shows how the size and style exposures of six global smart beta indexes shifted over a 15-year period. What it isn t Many have argued that smart beta is not beta. Asness agreed in his Financial Analysts Journal piece. You can believe your strategy works because you re taking extra risk or because others make mistakes, but if it deviates from cap weighting, you don t get to call it passive [investing], Asness wrote. And Vanguard research 2 shows that smart beta does not offer investors better risk-adjusted returns than market-cap-weighted indexes. It s not alpha, Philips said. We dispel this notion that even if markets are inefficient these strategies have been able to harvest those inefficiencies consistently over time. In order to determine if any value is added by these strategies, you have to account for those risk factor exposures. We show that after you do, outperformance dissipates and disappears. In other words, the outperformance suggested by some products can be duplicated by employing overweight tilts for the portions 2 Christopher Philips, The smart beta approach to investing: An evaluation of alternatives to market-cap-weighting in global equity indexes (to appear). Exposure to risk factors vary over time for non-market-cap-weighted strategies 60-month rolling style exposure of an alternative index versus a broad, developed equity market index, 1999 to 2014 Large value Large growth Mid value Mid growth Small value Small growth MSCI World GDP Weighted MSCI World Minimum Volatility MSCI World Risk Weighted FTSE RAFI Developed 1000 MSCI World Equal Weighted Stoxx Global Select Dividend 100 Notes: The figure displays the 60-month rolling inferred benchmark weights resulting from a tracking-error minimization for each index across the set of six MSCI World size and style indexes (the results are not materially affected by using FTSE benchmarks). Source: Vanguard, based on data from MSCI, FTSE, Dow Jones, and Thomson Reuters Datastream through March 31,

9 Rebalancing has not been a source of excess returns for an equal-weighted strategy This chart shows that a portfolio 80% that combines the three component 60 MSCI indexes in their respective weights was just as effective as 40 the equal-weighted version. Rolling 12-month total return /1/ 10/1/ /1/ /1/ /1/ /1/ /1/ 10/1/ MSCI World Equal Weighted Index 8/1/ /1/ /1/ /1/ /1/ 10/1/ % MSCI World Large Cap Index; 49% MSCI World Mid Cap Index; 27% MSCI World Small Cap Index 8/1/ /1/ 2014 Sources: Vanguard and Thomson Reuters Datastream, data through September 30, Notes: Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. of the market that have performed well for example, small and value stocks using traditional market-cap-weighted funds. Smart beta proponents also argue that some of their strategies benefit from a rebalancing effect as a result of the constant selling of appreciated stocks and the buying of depreciated stocks in order to maintain their targeted weights. Thus, in practice, proponents say, it fulfills the ultimate aim of investors to sell high and buy low. But by using the simplest of examples, the MSCI World Equal Weighted Index, Vanguard research demonstrates that the return series could be nearly perfectly replicated by proportionally combining the MSCI World Large Cap, MSCI World Mid Cap, and MSCI World Small Cap Indexes, which are all based on market capitalization (see the chart above). That no excess performance appeared systematically over time for the equal-weighted strategy calls into question the idea that a premium may be harvested through the mechanical process of rebalancing. So if advisors are thinking about using, or are using, smart beta products in an attempt to capture certain sectors of the market, they may want to consider taking more control by using products specifically designed to invest in those sectors. Smart beta can lead to value tilts, or a concentration in dividend stocks, but it s not giving the full experience you might desire, Philips said. If you re using smart beta as a satellite to the portfolio, you have to ask yourself, are there rational empirical reasons as to why this should hold on a forwardlooking basis? Free lunches don t exist; they just don t, Philips added. As an advisor, if you want to have that small-cap or dividend focus in the portfolio, smart beta is a way to get that, but probably not the best (or cheapest) way. 9

10 Tax year over, now what? Another tax year has passed, but this may be just the time to reevaluate your clients portfolios so you can potentially reduce their future tax bills. Because of lower portfolio turnover, index funds and ETFs are generally more tax-efficient than their actively managed peers. But tax efficiency doesn t start or stop with product selection. In the pursuit of a tax-efficient portfolio, your strategy and implementation may matter more than the products themselves, said Don Bennyhoff of Vanguard Investment Strategy Group. How active are you? For tax-sensitive investors, the investment strategy applied to a portfolio is a primary consideration. Even the most tax-efficient funds or ETFs can be utilized in tax-inefficient ways, noted Bennyhoff, and active trading is a common contributor to lower after-tax returns. For many investors, the choice of investment strategies strategic (focused on the long term and low turnover) or tactical (focused on the short term and more active trading) can be the greatest influence on the tax efficiency of their portfolios. Location matters While nearly everyone is familiar with the concept of asset allocation, the same cannot be said of asset location: the tax-efficient implementation of an investor s asset allocation. Asset location is the apportionment of assets between taxable and tax-advantaged accounts, How might assets be invested to raise after-tax returns? Investment account preference order Tax-advantaged accounts Investment selection preference order Active equity or similar tax-inefficient investments Taxable bonds Broad-market equity index funds or ETFs and it is one way an advisor can add value each year, with an expectation that the benefits will compound through time. As Bennyhoff emphasized, Asset location can be a valuable tool for improving the expected after-tax returns of a portfolio, not just for this year, but for years to come. To learn more about how asset location can potentially help, please see the Quantifying Vanguard Advisor s Alpha¹ research paper and related resources at advisors.vanguard.com/ advisorsalpha. For many investors and advisors, tax-efficient investing tends to garner the most attention at year-end, thanks to capital gains distributions from mutual funds and ETFs. However, the key to long-term tax-efficient investing is to be proactive, rather than reactive. Designing an investment strategy that minimizes trading and takes advantage of asset location at the onset of a new client relationship should pay much better dividends for your client s after-tax returns, as well as your professional relationship. Advisors might consider the following questions to help clients reduce tax bills for 2015: Have I identified which of my clients have large taxable accounts or face higher marginal tax rates and reviewed their portfolios to make sure the portfolios are tax-efficient? Are all my clients taking full advantage of tax-advantaged accounts? How can I further implement a tax-efficient asset location strategy going forward? 1 Francis M. Kinniry Jr., Colleen M. Jaconetti, Michael A. DiJoseph, and Yan Zilbering, Putting a value on your value: Quantifying Vanguard Advisor s Alpha. Valley Forge, Pa.: The Vanguard Group. Taxable accounts Broad-market equity index funds or ETFs Municipal/taxable bonds Active equity or similar tax-inefficient investments Source: Vanguard. 10

11 Does share-class structure affect capital gains? Vanguard has a unique and patented share-class structure Vanguard s U.S. ETFs are a share class of existing conventional mutual funds, an arrangement that provides economies of scale and lower costs. Three years ago, in response to questions about whether the share-class structure might increase capital gains distributions, Vanguard researched the issue to see what the data showed. Now, Vanguard is revisiting the original ten-year dataset of capital gains distributions from comparable equity ETFs from the three largest ETF providers, adding three more years of data. Equity ETFs capital gains distributions, For comparable funds offered by three ETF providers Broad market Mega Large Mid Small Value Blend Growth 0/17 0/36 0/13 0/7 0/7 0/7 0/15 0/28 0/15 0/0 0/0 0/0 0/18 0/18 0/18 0/26 0/30 0/26 0/13 1/22 0/13 0/12 0/27 0/12 0/36 0/36 0/36 1/9 4/22 2/9 0/18 0/18 0/18 0/36 0/36 0/36 9/13 3/10 1/13 Fund years with capital gains distributions (%) 0.0% 0.0% 0.5% 3.5% 6.6% Vanguard ETFs Years with capital gains distributions ishares ETFs (BlackRock) Years with capital gains distributions SPDR ETFs (State Street Global Advisors) Years with capital gains distributions Notes: Total fund years represents number of years that the funds could possibly have distributed capital gains. In some segments, more than one ETF from a provider was available, as reflected in the higher number of total fund years. For BlackRock and State Street ETFs, Bloomberg data were used in cases where the data were not available on the providers websites. Sources: Vanguard; Bloomberg L.P.; BlackRock, Inc.; and State Street Global Advisors. The performance data shown represent past performance, which is not a guarantee of future results. We again found nothing surprising, said Don Bennyhoff, a coauthor of the original paper, ETF Scorecard: Exploring the ETF sharestructure debate. 1 The pattern of capital gains distributions was determined more by the sub-asset class or style box than by the fund structure. Historically, mid-cap and small-cap funds are prone to more frequent capital gains distributions than larger-cap funds, since smaller-cap indexes tend to have more turnover in their constituents, which can lead to greater gains realizations. The data did not show a meaningful difference in the distribution patterns for either the share-class or the stand-alone stock ETF structures. None of the equity Vanguard ETFs in the dataset distributed capital gains during the 13-year period through 2013, though some of the comparable ETFs from other providers did. (Tax data for 2014 for competing firms were not available at the time of publication.) In the end, our share-class structure is unique and can provide some meaningful benefits for investors, said Bennyhoff. That said, the data do not illustrate anything uniquely different about the frequency of capital gains distributions for our ETFs. Even today, there is still a relatively short history of data to work with. The evidence continues to suggest that capital gains distributions are not related to ETFs structure and that advisors can instead focus on building more tax-efficient portfolios. 1 Donald G. Bennyhoff, Yan Zilbering, Francis M. Kinniry Jr., and Joel M. Dickson, ETF Scorecard: Exploring the ETF share-structure debate. Valley Forge, Pa.: The Vanguard Group. 11

12 Comments? Topics of interest? Write to us at Connect with Vanguard > advisors.vanguard.com For more information on Vanguard funds and ETF Shares, visit our website or call to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing. Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling. Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Investments in stocks issued by non-u.s. companies are subject to risks including country/regional risk and currency risk. We recommend that you consult a tax or financial advisor about your individual situation. Vanguard Financial Advisor Services P.O. Box 2900 Valley Forge, PA The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor. U.S. Patent Nos. 6,879,964; 7,337,138; 7,720,749; 7,925,573; 8,090,646; and 8,417,623. FAETFPWN