Vanguard Diversified High Growth ETF VDHG is part of Vanguard’s suite of multi-sector ETFs that are composed of global and domestic equities, fixed interest, and cash. This strategy offers an efficient way to get access to a diversified portfolio of securities across different asset classes, sectors, and regions. A low annual fee relative to active peers further increases its appeal from a cost perspective.

VDHG allocates 90% of the ETF to growth assets like shares and 10% to defensive assets like bonds. Additional ETFs provide access to conservative, balances and high growth portfolios which consist of VDCO, VDBA and VDGR.

Vanguard’s Asia-Pacific Investment Strategy Group is responsible for setting the strategic asset allocation for each of the ETFs. A strategic asset allocation is a long-term approach for allocating the ETF to different asset classes. This is set using forecasts for long-term asset class returns. On an annual basis the strategic asset allocation may be updated based on changes such as updates to the taxation of a particular asset class. Vanguard does not use a tactical asset allocation which are changes to allocations based on market conditions.

The ETF is created by using In-house index funds as the building blocks. These index funds represent the major asset classes included in the ETF.

The current allocations of VDHG are shown in the following table:

VDHG

If you are considering VDHG first focus on understanding the return needed to achieve your goal. I’ve outlined this process in my article on goal setting. VDHG allocates the highest percentage to growth assets of Vanguard’s line of multi-sector ETFs. That higher allocation should deliver higher returns over the long-term but with higher levels of volatility.

Volatility refers to how much a portfolio bounces around in price. And volatility is synonymous with risk in the investment industry but most long-term investors should be more concerned with achieving the return needed to reaching a goal. That is the real risk.

Why are investors concerned about the tax consequences of VDHG

Some retail investors are steering clear of Vanguard's multi-sector ETFs  arguing the fund lands them with unnecessarily high tax bills and drags on long-term performance.

Their complaint is Vanguard's decision to construct VDHG out of unlisted managed funds which forces investors to pay the taxman and lose out on compounding.

They lament that it could be different, claiming that were Vanguard to build VDHG using its staple of ETFs, instead of its unlisted funds, the potential tax bill would be reduced.

Vanguard has started to address this issue and has begun investing in ETFs within VDHG starting on July 1st. Over time they will gradually build up an investory of ETFs as the assets in VDHG grow. However, they are not planning on selling down any of managed fund holdings so the issue will persist. 

Peas in a pod: unlisted funds and ETFs

The controversy centres around a quirk in VDHG’s design: it’s an ETF made up of seven unlisted index funds. While similar on paper, ETFs and unlisted funds operate differently in practice. ETFs are bought and sold on a stock exchange via market makers, while investors trade unlisted fund shares directly with the fund manager—this will be important later.

Think of VDHG as an ETF wrapped around seven unlisted managed funds—a fund of funds.

Vanguard says the use of unlisted funds is a legacy from when ETFs were less available. For example, the Vanguard MSCI International Small Companies Index Fund is part of VDHG but the equivalent ETF was only launched in 2018, a year after VDHG first went to market.

And the size of VDHG today means changing to an all-ETF structure would impose transaction costs that could negate any tax benefits, according a spokesperson for Vanguard.

Using unlisted funds does have the benefit of helping minimise the costs associated with using market makers, says Reedman.

Unlisted funds and redemptions

The investors that are critical of the structure claim the decision to use unlisted funds instead of ETFs means higher tax bills and lower returns. The reason? Differences in how ETFs and unlisted funds pay out (redeem) investors leaving the fund.

When investors exit an unlisted fund, they’re paid out in cash. If fund managers sell assets to get that cash, it can create capital gains for the fund’s remaining investors. Those gains are passed on to investors as a taxable distribution. In effect, investors leaving unlisted funds can leave behind capital gains taxes for those that remain. 

In theory, this dynamic applies to both ETFs and unlisted funds. In practice, ETFs can stream this tax bill away from the fund’s investors to their market makers, says Michael Brown, finance director at VanEck.

Market makers are financial middlemen who trade ETF units on behalf of fund managers. In doing so, the capital gains involved in redemptions are streamed to them.

"From the ATO's point of view, there's no difference between listed and unlisted. It's the practical side of how the ETF works versus how the unlisted fund works, and part of that is the market maker," says Brown.

And because VDHG is made up of unlisted funds, redemptions in the underlying funds can create capital gains for holders of VDHG.

These capital gains add to the fund's overall distribution, which also includes interest income and dividends. Investors pay tax on these distributions, even where they are automatically reinvested.

Vanguard says it has ways to limit the tax impact of redemptions. Its portfolio managers minimise the need to sell assets by using money from incoming investors to pay out those leaving. New tax rules, the attribution managed investment trusts (AMIT) regime, allow the fund to “allocate” the capital gains from “significant redemptions” to the investor in question.

“We do have measures in place to mitigate the impact of a CGT event if it were to significantly impact the other investors in the fund,” says Reedman.

How much do redemptions add to the overall distributions for VDHG?

Vanguard won’t comment on specific redemption orders for its funds, but one proxy is the different distributions between the ETF and unlisted versions of the funds that make up VDHG. These funds are the same in all but structure and help isolate the impact of redemptions.

Differences range from a few tenths of a percent to more than two. For example, the Vanguard Australian Shares Index Fund had an annualised distribution of 4.62% over the past five years, slightly higher than the 4.19% from the ETF version. But that difference jumps to more than 2% for the ETF and unlisted versions of Vanguard International Shares over the same period.

A spokesperson for Vanguard acknowledged the difference in distributions between these funds is due to differences in the treatment of capital gains.

Higher distributions eat into returns, especially for large portfolios

The tax paid on distributions comes out of an investor’s portfolio and slows its long-term growth. More distributions, more tax, less compounding.

To illustrate the impact of higher distributions on investor returns, we built two hypothetical portfolios. The first mimics a wealthier investor. It starts with $50,000 and makes annual contributions of $15,000. Distributions are taxed at the maximum rate. The second portfolio starts with $10,000, contributes $10,000 each year and is taxed at the penultimate rate.

We modelled how each portfolio grew over 30 years when more of the return was paid as a distribution. Money paid out to the investor gets taxed and means less left to compound.

We ran three scenarios with a total return of 8% annually but varied the amount paid as a distribution. In the base scenario, the 8% was split between 1% as distribution and 7% as capital appreciation. We then increased the distribution to 1.5% and 2%. In each case, the total return stays the same, so a higher distribution meant less capital appreciation.

The results are a reminder of the importance of tax.

For the wealthy portfolio, moving from distributions of 1% to 1.5% meant almost $100,000 less after 30 years. Going from 1% to 2% cost almost $175,000 in final returns.

The impact for investors who started with a smaller pot was lower, ranging from around $50,000 to $77,000.

Bottom line, higher distributions lead to a smaller final portfolio. The impact is proportionally higher for larger portfolios at higher marginal tax rates.

The actual return impact depends on an individual’s situation and investors should seek tax advice prior to making investment decisions.

Note that in practice the difference is likely to be smaller. Most investors will pay less than the headline tax rate, in part because capital gains are discounted. Higher distributions also reduce the ultimate tax bill on selling the portfolio due to a higher cost base.

My take

Every investor’s situation is unique and there is certainly an appeal to an all in one solution like VDHG. However, there are ways to get the same exposure using a few Vanguard ETFs. These include Australian equity exposure using VAS, global equities through VGS and fixed income through VAF. All are highly rated by our analysts and can be found in our article on the top-rated Vanguard ETFs.

The two downsides to using multiple ETFs are transaction fees and the need for a modest amount of effort to keep your asset allocation aligned to your objectives. If you are investing periodically as many of us do a simple rotation between the different ETFs in a portfolio limits transaction costs. This can be done in a way that keeps asset allocation largely in line with what you would get through a multi—sector product like VDHG.

Another advantage that investors may get from using individual ETFs is that the fees are lower. VDHG charges 0.27% a year. VAS has a fee of 0.07%, VGS has a fee of 0.18% and VAF has a fee of 0.10%. The advantage of VDHG is that Vanguard will automatically rebalance the portfolio. This is valuable if an investor is not contributing any additional money and transaction fees on rebalancing would eat into returns. For an investor still contributing the rebalancing could be done with new contributions.

I think over the long-run the effort is worthwhile for many investors given the potential tax and fee savings.

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