A passionate group of retail investors is steering clear of Australia’s most popular multi-asset ETF, arguing the fund lands them with unnecessarily high tax bills and drags on long-term performance.

Their target is Vanguard’s Diversified High Growth ETF (ASX: VDHG), an ETF with $1.4 billion in assets and a behemoth in the direct-to-retail multi-asset space. Their complaint is Vanguard's decision to construct VDHG out of unlisted managed funds. Reddit is bristling with investors claiming that means higher capital gains tax (CGT) forcing investors to pay the taxman and lose out on compounding.

They voice their concerns in Reddit threads with titles such as: “VDHG tax efficiency”, “Tax inefficiency associated with VDHG” and “Tax Inefficiency of VDHG for High Income earners”.

“I would off (sic) been forking out tens of thousands of taxes due to the inefficiency of how the fund is structured,” said one participant.

“For those of us lucky enough to be in the top tax bracket (47%) we should be (sic) abandon ship,” commented another.

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 acknowledges there could be small tax impacts from the current structure of VDHG but argues the fund’s diversification and performance outweigh any tax drag.

“Ultimately we believe the benefits of the current structure outweigh any potential tax implications,” says Evan Reedman, head of product at Vanguard Australia.

Today, Morningstar dives into the nuances of the tax code to look at why VDHG has some investors riled up and whether others should be concerned. For those looking to learn more about the fund, see our overview here.

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.

This is not the only approach. For example, the BetaShares Diversified All Growth ETF (ASX: DHHF) is made up of four other ETFs, including one from Vanguard—an ETF wrapped in ETFs.

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.

There are no plans to make changes to VDHG’s structure at this time.

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

Unlisted funds and redemptions

That’s cold comfort for this clique of investors. They 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.

Vanguard is no stranger to the argument that unlisted funds are less attractive than ETFs from a tax perspective. It features in their own marketing material:

“Unlike unlisted managed funds, ETF investors do not receive any capital gains that are generated by the selling activity of other unitholders,” said a note from 2018.

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.

It’s not just about tax

In the absence of a change to VDHG's structure, the tussle over tax comes down to how well someone believes they can replicate the diversification and professional oversight of VDHG in a structure that pays less tax.

An all ETF multi-asset fund such as the BetaShares Diversified All Growth ETF reduces distributions from redemptions, but it’s not an exact substitute. The asset allocation differs, for example the fund does not own any bonds.

For some, the solution is to “roll their own”— creating a parcel of ETFs that mimic VDHG or an investor’s own strategic asset allocation. Where only ETFs are used, the tax issues of unlisted funds are avoided.

This needs to be weighed against taking on the task of setting an asset allocation and actively rebalancing the portfolio, says Steven Le, a manager research analyst at Morningstar.

“They have to be cognisant to the balance between growth and defensive assets. They need to monitor how their portfolio is performing to ensure they’re rebalancing in line with their risk profile,” he says.

Rebalancing oneself comes with trading fees and the possibility of incurring capital gains taxes. There’s also the risk of human error, investors may forget.

It’s this behavioural side of investing that sometimes gets overshadowed in the Reddit debates over tax minimisation. Theoretical tax savings may not materialise for the many investors who lack the time or knowledge to construct and manage a portfolio. As one participant says:

“The value of VDHG is in the simplicity and lack of complexity. You’re more likely to stay the course. Investing isn’t just mathematical, it’s behavioural…I honestly think too many people get hung up on tax when they shouldn’t.”

The article was amended to reflect that the BetaShares Diversified All Growth ETF does invest beyond large caps.