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.

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 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.

This episode explores the ETF, looking at the pros and cons of having a diversified investment with one trade, but with potential tax consequences.

You can find the full article here.

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The full transcript of the podcast can be found below:

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Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: Okay, we're going to start out a little differently today. We are going to embarrass you, Shani.

Jayamanne: It's normally you, Mark.

LaMonica: I know. So, this is a new thing. So, I bet you some of the listeners follow you on LinkedIn. But for those that don't, I want to read one of your recent posts. It read, growing up, it was my dream to be on the cover of Total Girl magazine. I guess this isn't too bad either. And the "it" you were referring to was a recent article that you were in, and it was published in the AFR. And that's pretty impressive just by itself. But the really special thing is that you were on the cover of the AFR. So, they put a picture of you on the masthead and you were actually covering the W in financial review. So, I was very proud to see that. I mean, what do you think?

Jayamanne: It's very nice, Mark. Thank you for bringing that up and embarrassing me. But I got a lot of really nice congratulatory messages on LinkedIn. But my favorite was that you took an old cover of Total Girl and you put my face on it.

LaMonica: And I had never heard of Total Girl before you mentioned that. Now, I'm going to continue embarrassing you. You also were just named as a finalist in another award. So, you want to talk about what that award is?

Jayamanne: This is not the Shani show, Mark.

LaMonica: It is. If I ever accomplish something, we can talk about me. But you are finalist for Women's Leadership Award…

Jayamanne: I am.

LaMonica: …which is also really impressive. And you were the finalist in another Women's Leadership Award earlier this year, but you went to Europe, and I had to go to the dinner by myself.

Jayamanne: You did, which was very nice of you.

LaMonica: I'm a nice guy.

Jayamanne: Yeah.

LaMonica: All right. So now that I've thoroughly embarrassed you.

Jayamanne: Let's talk about the VDHG, which is what our topic is today.

LaMonica: Yeah, we're going to do a deep dive today, Shani.

Jayamanne: Yeah. And normally we do deep dives on shares, but today we are switching things up and going through an ETF.

LaMonica: OK, you mentioned the ticker. But what we're talking about is the Vanguard Diversified High Growth ETF, and with that ticker that you just mentioned, VDHG. And this is part of Vanguard's suite of multi-sector ETFs that are composed of global and domestic equities, fixed interest and cash. And this is just basically an efficient way for an investor to get a diversified portfolio across all those asset classes and sectors and regions. There's a low fee on this thing relative to a lot of the other active ETFs. And so that makes it appealing as well.

Jayamanne: And as the high growth option, VDHG allocates 90% of the ETF to growth assets like shares and 10% to defensive assets like bonds. Additional ETFs provide access to conservative, balanced and high growth portfolios, which are VDCO, VDBA and VDGR.

LaMonica: Well, there we go. That's a lot of VD for this podcast. But we're going to talk a little bit about this ETF. And so, we'll start with the process. So, Vanguard has a group called the Asia Pacific Investment Strategy Group. And they are responsible for setting the strategic asset allocation for each ETF. And a strategic asset allocation is a long-term approach for allocating this ETF to those different asset classes that I was talking about. And the way that they do that is they use forecasts for long-term asset class returns. And on an annual basis, they may update the strategic asset allocation if there are changes or if there are updates to how something is being taxed. And that's really the process that they go through. Now, it's important to note that they do not use tactical asset allocation. So, they're not going to change those allocations to those different asset classes based on market conditions.

Jayamanne: The ETF is created using in-house index funds as building blocks. These index funds represent the major asset classes included in the ETF. Now, this is important, and we'll get back to it. But first, we want to remind listeners that if you are considering VDHG, first focus on understanding the return you need to achieve your goal. 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 a higher level of volatility.

LaMonica: Yeah, and of course, volatility refers to how much a portfolio bounces around in price. And volatility in the investment industry is synonymous with risk. But we've said this multiple times on here, right, Shani, that most long-term investors should be more concerned with achieving the return needed to reaching their goal and not focusing on the short-term risk of volatility.

Jayamanne: And there we have it. This is a way for an investor to get a fully diversified portfolio in one trade, which is helpful if you want simplicity. But there is a potential price to be paid for that simplicity, which is what we're going to focus on in the podcast.

LaMonica: And that is what we told everyone to remember. And that is the way that this ETF gives investors exposure for lots of different asset classes is because the ETF is just a wrapper around managed funds that track different indexes associated with all those asset classes.

Jayamanne: And this is causing some investors to steer clear of this ETF. And their complaint is Vanguard's decision to construct VDHG out of the unlisted managed funds which forces investors to pay the taxman and lose out on compounding.

LaMonica: And what these investors want is they want that wrapper ETF to hold other ETFs instead of managed funds. And in theory, this would be easy to do since Vanguard has ETFs and managed funds that track all these indexes.

Jayamanne: But 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.

LaMonica: And these differences in how ETFs and unlisted funds pay out or redeem investors leaving the fund matters. So, 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. So, those gains are passed on, those capital gains are passed on to investors as a taxable distribution. So, in effect, investors leaving unlisted funds can leave behind capital gains taxes for those that remain.

Jayamanne: And in theory, this dynamic applies to both ETFs and unlisted funds. In practice, ETFs can stream this tax bill away from the fund investors to their market makers. 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.

LaMonica: So, because VDHG is made up of unlisted funds, redemptions in the underlying funds can create these capital gains that we talked about. And these capital gains, you may miss them because they're added to the fund's overall distribution, which includes any interest income or dividends, but also, of course, these capital gains. And then you pay tax on these distributions, even if they're automatically reinvested.

Jayamanne: Are you confused yet?

LaMonica: I'm always confused. As you said, I'm an old man, so everything confuses me.

Jayamanne: Okay. So perhaps we can talk about how this works in practice. Differences range from a few tenths of a percent to more than two. For example, the Vanguard Australian Shares Index Fund has an annualized 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's International Shares over the same period.

LaMonica: And of course, the tax that's paid on distributions comes out of an investor's portfolio, and that, of course, slows the long-term growth. So, more distributions means more tax and means less compounding. So, to illustrate that – and this is from an article that we recently published – so we looked at what are the impacts on hypothetical – on two hypothetical portfolios of investors. So, the first mimics a wealthier investor, which simply means…

Jayamanne: This can be your portfolio.

LaMonica: Oh, this is my portfolio? Yeah. If I was truly wealthy, I would not be sitting here doing this. But of course, the wealthier portfolio or the portfolio of a wealthier investor faces higher taxes. So, if we start with $50,000, we make annual contributions of $15,000, and distributions are, as I said, taxed at that maximum marginal tax rate. And then the second portfolio is a less wealthy investor – so, starts at $10,000, contributes $10,000 each year, and it's taxed at the penultimate rate.

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Jayamanne: So, we modeled 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. And because tax rates are different for everyone, we looked at a wealthy cohort at the highest marginal tax rate and a lower marginal tax rate for the non-wealthy cohort.

LaMonica: Okay. So, bear in mind that these are all estimates because we don't know how much of future distributions will be based on dividends and how much will be capital gains. So, this is history, but if the fund structure meant the capital gains, the capital gains portion of that distribution moved from 1% to 1.5%, it meant almost $100,000 less after 30 years. And that's in the wealthy example. In the non-wealthy example, it was $50,000 lower.

Jayamanne: But the bottom line is that higher distributions lead to a smaller final portfolio. The impact is proportionally higher for larger portfolios at higher marginal tax rates. Please note that in practice, the difference is likely to be smaller. Most investors will pay less than the headline rate in tax, 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.

LaMonica: Okay, that was a lot, like a lot of tax talks…

Jayamanne: Yes.

LaMonica: …and a lot of us talking on an audio format about this modeling in figures.

Jayamanne: Yes, there is an article there. So, we'll pop it in the episode notes.

LaMonica: There's an article. So, you can read that. But let us just summarize how investors should think about this. The taxes on VDHG will be higher than if an investor simply purchased the underlying ETFs. So, every investor situation is, of course, 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. And all of those, or those three that I mentioned, they're all highly rated by our analysts.

Jayamanne: And the two downsides to using multiple ETFs are the transaction fees and the need for a modest amount of effort to keep your asset allocation aligned to your objectives. If you're 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.

LaMonica: And there's another advantage, Shani. And the other advantage is that the fees are lower. So 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%. Of course, the advantage and what you're getting to pay more to VDHG is that they will automatically rebalance that portfolio, so it aligns with that strategic asset allocation. And that is valuable, especially if an investor is not contributing any additional money. Because of course, then they would have to rebalance by selling and buying. And there are transaction fees. But as Shani pointed out in her example, if an investor is still contributing, the rebalancing could be done without new contributions.

So that is our episode. I mean, what would you do? Do you like this all-in-one one ETF, or do you think you'd go for the underlying ETFs?

Jayamanne: I do the underlying ETFs in practice. So that's what I do and what I would do.

LaMonica: Yeah, I would too. Because obviously lower taxes are really important because we of course are trying to compound and build our portfolios. But thank you guys very much for listening. On the next episode, I'm sure there will be six or seven other awards that Shani has won that I can talk about. If anyone has any questions, email me at my email address, which is in the show notes. Thank you.

[Advertisement: Investing Compass is a podcast we started to explore the fundamentals of investing and help you with achieving your financial goals, whatever they may be.

ANZ's 5 in 5 have sponsored this episode of Investing Compass. We also listen to 5 in 5 ourselves to keep up to date with the latest economic, markets, and business news each weekday. One of the things that we like about the podcast is that it has a similar approach to us. They leverage the insightful experts that they have across their global network to provide a rounded and level-headed analysis of news and insights each weekday.

You can find them in your preferred podcast player or click the link in the episode description to follow them and have a listen after us.]

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)