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Tax-managed index funds defer capital-gains distributions by, among other things, offsetting capital gains with losses and deviating from their underlying indexes to avoid having to sell appreciated assets. But if the funds are successful, it seems that the share of unrealized capital gains will grow indefinitely. Right now, the unrealized appreciation of Vanguard Tax-Managed Small-Cap Fund Admiral Shares is 28.4% of NAV. As long as the fund delivers decent returns over the long term, is there anything stopping this amount from ballooning to, say, 90% fifty years hence?

If this happens, won't new investors be scared away by the prospect of owing taxes on these gains? For example, a financial crisis or a superior new investment technology could lead investors to dump their shares of tax-managed index funds, triggering enormous capital-gains distributions. And if new investors are scared away, won't the fund be forced to sell its assets to cover redemptions (even if there is no disruptive event), leading to larger capital-gains distributions than in the past?

Finally, do ETFs avoid this problem (assuming it is a problem)?

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Could you give an example of a tax-managed fund that also claims to be an index fund? Does the prospectus of the Vanguard Tax-Managed Small-Cap Fund claim to follow a specific index? Certainly can't tell from the title! –  Dilip Sarwate Oct 25 '12 at 22:34
    
@DilipSarwate The Vanguard Tax-Managed Small-Cap Fund tracks the S&P 600. –  Patrick Brinich-Langlois Oct 25 '12 at 23:47
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No, neither does it track the S&P Small Cap 600 Index nor does it claim that it tracks this index. It is an actively-managed fund. Read the information provided carefully: while VTMSX invests in the stocks in the $&P 600 Index and in approximately the same proportion, it can do other things like invest in derivatives, futures, and the like. In contrast, VFIAX is an index fund and says right up front that "the fund employs a “passive management”—or indexing—investment approach designed to track the performance of the Standard & Poor’s 500 Index" –  Dilip Sarwate Oct 26 '12 at 3:18
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The biggest investment by far in the Tax-Managed Small-Cap Fund is the Vanguard REIT ETF (3.8% vs 0.6% for the 2nd biggest investment) –  mhoran_psprep Oct 26 '12 at 10:09
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I don't know that I can answer the question fully, but 2 points. The percent that represent capital gains certainly can't exceed 100. Did you mean 50% but the 500% is a typo?

More important, funds held in retirement accounts have no issue with this, Cap Gains are meaningless within tax deferred accounts. I don't know the ratio of stocks held in these accounts vs outside, just that the 2011 year end total retirement account worth was $17 trillion. (That's 12 zeros) This strikes me as a high ratio, although more numbers digging is in order.

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The 500% is indeed an error, but it was because I was thinking about it the wrong way (as a percentage of the purchase price rather than of the current value). So the worst that could happen is that it would approach 100%. I agree that there wouldn't be a problem if I were holding the shares in a tax-exempt account, but I (and presumably most of the other investors) hold the shares in a taxable account, since it would be a little bit silly to hold a tax-managed fund in a tax-free account. –  Patrick Brinich-Langlois Oct 26 '12 at 0:06
    
Agreed. In a rising market, the embedded gains are going to trend up, and they will probably have more of an issue with this phenomenon. The distributed dividend for 2011 was only 24 cents, less than 1% of the fund value. Not likely there would ever be a run on such a fund. –  JoeTaxpayer Oct 26 '12 at 11:42
    
@JoeTaxpayer Could you add a few words of explanation as to why the unrealized capital gains in a mutual fund portfolio cannot exceed 100%? –  Dilip Sarwate Apr 25 '13 at 18:34
    
@DilipSarwate - I meant the remark as a given, how could the assets of a fund ever have a lower than zero basis? Even if we had a round of hyperinflation, add afew zeros to the price of everything, the basis would approach, but couldn't drop below, zero. –  JoeTaxpayer Apr 25 '13 at 19:10
    
@JoeTaxpayer Oh, OK, I misunderstood the statement "percent that represents capital gains can't exceed 100" to mean that the capital gains were for some reason restricted to being less than 100% of the basis. What you are saying is that the entire current share price cannot consist solely of unrealized capital gains. –  Dilip Sarwate Apr 25 '13 at 19:24
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Right now, the unrealized appreciation of Vanguard Tax-Managed Small-Cap Fund Admiral Shares is 28.4% of NAV. As long as the fund delivers decent returns over the long term, is there anything stopping this amount from ballooning to, say, 90% fifty years hence?

I'd have a heck of a time imagining how this grows to that high a number realistically. The inflows and outflows of the fund are a bigger question along with what kinds of changes are there to capital gains that may make the fund try to hold onto the stocks longer and minimize the tax burden.

If this happens, won't new investors be scared away by the prospect of owing taxes on these gains? For example, a financial crisis or a superior new investment technology could lead investors to dump their shares of tax-managed index funds, triggering enormous capital-gains distributions. And if new investors are scared away, won't the fund be forced to sell its assets to cover redemptions (even if there is no disruptive event), leading to larger capital-gains distributions than in the past?

Possibly but you have more than a few assumptions in this to my mind that I wonder how well are you estimating the probability of this happening.

Finally, do ETFs avoid this problem (assuming it is a problem)?

Yes, ETFs have creation and redemption units that allow for in-kind transactions and thus there isn't a selling of the stock. However, if one wants to pull out various unlikely scenarios then there is the potential of the market being shut down for an extended period of time that would prevent one from selling shares of the ETF that may or may not be as applicable as open-end fund shares.

I would however suggest researching if there are hybrid funds that mix open-end fund shares with ETF shares which could be an alternative here.

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