IShares offer tax benefits in relation to mutual funds

IVV's per share distribution and net asset values at time of distribution were obtained from Barclays Global Investors. They were used to calculate per dollar distributions as shown in Table 5.6. Using the tax brackets shown in

Table 5.6 iShares 500 index fund (IVV) historical distributions

Distributions per share* Distributions per dollar invested

Table 5.6 iShares 500 index fund (IVV) historical distributions

Distributions per share* Distributions per dollar invested

Ordinary

Ordinary

income &

income &

Record date

S.T.C.G.

L.T.C.G

NAV

S.T.C.G.

L.T.C.G

06/21/00

$0.11941

$0.00000

$147.86

0.000808

0.000000

09/20/00

$0.27659

$0.00000

$144.98

0.001908

0.000000

12/13/00

$0.43896

$0.00000

$135.78

0.003233

0.000000

Total 2000

$0.834963

$0.000000

0.005948

0.000000

03/12/01

$0.24327

$0.00000

$117.78

0.002065

0.000000

06/11/01

$0.35238

$0.00000

$125.77

0.002802

0.000000

10/02/01

$0.39341

$0.00000

$105.51

0.003729

0.000000

12/17/01

$0.33979

$0.00000

$113.85

0.002985

0.000000

Total 2001

$1.328856

$0.000000

0.011580

0.000000

03/11/02

$0.29291

$0.00000

$116.89

0.002506

0.000000

06/17/02

$0.37254

$0.00000

$103.84

0.003588

0.000000

09/16/02

$0.39444

$0.00000

$89.47

0.004409

0.000000

12/16/02

$0.42259

$0.00000

$91.25

0.004631

0.000000

Total 2002

$1.482466

$0.000000

0.015133

0.000000

03/10/03

$0.33541

$0.00000

$81.00

0.004141

0.000000

06/16/03

$0.36711

$0.00000

$101.36

0.003622

0.000000

09/15/03

$0.42120

$0.00000

$101.72

0.004141

0.000000

12/15/03

$0.51447

$0.00000

$107.14

0.004802

0.000000

Total 2003

$1.638183

$0.000000

0.016705

0.000000

Average

(2000-2003)

$1.321117

0.000000

0.012342

0.000000

Note: * Distributions per share and NAV were obtained from Barclays Global Investor.

Note: * Distributions per share and NAV were obtained from Barclays Global Investor.

Table 5.7 Tax comparison - iShares 500 index fund (IVV) versus VFINX

Panel A: Tax liability per dollar invested - iShares 500 index fund (IVV)

Taxable income per dollar invested (I)

Tax liability per dollar invested (II)

Ordinary

Total

Ordinary

income

taxable

income

Total tax

Year

& S.T.C.G.

L.T.C.G

income

& S.T.C.G.

L.T.C.G

liability

2000

$0.005948

$0.000000

$0.005948

$0.002356

$0.000000

$0.002356

2001

$0.011580

$0.000000

$0.011580

$0.004528

$0.000000

$0.004528

2002

$0.015133

$0.000000

$0.015133

$0.005841

$0.000000

$0.005841

2003

$0.016705

$0.000000

$0.016705

$0.005847

$0.000000

$0.005847

Average

$0.012342

$0.000000

$0.012342

$0.004643

$0.000000

$0.00464

Panel B: Tax liability per dollar invested -

Vanguard 500 index fund (VFINX)

Taxable income per dollar

Tax liability per dollar

invested (III)

invested (IV)

2000 $0.009928 $0.000000 $0.009928 $0.003931 $0.000000 $0.003931

2001 $0.012395 $0.000000 $0.012395 $0.004847 $0.000000 $0.004847

2002 $0.015811 $0.000000 $0.015811 $0.006103 $0.000000 $0.006103

2003 $0.015584 $0.000000 $0.015584 $0.005454 $0.000000 $0.005454

Average $0.013430 $0.000000 $0.013430 $0.005084 $0.000000 $0.00508 Panel C: IVV vs VFINX

Tax liability per dollar invested (I-III)

Tax savings of IVV as % of VFINX

Ordinary

Total

Ordinary

income

taxable

income

Total tax

Year

& S.T.C.G.

L.T.C.G

income

& S.T.C.G.

L.T.C.G savings

2000 -$0.00398

2001 -$0.00081 2002 -$0.00068 2003 $0.00112 Average -$0.00109

Average tax savings of IVV as a % of Vanguard 500

Table 5.2 and the appropriate tax rates for long-term capital gains, we calculated the tax liability per dollar invested for both IVV and VFINX (Panel A and B, respectively of Table 5.7). Panel C of the same Exhibit shows that in relation to VFINX, all IVV's tax savings come from ordinary income and short-term capital gains (8.67%). In comparison, only 3.25% of the tax savings comes from these two income categories when the tax liabilities of the VFINX and SPY were measured against each other.

Now, let us assume that it's true that mutual funds routinely keep some of the dividends received as a cushion in case they face an unexpected and sudden high redemption rate, such as the one that characterized the early 2000s. Although the iShare 500, as an Open-end structure, also is entitled to reinvesting its dividends received, its similarities with a mutual fund such as the Vanguard 500 may stop there. Indeed, unlike the latter, it can behave like any other ETF when caught unexpectedly by a high redemption rate. The ETF creation/redemption process precludes the need for maintaining cash balances for redemption purposes: it redeems investors in-kind not in cash. This means that, theoretically, the iShare 500 manager does not need to maintain cash balances, since the redemption activities of departing investors are covered in kind. As we can easily imagine what would happen to these dividends when reinvested back into the portfolio in a declining market, we can credibly say that in a bear market, those who invested in the iShare 500 may be less likely to see income passed on to them than the Vanguard 500 investors.

In our comparison of the SPDR 500 to the Vanguard 500, we explained why the tax savings enjoyed by the former over the latter could have been more significant if it was not for the bear market of the early 2000s. In the case of the iShare 500, under a bear market scenario, the fact that it could reinvest all of its dividends if it chooses, instead of in parts, seemingly takes that "edge" away from the Vanguard 500. The resulting higher tax savings from income distributions7 (8.67% as shown in Table 5.7's Panel C, versus 3.25% when the Vanguard 500 is compared to the SPDR 500) seems to indicate that the iShare 500 might have done just that.

As simple as this might appear, IVV current investors have, overall, received less dividend income from their reinvested dividends than their VFINX counterparts, resulting in less tax paid. This can easily be verified. As shown in 5.6, except for 2003, marking the beginning of a market rebound, IVV holders have received less dividend income per share than VFINX investors. This also means that the IVV manager has not been skittish with regard to the fund's dividend reinvestment strategy in the face of an enduring bear market. This situation has apparently lasted long

7 Indeed, all income comes from dividends because neither VFINX nor IVV distributed short-term capital gains during the period under consideration as shown in Tables 5.3 and 5.6, respectively.

enough to generate the aforementioned tax advantage for IVV investors due to less income distributed to them.

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