ETF share class “tax contagion” is, sadly, something we need to care about

Pry before you buy

Earlier this year, SEC ordered Vanguard to pay more than $100 million for misleading shareholders.

In 2020, Vanguard lowered the minimum for its institutional Target Retirement Fund share class. Retail investors sold their investor shares to switch share classes and save a little money, but this forced the fund to realize capital gains. Those gains were distributed to the remaining investor class shareholders, who weren’t warned they might be stuck with a tax bill.

This is perhaps the largest case of “tax contagion,” when tax costs are pushed from one share class to another.

Though it doesn’t involve an ETF share class, it may in the future.

Investors and advisers assessing an ETF need to consider if it is a share class of a mutual fund that might stick shareholders with a tax bill.

Below, I provide a framework for assessing tax contagion risk, which seems relevant given the 62 applications to attach an ETF share class to a mutual fund.

Ben Johnson over at Morningstar has been ratatat-tatting each new ETF share class petition for the past year.