Article: How Vanguard Patented A Way To Avoid Taxes On Mutual Funds

[steelyman]

The Bogleheads are probably all over this one. I received it through Bloomberg. It’s an article about how Vanguard uses mutual funds and ETFs to improve tax efficiency.

Quote:

Like flipping a light switch, Vanguard Group Inc. has figured out a way to shut off taxes in its mutual funds. The first to benefit was the Vanguard Total Stock Market Index Fund. Investors’ end-of-year tax forms abruptly stopped showing capital gains in 2001, even as the fund went on to generate billions of dollars of them. By 2011, Vanguard had flipped the switch in 14 stock funds. In all, these funds have booked $191 billion in gains while reporting zero to the Internal Revenue Service.

https://www.bloomberg.com/graphics/2...fund-tax-dodge

[audreyh1]

I knew that Vanguard had adopted an ETF-like mechanism to avoid capital gains in their associated index mutual fund, and I knew it was patented. Thanks for the article that spells out the details.

Quote:

The rule says that a fund can avoid recognizing taxable gains on an appreciated stock if the shares are used to pay off a withdrawing investor. The rule applies to both ETFs and mutual funds, but mutual funds rarely take advantage of it because their investors almost always want cash. ETFs use it all the time, because they don’t transact directly with regular investors. Instead, they deal with Wall Street middlemen such as banks and market makers. It’s those firms, not retail investors, that expand the ETF by depositing assets or shrink it by withdrawing. These transactions are usually done with stocks rather than cash. The middlemen, in turn, trade with regular investors who want to buy and sell ETF shares. Trading with middlemen presents ETFs a tax-cutting opportunity. Whenever one of these firms makes a withdrawal request, an ETF can deliver its oldest, most appreciated stocks, the ones most likely to generate a tax bill someday. If the ETF wants to cut its taxes further, it can generate extra withdrawals just to harvest the tax break. A heartbeat is when an ETF asks a friendly bank or market maker to deposit some stock in the fund for a day or two, then take different stock out. Some critics call these trades an abuse of the tax code. But with the help of heartbeats, most stock ETFs, even ones that change holdings frequently, are able to cut their capital-gains taxes to zero.

Hmmmm -

I wonder if that was part of Vanguard's motivated to create ETFs?