[How ETFs use "Heartbeat trades" to avoid taxes, Vanguard's patent]

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[How ETFs use "Heartbeat trades" to avoid taxes, Vanguard's patent]

Post by retiringwhen » Fri Mar 29, 2019 3:41 pm

[Title was "Bloomberg--Vanguard Patented a Way to Avoid Taxes on Mutual Funds" --admin LadyGeek]

Linked here is an article on Bloomberg about how ETFs use essentially manufactured trades with banks to wash-out low-cost basis shares to keep from realizing gains in their normal flow (the implication being that the normal ETF Share create/destruction process is not sufficiently large to achieve the goal on its own). They call them heartbeat trades because of how the trades look on volume charts (once every quarter or so, there is a massive trade, then quickly afterwards, one or more large trades that essentially unwind the original trade, usually within a week)

https://www.bloomberg.com/graphics/2019 ... -save-big/

Several thoughts here:

1.) It appears that if you see an ETF that is actually regularly distributing LTCG they are not taking advantage of this process, thus one to ignore in taxable accounts.

2.) The article does not really describe why the banks would participate in this type of trade. There must be something in it for them. Maybe they are just exaggerated versions of their arbitrage strategies? I don't really know. Maybe there is a tax arbitrage on the banks' proprietary trading side as well?

3.) This approach does appear to be fully engaged by Vanguard and since they have the share-class innovation/patent, this means they are using the heartbeats to more fully clear out the mutual fund shares as well. It seems to me that it does show there is real value in the Vanguard patent. It will be interesting to see how quickly other fund complexes begin to use the strategy after the patent expires.

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Heartbeats - The ETF Tax Dodge

Post by under_tha_radar » Fri Mar 29, 2019 5:51 pm

[Thread merged into here, see below. --admin LadyGeek]
Starting to make more sense why mutual funds report taxable events over ETFs.

“Imagine that a grocer got a tax deduction every time someone returned a box of cornflakes to his store. Heartbeats are when the grocer asks a friend to buy all the boxes and return them, just to pocket more deductions.“

https://www.bloomberg.com/graphics/2019 ... -save-big/

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Re: Heartbeats - The ETF Tax Dodge

Post by Whakamole » Fri Mar 29, 2019 6:17 pm

I haven't read the whole article, but this sounds like they are talking about the well-known redemption mechanism where an ETF gives appreciated stock to an AP. Why is that a tax dodge?

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Re: Heartbeats - The ETF Tax Dodge

Post by vineviz » Fri Mar 29, 2019 6:20 pm

Whakamole wrote:
Fri Mar 29, 2019 6:17 pm
I haven't read the whole article, but this sounds like they are talking about the well-known redemption mechanism where an ETF gives appreciated stock to an AP. Why is that a tax dodge?
No, this is different.

I still haven’t figured out how banks shed the gain, though.
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Re: Heartbeats - The ETF Tax Dodge

Post by under_tha_radar » Fri Mar 29, 2019 6:21 pm

I think the spirit of the “tax dodge” is the transactions are created for the sole purpose of not creating a taxable event on the appreciated securities.

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Re: Heartbeats - The ETF Tax Dodge

Post by SlowMovingInvestor » Fri Mar 29, 2019 6:55 pm

vineviz wrote:
Fri Mar 29, 2019 6:20 pm
Whakamole wrote:
Fri Mar 29, 2019 6:17 pm
I haven't read the whole article, but this sounds like they are talking about the well-known redemption mechanism where an ETF gives appreciated stock to an AP. Why is that a tax dodge?
No, this is different.

I still haven’t figured out how banks shed the gain, though.
I think what they're saying is that banks don't have a gain because the cost basis for the shares is the price at which they receive the shares (or maybe the price at which they buy the ETF before submitting for redemption). So any embedded gain in the shares is 'washed' away.

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Re: Heartbeats - The ETF Tax Dodge

Post by LadyGeek » Fri Mar 29, 2019 7:00 pm

I merged under_tha_radar's thread into the on-going discussion.
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Re: Heartbeats - The ETF Tax Dodge

Post by livesoft » Fri Mar 29, 2019 7:03 pm

I did not read the article, but another mechanism that would work:

Authorized participants could be aware of shares that were in IRAs, 401(k)s, 403(b)s, and other tax-advantaged accounts and somehow make sure that the low-basis underlying stocks get unloaded into those kinds of the accounts while at the same time letting shares with losses and no or minimal gains used in taxable accounts.
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Re: Heartbeats - The ETF Tax Dodge

Post by under_tha_radar » Fri Mar 29, 2019 7:03 pm

The short story here is the appreciated securities are transferred without creating a taxable event. SO, the benefactor eventually pays taxes when they sell but they don’t pay along the way (ie during the transfer).

Compare this to a mutual fund where managers run their own tax efficient practice but this particular arrow is not in the quiver.

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Re: Heartbeats - The ETF Tax Dodge

Post by SlowMovingInvestor » Fri Mar 29, 2019 7:06 pm

under_tha_radar wrote:
Fri Mar 29, 2019 7:03 pm
The short story here is the appreciated securities are transferred without creating a taxable event. SO, the benefactor eventually pays taxes when they sell but they don’t pay along the way (ie during the transfer).
I don't think so. The gains are washed out when the 'benefactor' gets the shares. I doubt even the most eager-to-please bank would take a big tax hit by buying shares that have a cost basis lower than their acquisition price.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by F150HD » Fri Mar 29, 2019 9:40 pm

super interesting article. So is this the 'secret sauce' that makes ETFs more tax efficient then a Fund?

Waiting for nisiprius to chime in with his bottle of beer analogy :D

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by HEDGEFUNDIE » Fri Mar 29, 2019 9:47 pm

Matt Levine once again dropping some knowledge:
To get rid of appreciated stocks—without selling them—the ETF will give them to a big investment bank in redemption for shares of the ETF. Usually the way in-kind redemption of ETF shares works is that the bank gives the ETF a bunch of ETF shares, and the ETF gives the bank back a complete representative sample of the shares in the ETF: The redemption turns the ETF shares into the underlying portfolio. But that is not a legal requirement, and the ETF and the bank can negotiate for some other redemption basket of stock. If the ETF owns some stocks that it wants to get rid of, it can give the bank only those stocks in redemption for its ETF shares. Instead of selling them and paying taxes, it hands them out to a shareholder as part of an in-kind redemption, and avoids taxes.

But this only works if the bank actually owns a lot of shares of the ETF, so that it can redeem them. That will not generally be the case. And so to make this work, the bank will buy a bunch of shares in the ETF—or rather, do a “create” transaction by handing the ETF a basket of the underlying stocks and getting back shares of the ETF—a few days before it needs to do the redemption. 6 The bank pumps stock—sometimes billions of dollars’ worth—into the ETF, only so that it can suck billions of dollars’ worth of different stock out of the ETF a couple of days later. Thus, “heartbeat.”
https://www.bloomberg.com/opinion/artic ... s-business

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by ThrustVectoring » Fri Mar 29, 2019 10:01 pm

An important thing to note about this: it does not avoid taxes as such, rather it merely defers them. It's the difference between having a share worth $100, and having a $1 capital gains payment and a share worth $99.
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Re: How ETFs use "Heartbeats" to wash-out gains

Post by stlutz » Fri Mar 29, 2019 10:02 pm

This was a nice response to the BBG piece:

https://www.etf.com/sections/blog/etfs- ... -advantage

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by LadyGeek » Fri Mar 29, 2019 10:13 pm

To put the above articles in context, it's important to understand how an ETF works. From the SEC: Mutual Funds and Exchange-Traded Funds (ETFs) – A Guide for Investors (underline is mine)
How ETFs Work

Like mutual funds, ETFs are SEC-registered investment companies that offer investors a way to pool their money in a fund that makes investments in stocks, bonds, other assets or some combination of these investments and, in return, to receive an interest in that investment pool. Unlike mutual funds, however, ETFs do not sell individual shares directly to, or redeem their individual shares directly from, retail investors. Instead, ETF shares are traded throughout the day on national stock exchanges and at market prices that may or may not be the same as the NAV of the shares.

ETF sponsors enter into contractual relationships with one or more Authorized Participants —financial institutions which are typically large broker-dealers. Typically, only Authorized Participants purchase and redeem shares directly from the ETF. In addition, they can do so only in large blocks (e.g., 50,000 ETF shares) commonly called creation units, and they typically “pay” for the creation units in an in-kind exchange with a group or basket of securities and other assets that generally mirrors the ETF’s portfolio.

Once an Authorized Participant receives the block of ETF shares, the Authorized Participant may sell the ETF shares in the secondary market to investors. An ETF share is trading at a premium when its market price is higher than the value of its underlying holdings. An ETF share is trading at a discount when its market price is lower than the value of its underlying holdings. A history of the end-of-day premiums and discounts that an ETF experiences—i.e., its NAV per share compared to its closing market price per share —can usually be found on the website of the ETF or its sponsor. Like a mutual fund, an ETF must calculate its NAV at least once every day.
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Re: Heartbeats - The ETF Tax Dodge

Post by AlphaLess » Fri Mar 29, 2019 10:55 pm

under_tha_radar wrote:
Fri Mar 29, 2019 5:51 pm
[Thread merged into here, see below. --admin LadyGeek]
Starting to make more sense why mutual funds report taxable events over ETFs.

“Imagine that a grocer got a tax deduction every time someone returned a box of cornflakes to his store. Heartbeats are when the grocer asks a friend to buy all the boxes and return them, just to pocket more deductions.“

https://www.bloomberg.com/graphics/2019 ... -save-big/
The grocer return analogy does not apply.

This is a clear application of an established law and specific lot identification.
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Re: How ETFs use "Heartbeats" to wash-out gains

Post by grabiner » Sun Mar 31, 2019 11:10 am

This is not even restricted to ETFs; it just isn't common with mutual funds. Vanguard reserves the right to redeem shares of its mutual funds in-kind rather than as cash, and I believe Vanguard Tax-Managed Small-Cap did that once with a large institutional investor.
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Re: How ETFs use "Heartbeats" to wash-out gains

Post by typical.investor » Sun Mar 31, 2019 11:24 am

HEDGEFUNDIE wrote:
Fri Mar 29, 2019 9:47 pm
Matt Levine once again dropping some knowledge:
To get rid of appreciated stocks—without selling them—the ETF will give them to a big investment bank in redemption for shares of the ETF. Usually the way in-kind redemption of ETF shares works is that the bank gives the ETF a bunch of ETF shares, and the ETF gives the bank back a complete representative sample of the shares in the ETF: The redemption turns the ETF shares into the underlying portfolio. But that is not a legal requirement, and the ETF and the bank can negotiate for some other redemption basket of stock. If the ETF owns some stocks that it wants to get rid of, it can give the bank only those stocks in redemption for its ETF shares. Instead of selling them and paying taxes, it hands them out to a shareholder as part of an in-kind redemption, and avoids taxes.

But this only works if the bank actually owns a lot of shares of the ETF, so that it can redeem them. That will not generally be the case. And so to make this work, the bank will buy a bunch of shares in the ETF—or rather, do a “create” transaction by handing the ETF a basket of the underlying stocks and getting back shares of the ETF—a few days before it needs to do the redemption. 6 The bank pumps stock—sometimes billions of dollars’ worth—into the ETF, only so that it can suck billions of dollars’ worth of different stock out of the ETF a couple of days later. Thus, “heartbeat.”
https://www.bloomberg.com/opinion/artic ... s-business
Interesting but I don’t understand.

How can the bank have billions of dollar worth of exposure for a couple days? I mean what if markets tanked that day ‘87 style?

Is the goodwill really worth the risk?

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by Theoretical » Sun Mar 31, 2019 7:12 pm

They would hedge with futures contracts to a near-net 0 exposure, more or less, while they have the holdings.

It’s harder for specialized or sector funds, but a perfect fit isn’t that crucial.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by retiringwhen » Sun Mar 31, 2019 7:58 pm

stlutz wrote:
Fri Mar 29, 2019 10:02 pm
This was a nice response to the BBG piece:

https://www.etf.com/sections/blog/etfs- ... -advantage
I agree, the author points out how the ETF model is really much more tax-fair to the retail investor thus putting the lie to much of the sinister tone of the original Bloomberg article.

He does try to explain why the banks may participate, but the story still seems weak. I am guessing by reading between the lines that what is really happening is that creation and redemption process between the ETF provider and the banks are likely NOT full baskets of stocks, but only the ones that the two parties wish to clear off their books (didn't realize that was legal). This leaves the idea that maybe the bank and the ETF provider are just essentially doing a private trade (of in-kind assets) that has tax side-benefits.

Additionally, many banks will have large funds that are probably mostly indexed, so they may have huge balance sheets full of these ETFs, so the exposure issue is less of a concern than may first appear.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by HEDGEFUNDIE » Sun Mar 31, 2019 8:00 pm

retiringwhen wrote:
Sun Mar 31, 2019 7:58 pm
stlutz wrote:
Fri Mar 29, 2019 10:02 pm
This was a nice response to the BBG piece:

https://www.etf.com/sections/blog/etfs- ... -advantage
I agree, the author points out how the ETF model is really much more tax-fair to the retail investor thus putting the lie to much of the sinister tone of the original Bloomberg article.

He does try to explain why the banks may participate, but the story still seems weak. I am guessing by reading between the lines that what is really happening is that creation and redemption process between the ETF provider and the banks are likely NOT full baskets of stocks, but only the ones that the two parties wish to clear off their books (didn't realize that was legal).This leaves the idea that maybe the bank and the ETF provider are just essentially doing a private trade (of in-kind assets) that has tax side-benefits.
This is exactly the point of the BB article and why its sinister tone is entirely appropriate.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by retiringwhen » Sun Mar 31, 2019 8:12 pm

HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:00 pm
retiringwhen wrote:
Sun Mar 31, 2019 7:58 pm
stlutz wrote:
Fri Mar 29, 2019 10:02 pm
This was a nice response to the BBG piece:

https://www.etf.com/sections/blog/etfs- ... -advantage
I agree, the author points out how the ETF model is really much more tax-fair to the retail investor thus putting the lie to much of the sinister tone of the original Bloomberg article.

He does try to explain why the banks may participate, but the story still seems weak. I am guessing by reading between the lines that what is really happening is that creation and redemption process between the ETF provider and the banks are likely NOT full baskets of stocks, but only the ones that the two parties wish to clear off their books (didn't realize that was legal).This leaves the idea that maybe the bank and the ETF provider are just essentially doing a private trade (of in-kind assets) that has tax side-benefits.
This is exactly the point of the BB article and why its sinister tone is entirely appropriate.
I disagree, if VTI has 1000 shares of BRK.B to get rid of and needs 10,000 shares of Apple and UBS is willing to be on the other side of that trade, what is sinister about that? There are private transactions all the time between institutional participants in the market all the time?...

Here is justification for why Vanguard was doing it last year to prepare for a major change in Sectors by their index providers: https://www.etf.com/sections/features-a ... nopaging=1

This article does point out that there is a cost to the trading that must be considered, but at least in this case the trades had to happen anyway, so doing them in a tax-efficient manner only seems prudent/responsible.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by HEDGEFUNDIE » Sun Mar 31, 2019 8:15 pm

retiringwhen wrote:
Sun Mar 31, 2019 8:12 pm
HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:00 pm
retiringwhen wrote:
Sun Mar 31, 2019 7:58 pm
stlutz wrote:
Fri Mar 29, 2019 10:02 pm
This was a nice response to the BBG piece:

https://www.etf.com/sections/blog/etfs- ... -advantage
I agree, the author points out how the ETF model is really much more tax-fair to the retail investor thus putting the lie to much of the sinister tone of the original Bloomberg article.

He does try to explain why the banks may participate, but the story still seems weak. I am guessing by reading between the lines that what is really happening is that creation and redemption process between the ETF provider and the banks are likely NOT full baskets of stocks, but only the ones that the two parties wish to clear off their books (didn't realize that was legal).This leaves the idea that maybe the bank and the ETF provider are just essentially doing a private trade (of in-kind assets) that has tax side-benefits.
This is exactly the point of the BB article and why its sinister tone is entirely appropriate.
I disagree, if VTI has 1000 shares of BRK.B to get rid of and needs 10,000 shares of Apple and UBS is willing to be on the other side of that trade, what is sinister about that? There are private transactions all the time between institutional participants in the market all the time?...

Here is justification for why Vanguard was doing it last year to prepare for a major change in Sectors by their index providers: https://www.etf.com/sections/features-a ... nopaging=1

This article does point out that there is a cost to the trading that must be considered, but at least in this case the trades had to happen anyway, so doing them in a tax-efficient manner only seems prudent/responsible.
Other than the fact that it’s [legal, loophole-enabled] tax evasion, nothing sinister at all...

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by DonIce » Sun Mar 31, 2019 8:19 pm

I'm not understanding something here. If the ETF hands off shares that have a high tax liability (due to low basis?) and receives shares that have a low tax liability in exchange, isn't the tax benefit that the ETF receives counterbalanced by a tax liability that the bank receives? Similarly, why would a withdrawing investor agree to receive shares with the highest tax liability, rather than a tax liability that is representative of the average in the ETF?

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by retiringwhen » Sun Mar 31, 2019 8:20 pm

HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:15 pm
Other than the fact that it’s [legal, loophole-enabled] tax evasion, nothing sinister at all...
Performing a legal activity is by definition NOT tax evasion.

People do all kinds of things that other people think are wrong from a tax-theory perspective every day without any concern of being charged with doing something sinister. Let's say, Backdoor Roth Conversions, Tax-Loss Harvesting between different mutual funds that track different but functionally equivalent indexes, just to name two.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by retiringwhen » Sun Mar 31, 2019 8:22 pm

DonIce wrote:
Sun Mar 31, 2019 8:19 pm
I'm not understanding something here. If the ETF hands off shares that have a high tax liability (due to low basis?) and receives shares that have a low tax liability in exchange, isn't the tax benefit that the ETF receives counterbalanced by a tax liability that the bank receives? Similarly, why would a withdrawing investor agree to receive shares with the highest tax liability, rather than a tax liability that is representative of the average in the ETF?
because the receiving bank does not inherit the cost-basis, it is set at the transaction price like in any other transaction. That is the bizarre part of the rule, the authorized participant relationship has this odd side effect.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by SlowMovingInvestor » Sun Mar 31, 2019 8:30 pm

retiringwhen wrote:
Sun Mar 31, 2019 8:20 pm
HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:15 pm
Other than the fact that it’s [legal, loophole-enabled] tax evasion, nothing sinister at all...
Performing a legal activity is by definition NOT tax evasion.
Evasion is a strong term, but 'tax avoidance via a sham transaction' strikes me as a reasonably way to describe this action when there isn't an underlying business reason (there can be legit reasons, and some are mentioned in the article).

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by HEDGEFUNDIE » Sun Mar 31, 2019 8:32 pm

SlowMovingInvestor wrote:
Sun Mar 31, 2019 8:30 pm
retiringwhen wrote:
Sun Mar 31, 2019 8:20 pm
HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:15 pm
Other than the fact that it’s [legal, loophole-enabled] tax evasion, nothing sinister at all...
Performing a legal activity is by definition NOT tax evasion.
Evasion is a strong term, but 'tax avoidance via a sham transaction' strikes me as a reasonably way to describe this action when there isn't an underlying business reason (there can be legit reasons, and some are mentioned in the article).
+1.

If I own Apple shares directly, and they appreciate, and I need to sell them, I need to pay capital gains taxes. Same if I own those shares through a mutual fund.

But an ETF can conveniently wash those gains away through a “heartbeat” transaction.

That is the point of the article, and it’s a really big deal.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by SlowMovingInvestor » Sun Mar 31, 2019 8:38 pm

retiringwhen wrote:
Sun Mar 31, 2019 8:12 pm

I disagree, if VTI has 1000 shares of BRK.B to get rid of and needs 10,000 shares of Apple and UBS is willing to be on the other side of that trade, what is sinister about that? There are private transactions all the time between institutional participants in the market all the time?...

Here is justification for why Vanguard was doing it last year to prepare for a major change in Sectors by their index providers: https://www.etf.com/sections/features-a ... nopaging=1
The reasons you mention are legit and one was even mentioned in the article. But I think the article also says that on occasion the only motivation is tax avoidance, not a legitimate busness reason.

It seems to me the way it works is like this: A bank buys ETFs, then takes a basket of stocks from a market participant for the ETF shares, then after 1-2 days submits the basket and asks for ETFs. And hedges risk via futures. The net effect is that all the gain in the stocks is washed out.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by typical.investor » Sun Mar 31, 2019 8:44 pm

SlowMovingInvestor wrote:
Sun Mar 31, 2019 8:30 pm
retiringwhen wrote:
Sun Mar 31, 2019 8:20 pm
HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:15 pm
Other than the fact that it’s [legal, loophole-enabled] tax evasion, nothing sinister at all...
Performing a legal activity is by definition NOT tax evasion.
Evasion is a strong term, but 'tax avoidance via a sham transaction' strikes me as a reasonably way to describe this action when there isn't an underlying business reason (there can be legit reasons, and some are mentioned in the article).
I disagree.

There is an extremely legitimate reason for doing this. It's called fairness and is a principle to which I think the markets should aspire. I would trust you agree.

As an investor, why should I be liable for capital gains incurred by other investors?

Read the NADIG article linked above.
And let’s be absolutely clear: ETF investors are paying taxes, and doing so completely fairly. They’re paying when they sell, not when other people sell, and not because the portfolio rebalanced months before they bought in.
I think the 'tax avoidance via a sham transaction' label is unwarranted and ignorant of the actual fairness of the process.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by DonIce » Sun Mar 31, 2019 8:48 pm

HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:32 pm
If I own Apple shares directly, and they appreciate, and I need to sell them, I need to pay capital gains taxes. Same if I own those shares through a mutual fund.

But an ETF can conveniently wash those gains away through a “heartbeat” transaction.

That is the point of the article, and it’s a really big deal.
If you own shares of an ETF, you pay capital gains tax when you sell those shares. If ETFs didn't do this, you'd be constantly paying capital gains as a result of other people buying and selling shares of the ETF.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by HEDGEFUNDIE » Sun Mar 31, 2019 8:52 pm

DonIce wrote:
Sun Mar 31, 2019 8:48 pm
HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:32 pm
If I own Apple shares directly, and they appreciate, and I need to sell them, I need to pay capital gains taxes. Same if I own those shares through a mutual fund.

But an ETF can conveniently wash those gains away through a “heartbeat” transaction.

That is the point of the article, and it’s a really big deal.
If you own shares of an ETF, you pay capital gains tax when you sell those shares. If ETFs didn't do this, you'd be constantly paying capital gains as a result of other people buying and selling shares of the ETF.
Which is exactly what mutual funds have to do.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by DonIce » Sun Mar 31, 2019 8:57 pm

HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:52 pm
Which is exactly what mutual funds have to do.
So? ETFs are different things than mutual funds. MLPs are taxed differently, ETFs that hold futures are taxed differently, REITs are taxed differently, etc. All kinds of different investment vehicles have subtly different tax structures and strategies. What matters is if they are taxed fairly. And as long as an investor in an ETF pays capital gains on all the appreciation that happens from when they buy a share to when they sell a share, it seems to me that it is indeed taxed fairly. And if it also achieves greater simplicity for the investor (by not having to report capital gains that the investor didn't actually realize on a yearly basis) then all the better.

Edit: Also someone posted above that some mutual funds do this also.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by typical.investor » Sun Mar 31, 2019 9:00 pm

HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:52 pm
DonIce wrote:
Sun Mar 31, 2019 8:48 pm
HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:32 pm
If I own Apple shares directly, and they appreciate, and I need to sell them, I need to pay capital gains taxes. Same if I own those shares through a mutual fund.

But an ETF can conveniently wash those gains away through a “heartbeat” transaction.

That is the point of the article, and it’s a really big deal.
If you own shares of an ETF, you pay capital gains tax when you sell those shares. If ETFs didn't do this, you'd be constantly paying capital gains as a result of other people buying and selling shares of the ETF.
Which is exactly what mutual funds have to do.
Which simply makes mutual funds (except dual share class which has ETF properties) poor investment vehicles due to the capricious treatment of tax liability. Unless of course they are in tax deferred.

In any case, many expats are taxed on US tax sheltered accounts. For those expats, I would recommend ETFs to avoid the situation of having to pay a foreign government taxes in your US retirement account because someone else changed their holdings.

And actually, expats are legally barred from buying US mutual funds. I see no reason why ETFs shouldn't have a different tax treatment. They are different vehicles legally.
Last edited by typical.investor on Sun Mar 31, 2019 9:27 pm, edited 1 time in total.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by typical.investor » Sun Mar 31, 2019 9:02 pm

HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:32 pm
If I own Apple shares directly, and they appreciate, and I need to sell them, I need to pay capital gains taxes. Same if I own those shares through a mutual fund.

But an ETF can conveniently wash those gains away through a “heartbeat” transaction.

That is the point of the article, and it’s a really big deal.
Show me how an investor can buy Apple via an ETF and not pay taxes on capital gains when they sell. Please. I'm waiting. Tax advantaged accounts aside, you simply can't.
DonIce wrote:
Sun Mar 31, 2019 8:48 pm
If you own shares of an ETF, you pay capital gains tax when you sell those shares. If ETFs didn't do this, you'd be constantly paying capital gains as a result of other people buying and selling shares of the ETF.
I completely agree with this view.
Last edited by typical.investor on Sun Mar 31, 2019 9:09 pm, edited 1 time in total.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by DonIce » Sun Mar 31, 2019 9:04 pm

typical.investor wrote:
Sun Mar 31, 2019 9:02 pm
Really! Show me how an investor can buy Apple via an ETF and not pay taxes on capital gains when they sell. Please. I'm waiting. Tax advantaged accounts aside, you simply can't.
Hmm, did you mean to respond to someone else? I did not make such a claim.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by typical.investor » Sun Mar 31, 2019 9:10 pm

DonIce wrote:
Sun Mar 31, 2019 9:04 pm
typical.investor wrote:
Sun Mar 31, 2019 9:02 pm
Really! Show me how an investor can buy Apple via an ETF and not pay taxes on capital gains when they sell. Please. I'm waiting. Tax advantaged accounts aside, you simply can't.
Hmm, did you mean to respond to someone else? I did not make such a claim.
The really agrees with your point.

The challenge is to the comment you responded.

I redid the original.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by HEDGEFUNDIE » Sun Mar 31, 2019 9:10 pm

typical.investor wrote:
Sun Mar 31, 2019 9:02 pm
DonIce wrote:
Sun Mar 31, 2019 8:48 pm
HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:32 pm
If I own Apple shares directly, and they appreciate, and I need to sell them, I need to pay capital gains taxes. Same if I own those shares through a mutual fund.

But an ETF can conveniently wash those gains away through a “heartbeat” transaction.

That is the point of the article, and it’s a really big deal.
If you own shares of an ETF, you pay capital gains tax when you sell those shares. If ETFs didn't do this, you'd be constantly paying capital gains as a result of other people buying and selling shares of the ETF.
Really! Show me how an investor can buy Apple via an ETF and not pay taxes on capital gains when they sell. Please. I'm waiting. Tax advantaged accounts aside, you simply can't.
This is easier to conceptualize when you consider actively managed ETFs that pick stocks and have high turnover. The tax drag of the turnover can be mitigated with the heartbeat transaction.

Yes, as an individual investor, you do pay cap gains on the ETF when you sell the ETF, and that is fair.

But you should have also been paying the cap gains on the individual holdings that the active manager jumped out of, as he/she jumped out of them.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by typical.investor » Sun Mar 31, 2019 10:06 pm

HEDGEFUNDIE wrote:
Sun Mar 31, 2019 9:10 pm
typical.investor wrote:
Sun Mar 31, 2019 9:02 pm
DonIce wrote:
Sun Mar 31, 2019 8:48 pm
HEDGEFUNDIE wrote:
Sun Mar 31, 2019 8:32 pm
If I own Apple shares directly, and they appreciate, and I need to sell them, I need to pay capital gains taxes. Same if I own those shares through a mutual fund.

But an ETF can conveniently wash those gains away through a “heartbeat” transaction.

That is the point of the article, and it’s a really big deal.
If you own shares of an ETF, you pay capital gains tax when you sell those shares. If ETFs didn't do this, you'd be constantly paying capital gains as a result of other people buying and selling shares of the ETF.
Really! Show me how an investor can buy Apple via an ETF and not pay taxes on capital gains when they sell. Please. I'm waiting. Tax advantaged accounts aside, you simply can't.
This is easier to conceptualize when you consider actively managed ETFs that pick stocks and have high turnover. The tax drag of the turnover can be mitigated with the heartbeat transaction.

Yes, as an individual investor, you do pay cap gains on the ETF when you sell the ETF, and that is fair.

But you should have also been paying the cap gains on the individual holdings that the active manager jumped out of, as he/she jumped out of them.
I'm not personally going to say what taxation should be. I think that violates forum policy.

I will point out the researched fact that access to tax sheltered accounts varies by the individual.

For instance, some research shows "40 percent of full-time private sector workers in the U.S. lack access to an employer-based retirement saving plan." (2016 Pew).

This means that currently with mutual funds that changes in those holdings by some investors means others who don't have access to tax sheltered account have to actually pay the capital gains of inventors who wouldn't have to pay them anyway.

As for the assertion that actively managed mutual funds are getting a free ride, it doesn't seem like a huge problem -probably because of daily disclosure requirements:
The first actively managed ETF came to market in 2008, but 100+ funds later, active management in ETFs has struggled to get much traction in the equity space. Out of more than $2 trillion in U.S.-listed ETF assets as of 2015, less than 1% was tied to actively managed funds.
Under current US law, there are US investors who don't have access to tax sheltered accounts at all. The ETF vehicle at least lets those investors only pay capital gains taxes on their sales and not on someone else's sales.

My financial advice is for those investors (expats whose US retirement accounts are taxed by overseas governments and whose foreign retirement programs are not recognized by the US as tax sheltered) to use ETFs for as long as they are available. Otherwise you will be paying taxes when investors who have tax sheltered accounts freely change positions because it has no impact for them to do so.

Simply stated, everyone could choose to use an actively managed ETF if they wanted. Not everyone has the same access to tax sheltered accounts (even for non-expats in the US).

I'll say it again, under currently tax law, whether right or wrong, ETFs enable a category of investors to avoid paying capital gains on sales by other investors who wouldn't have to pay anything anyway. This is simply a fact.

And everyone, everyone has access to ETFs. So explain again why they are an unfair "tax dodge" if you would please.
Last edited by typical.investor on Sun Mar 31, 2019 10:45 pm, edited 2 times in total.

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Re: How ETFs use "Heartbeats" to wash-out gains

Post by ThrustVectoring » Sun Mar 31, 2019 10:41 pm

typical.investor wrote:
Sun Mar 31, 2019 11:24 am
HEDGEFUNDIE wrote:
Fri Mar 29, 2019 9:47 pm
Matt Levine once again dropping some knowledge:
To get rid of appreciated stocks—without selling them—the ETF will give them to a big investment bank in redemption for shares of the ETF. Usually the way in-kind redemption of ETF shares works is that the bank gives the ETF a bunch of ETF shares, and the ETF gives the bank back a complete representative sample of the shares in the ETF: The redemption turns the ETF shares into the underlying portfolio. But that is not a legal requirement, and the ETF and the bank can negotiate for some other redemption basket of stock. If the ETF owns some stocks that it wants to get rid of, it can give the bank only those stocks in redemption for its ETF shares. Instead of selling them and paying taxes, it hands them out to a shareholder as part of an in-kind redemption, and avoids taxes.

But this only works if the bank actually owns a lot of shares of the ETF, so that it can redeem them. That will not generally be the case. And so to make this work, the bank will buy a bunch of shares in the ETF—or rather, do a “create” transaction by handing the ETF a basket of the underlying stocks and getting back shares of the ETF—a few days before it needs to do the redemption. 6 The bank pumps stock—sometimes billions of dollars’ worth—into the ETF, only so that it can suck billions of dollars’ worth of different stock out of the ETF a couple of days later. Thus, “heartbeat.”
https://www.bloomberg.com/opinion/artic ... s-business
Interesting but I don’t understand.

How can the bank have billions of dollar worth of exposure for a couple days? I mean what if markets tanked that day ‘87 style?

Is the goodwill really worth the risk?
The banks will have a hedged position here, shorting either the underlying stocks or the ETF itself, depending on the trading price of the ETF compared to the underlying assets. The only real risk involved is that the market will unexpectedly close, forcing the bank to hold short positions that they want to liquidate.
Current portfolio: 60% VTI / 40% VXUS

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Bloomberg--Vanguard Patented a Way to Avoid Taxes on Mutual Funds

Post by MFInvestor » Wed May 01, 2019 6:55 am

[Thread merged into here, see below. --admin LadyGeek]

Bloomberg article 5/1/2019

"Vanguard Patented a Way to Avoid Taxes on Mutual Funds"


Interesting article. My favorite phrase "Although the dialysis machine has attracted little notice outside Vanguard, it has been controversial within the firm, according to two people with knowledge of the matter."



https://www.bloomberg.com/graphics/2019 ... tax-dodge/

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.

This astounding success gives Vanguard funds an edge over competitors. Yet the world’s second-largest asset manager has avoided drawing attention to it. Top executives at the Malvern, Pennsylvania-based firm don’t want U.S. policymakers looking too closely at how they’re doing it, according to a former insider.

But a review of financial statements and trading data shows that Vanguard relies substantially on so-called heartbeat trades, which wash away taxes by rapidly pumping stocks in and out of a fund. These controversial transactions are common in exchange-traded funds—a record $98 billion of them took place last year, according to data compiled by Bloomberg News—but only Vanguard has used them routinely to also benefit mutual funds.
Here’s how it works: Vanguard attaches a more tax-efficient ETF to an existing mutual fund. Then the ETF siphons appreciated stocks out of the mutual fund without incurring taxes, often using heartbeat trades. Robert Gordon, who has written about the concept and is president of Twenty-First Securities Corp. in New York, calls it a tax “dialysis machine.”

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Re: Bloomberg--Vanguard Patented a Way to Avoid Taxes on Mutual Funds

Post by 3-20Characters » Wed May 01, 2019 6:59 am

I hope that this sort of reporting doesn’t attract congressional attention/action. I much prefer holding funds over ETFs in taxable (and tax advantaged).

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Re: Bloomberg--Vanguard Patented a Way to Avoid Taxes on Mutual Funds

Post by RadAudit » Wed May 01, 2019 7:17 am

3-20Characters wrote:
Wed May 01, 2019 6:59 am
I hope that this sort of reporting doesn’t attract congressional attention/action.
MFInvestor wrote:
Wed May 01, 2019 6:55 am
Robert Gordon, who has written about the concept and is president of Twenty-First Securities Corp. in New York, calls it a tax “dialysis machine.”
I can't imagine that someone in government doesn't know about it already; but, JIC they missed it and are too lazy to Google it. - http://www.twenty-first.com/pdf/On_Wall ... 9_2016.pdf

Of course you do have to read a little bit because it is easy to miss - I.R.C. § 852(b)(6) Section 311(b) Not To Apply To Certain Distributions — Section 311(b) shall not apply to any distribution by a regulated investment company to which this part applies, if such distribution is in redemption of its stock upon the demand of the shareholder.
Last edited by RadAudit on Wed May 01, 2019 7:54 am, edited 3 times in total.
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Re: Bloomberg--Vanguard Patented a Way to Avoid Taxes on Mutual Funds

Post by Maid of the Mist » Wed May 01, 2019 7:20 am

I don’t completely understand. Do the capital gains just go away? How will these capital gains show up eventually? Will they hit the etf shareholder someday down the road?

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Re: Bloomberg--Vanguard Patented a Way to Avoid Taxes on Mutual Funds

Post by Maid of the Mist » Wed May 01, 2019 7:23 am

Never mind. The prior article explains it and it is fascinating.

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Re: Bloomberg--Vanguard Patented a Way to Avoid Taxes on Mutual Funds

Post by JoMoney » Wed May 01, 2019 7:52 am

Is anyone able to decode this statement? How is this bad for "confidence in capital markets"?
I can understand other fund companies not being happy with Vanguard's advantages, but how is this at all bad for the customers?
...Mario Gabelli, founder of mutual fund manager Gamco Investors Inc., said he’s long called for ending ETFs’ tax advantage over mutual funds. Vanguard may have found a way to level the playing field by using heartbeats, he said, but he’s not tempted to copy it.

“You’re going against the intent of the system and finding ways to manipulate it,” Gabelli said. “It’s not good for confidence in the capital markets, and shame on Vanguard for doing it.”
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: Bloomberg--Vanguard Patented a Way to Avoid Taxes on Mutual Funds

Post by RadAudit » Wed May 01, 2019 7:57 am

JoMoney wrote:
Wed May 01, 2019 7:52 am
Is anyone able to decode this statement?
Just a guess. It's Wall Street-ese for "I didn't think of it first."

It's part of the long debate on tax avoidance vs. tax evasion. I hold with the idea you are only required to pay what you have to pay. The IRS will fix this when the it becomes a big enough problem to someone. According to the article that ought to be about 2023 when VG's patent runs out - if not before.
FI is the best revenge. LBYM. Invest the rest. Stay the course. - PS: The cavalry isn't coming, kids. You are on your own.

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Re: Bloomberg--Vanguard Patented a Way to Avoid Taxes on Mutual Funds

Post by Tdubs » Wed May 01, 2019 8:05 am

Dang, I was going to post this. BH has always discussed this Vanguard advantage. Now I understand it.

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Re: Bloomberg--Vanguard Patented a Way to Avoid Taxes on Mutual Funds

Post by Whakamole » Wed May 01, 2019 8:14 am

JoMoney wrote:
Wed May 01, 2019 7:52 am
Is anyone able to decode this statement? How is this bad for "confidence in capital markets"?
I can understand other fund companies not being happy with Vanguard's advantages, but how is this at all bad for the customers?
...Mario Gabelli, founder of mutual fund manager Gamco Investors Inc., said he’s long called for ending ETFs’ tax advantage over mutual funds. Vanguard may have found a way to level the playing field by using heartbeats, he said, but he’s not tempted to copy it.

“You’re going against the intent of the system and finding ways to manipulate it,” Gabelli said. “It’s not good for confidence in the capital markets, and shame on Vanguard for doing it.”
Gabelli is the last person who should be saying "shame" on anyone.

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Re: Bloomberg--Vanguard Patented a Way to Avoid Taxes on Mutual Funds

Post by 3-20Characters » Wed May 01, 2019 9:04 am

RadAudit wrote:
Wed May 01, 2019 7:17 am
3-20Characters wrote:
Wed May 01, 2019 6:59 am
I hope that this sort of reporting doesn’t attract congressional attention/action.
MFInvestor wrote:
Wed May 01, 2019 6:55 am
Robert Gordon, who has written about the concept and is president of Twenty-First Securities Corp. in New York, calls it a tax “dialysis machine.”
I can't imagine that someone in government doesn't know about it already; but, JIC they missed it and are too lazy to Google it. - http://www.twenty-first.com/pdf/On_Wall ... 9_2016.pdf

It’s not a matter of finding out. It’s a matter of it becoming public knowledge and then the spinning it into some fake outrage that the uninformed public focuses on. Politicians will generally support causes with little cost and lots of political upside. I don’t imagine vanguard having a bevy of lobbyists pleading their case, either.


Of course you do have to read a little bit because it is easy to miss - I.R.C. § 852(b)(6) Section 311(b) Not To Apply To Certain Distributions — Section 311(b) shall not apply to any distribution by a regulated investment company to which this part applies, if such distribution is in redemption of its stock upon the demand of the shareholder.

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