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

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
User avatar
Vulcan
Posts: 923
Joined: Sat Apr 05, 2014 11:43 pm

Vanguard's Dialysis Machine

Post by Vulcan » Wed May 01, 2019 9:54 am

[merged this post and a reply into the existing thread - moderator prudent]

A detailed article on Bloomberg today on Vanguard'd patented MF/ETF fund structure.

Vanguard Patented a Way to Avoid Taxes on Mutual Funds
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.
...
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.”
If you torture the data long enough, it will confess to anything. ~Ronald Coase

The Wizard
Posts: 13355
Joined: Tue Mar 23, 2010 1:45 pm
Location: Reading, MA

Re: Vanguard's Dialysis Machine

Post by The Wizard » Wed May 01, 2019 10:04 am

Neato!
Attempted new signature...

Silence Dogood
Posts: 1060
Joined: Tue Feb 01, 2011 9:22 pm

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

Post by Silence Dogood » Wed May 01, 2019 11:16 am

This is a non-story.

Vanguard has had this patent now for nearly two decades and as far as we know (and there in no reason to speculate otherwise) the IRS has never deemed it inappropriate.

Also, why did this article use Monsanto (a controversial company) as an example when they could have just as easily chosen a less controversial company? I'm guessing this was to generate more ad-revenue.

Vanguard is not a perfect company and there is plenty they could improve upon, but this is not one of them.

Let's stop giving this hit piece any more clicks.

talzara
Posts: 791
Joined: Thu Feb 12, 2009 7:40 pm

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

Post by talzara » Wed May 01, 2019 11:28 am

The article shows pre-ETF capital gains distributions of 1-2%, but the graph is for all Vanguard funds. The Small-Cap Index Fund has to realize a capital gain whenever a stock is promoted to Mid-Cap. The Total Stock Market Fund holds the whole market. It only has to sell a stock if it gets delisted, which is done at a loss.

Net shareholder redemptions can be solved by charging a redemption fee. Investors could buy mutual fund shares, but they would have to convert to ETFs to redeem. According to Gus Sauter, Vanguard's ETF shares were originally invented to help with redemptions: https://bogleheads.podbean.com/e/episod ... ick-ferri/ (Start at 23:47)

There would still be mergers and acquisitions, but how many M&A deals close with cash instead of stock? There are no realized capital gains when you receive stock in the merged company. It's a non-taxable transaction.

afan
Posts: 4309
Joined: Sun Jul 25, 2010 4:01 pm

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

Post by afan » Wed May 01, 2019 11:48 am

I have long known about the tax advantages of the etf structure and that making it a share class of the mutual funds spread those benefits to mutual fund investors. I never realized one could trade simply to unload the taxable gains. A great idea! Well worth the next to nothing one pays Vanguard to invest in VTI.

I can imagine an attempt to prevent these trades but it sounds like it would get complicated quickly. And that it might generate a lot of objections form the millions of people who benefit.

I will miss them if they are gone, but hard to imagine that making me ever sell my VTI.
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama

User avatar
Barry Barnitz
Wiki Admin
Posts: 3128
Joined: Mon Feb 19, 2007 10:42 pm
Contact:

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

Post by Barry Barnitz » Wed May 01, 2019 12:30 pm

Here are some articles from ETF.com dealing with "heartbeat" trading: regards,
Additional administrative tasks: Financial Page affiliate blog; finiki the Canadian wiki; The Bogle Center for Financial Literacy site; Wiki Bogleheads® España.

talzara
Posts: 791
Joined: Thu Feb 12, 2009 7:40 pm

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

Post by talzara » Wed May 01, 2019 12:38 pm

There's been discussion on Bogleheads about why other companies haven't licensed Vanguard's ETF patent. It turns out that USAA licensed the patent but never used it:
Vanguard has discussed licensing its hybrid ETF-mutual fund design to other firms, but no deal has come to fruition, according to people with knowledge of the talks. Those that have expressed interest included both index followers and active stock-pickers. United Services Automobile Association licensed the patent but never used it, and Van Eck Associates Corp. once sought regulatory approval for a similar design. Spokesmen for USAA and Van Eck declined to comment.

https://www.bloomberg.com/graphics/2019 ... tax-dodge/
However, no other mutual fund company has as much money in index funds. They wouldn't benefit as much from a dual-share structure as Vanguard.

alex_686
Posts: 4826
Joined: Mon Feb 09, 2015 2:39 pm

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

Post by alex_686 » Wed May 01, 2019 12:46 pm

Maid of the Mist wrote:
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?
They just go away. Not delayed, they just go away. A portion, anyway.
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.”
So, what makes a good tax? Fairness, probably. You have a portfolio of stocks. Should the taxes on those stocks be different if you held them directly or if you held them indirectly via a mutual fund? No. Hence why mutual funds make distributions at the end of the year. Having worked the desk I can tell you it makes no economic sense. It only reason it is done is to generate tax reporting transactions.

Now, 2 things.

First, ETFs found a loophole around this via the Unit Creation Processes. Meaning that 2 identical portfolios will have a different rate of taxation if it is a ETF or a mutual fund. I think this is unfair and that the tax code should be harmonized so the tax drag is the same regardless of the type of wrapper around the portfolio. My opinion, which is similar to the author's.

Next, Vanguard alone forged another loophole so a mutual fund can get the same tax benefit, then patent the loophole so they are the sole owner. Once again, why does Vanguard have this unfair advantage? I can see a limited time frame for this patent. The scuttlebutt is that Vanguard thinks it can keep this patent indefinitely. So, once again, unfair. At some point this loop hole should either be closed or opened to all.

User avatar
ResearchMed
Posts: 9177
Joined: Fri Dec 26, 2008 11:25 pm

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

Post by ResearchMed » Wed May 01, 2019 12:55 pm

RadAudit wrote:
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.
I'm still not quite clear how this exactly "works".

Is this tax "deferral" or tax "avoidance"?
That is, does it actually eliminate taxes on some shares, or does it simply cause the taxes to be paid later?

We don't do tax loss harvesting, so I'm not sure if this analogy is accurate, but if it is, then... TLH "saves" someone taxes that year, but in some future year, those "taxes saved" plus taxes on any additional increase in value *will* end up needing to be accounted for.
[And if that person is now in a lower tax bracket, then yes, there would be a tax savings, meaning less tax paid overall. But ceteris paribus with respect to tax rates, those taxes are deferred, not "saved" totally.]

My question here is less about TLH and more about the way Vanguard's "dialysis machine" works...

RM
This signature is a placebo. You are in the control group.

User avatar
jeffyscott
Posts: 8140
Joined: Tue Feb 27, 2007 9:12 am
Location: Wisconsin

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

Post by jeffyscott » Wed May 01, 2019 1:02 pm

ResearchMed wrote:
Wed May 01, 2019 12:55 pm
RadAudit wrote:
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.
I'm still not quite clear how this exactly "works".

Is this tax "deferral" or tax "avoidance"?
That is, does it actually eliminate taxes on some shares, or does it simply cause the taxes to be paid later?

We don't do tax loss harvesting, so I'm not sure if this analogy is accurate, but if it is, then... TLH "saves" someone taxes that year, but in some future year, those "taxes saved" plus taxes on any additional increase in value *will* end up needing to be accounted for.
[And if that person is now in a lower tax bracket, then yes, there would be a tax savings, meaning less tax paid overall. But ceteris paribus with respect to tax rates, those taxes are deferred, not "saved" totally.]

My question here is less about TLH and more about the way Vanguard's "dialysis machine" works...

RM
It just defers the taxes until you actually sell shares of the fund. Since you don't get capital gains distributions, your cost basis is not changed.

I was not sure how this actually worked before, I just knew the end result was no distributions. Apparently the fund can change it's cost basis on the shares of stock it owns by these trades, but your cost basis remains the same because that is based on what you paid for the fund and the fund is not required to distribute any cap gains because the redemption was done in kind.
Time is your friend; impulse is your enemy. - John C. Bogle

User avatar
dodecahedron
Posts: 4524
Joined: Tue Nov 12, 2013 12:28 pm

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

Post by dodecahedron » Wed May 01, 2019 1:13 pm

alex_686 wrote:
Wed May 01, 2019 12:46 pm
Maid of the Mist wrote:
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?
They just go away. Not delayed, they just go away. A portion, anyway.
From the point of view of the fund´s shareholders, the capital gains are just deferred. The gains do not go away as a result of Vanguard´s action. Without Vanguard´s ¨dialysis machine¨, fund shareholders who eventually sell their shares would have a higher cost basis and thus lower taxable capital gains down the road at the time they sell their shares. With the dialysis machine, they may have zero capital gains now but will have higher ones if and when they sell.

Of course, if a taxpayer never sells during their lifetime or donates shares to charity, all untaxed gains go away. But that is a conceptually separate issue. Vanguard´s dialysis machine does not in and of itself make any capital gains go away, it just delays the point at which they must be declared for tax purposes.

vu8
Posts: 353
Joined: Tue May 29, 2018 10:15 am
Location: Columbus, Ohio

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

Post by vu8 » Wed May 01, 2019 1:44 pm

Gadget wrote:
Wed May 01, 2019 1:33 pm
Such negative connotations in this article for something that works to every investor's advantage.
Well said. We gotta understand what kind of picture different media is trying to paint for their audience. In reality, I would say this brings investors huge advantages as they wouldn't have to worry about the annual distributions of capital gains, therefore increasing the tax efficiency of the mutual funds, helping the index investors saving a little bit more.

User avatar
beyou
Posts: 2737
Joined: Sat Feb 27, 2010 3:57 pm
Location: Northeastern US

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

Post by beyou » Wed May 01, 2019 1:55 pm

I read the article this morning. I work in the fund industry, and at one point worked for one of the major ETF providers.

From where I stand this article is old news and Vanguard has benefited now for many years from their foresight to build up the index mutual fund business. These funds already have a tax advantage of low turnover due to index strategy, later benefited from the shear size of the funds.
Inflows and outflows of cash to/from the funds can be offset to avoid selling shares at realized gains for fund withdrawals. This is a benefit of being a large fund, active or passive, ETF or open end. The advent of ETFs and Vanguard's foresight to make them shareclasses of existing funds was the real insight and advantage that only Vanguard could fully leverage. If you have large ETFs and large open end funds, treating them as one huge pool gives you more opportunities to match incoming/outgoing shareholder cash. Some ETF providers have large ETFs, others like Vanguard had large open end index funds, but only Vanguard has combined the together in such an efficient manner.

The idea of in-kind redemptions of stock is something many ETF providers can do to reduce taxes. But the ability to both have in-kind redemptions AND cross incoming/outgoing cash among a very large number of investors is a unique advantage of the size of Vanguard's funds. And there is a positive feedback loop, the more benefit, the more people buy their funds, and then even more tax benefit. Once you get the lead here it's tough to lose it.
The patent to combine ETF and open end funds as share classes of a single pool of assets was a idea that gives them time to develop such a huge advantage. When the patent expires, the lead will be so large wont matter much if others come out with small versions of the same structure, their costs will be much higher.

User avatar
Phineas J. Whoopee
Posts: 8575
Joined: Sun Dec 18, 2011 6:18 pm

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

Post by Phineas J. Whoopee » Wed May 01, 2019 1:59 pm

There's yesterday's news, and then there's the beginning of last decade's news. The Bloomberg story is an example of the latter.
PJW

lukestuckenhymer
Posts: 181
Joined: Wed May 30, 2018 11:53 am

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

Post by lukestuckenhymer » Wed May 01, 2019 2:57 pm

Some critics call these trades an abuse of the tax code
Some critics = Vanguard's competitors ?

The tone of the article clearly indicates which side of the argument they are on. Is Bloomberg hoping the Feds crack down? By targeting Vanguard, do they think they are crusaders against the evil tax dodgers of the world?

It's also a remarkable headline... It reads as if they have just patented it recently, not 18 years ago.

sarabayo
Posts: 314
Joined: Fri Jun 29, 2018 6:59 pm

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

Post by sarabayo » Wed May 01, 2019 3:31 pm

talzara wrote:
Wed May 01, 2019 12:38 pm
However, no other mutual fund company has as much money in index funds. They wouldn't benefit as much from a dual-share structure as Vanguard.
Why is this a benefit specifically to index mutual funds? Couldn't any mutual fund, including an active one, benefit from this strategy if it had an ETF share class?

User avatar
jeffyscott
Posts: 8140
Joined: Tue Feb 27, 2007 9:12 am
Location: Wisconsin

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

Post by jeffyscott » Wed May 01, 2019 3:35 pm

alex_686 wrote:
Wed May 01, 2019 2:04 pm
I will extend this.

The ETF loophole allows lower taxes in exchange for higher complexity. What does this extra complexity add? I would say it subtracts value. Because of this extra complexity, this loophole tends to benefit those who can afford the time and effort to exploit these loopholes, which tends to be the rich. The poor usually don't have the time or capacity to figure out that ETFs are the better choice than mutual funds.

I am for low taxes. Even more importantly, I am for simply parsimonious taxes. The thrust is not what the level of taxes should be, but why mutual funds and ETFs are taxed differently.
The poor, or actually about 80% of taxpayers, also get little benefit as they'd pay 0% on long-term cap gains anyway...so all a fund really needs to do for them is avoid distributing short term capital gains. In addition, if they have access to a 401K, 403b, or 457, most of them probably won't have a taxable account to begin with.

It's nice that for those of us having a preference for mutual funds that Vanguard came up with this one weird trick to make mutual funds as tax efficient as ETFs. Now at a cost of about 0.02% in extra expenses, though.
Time is your friend; impulse is your enemy. - John C. Bogle

stan1
Posts: 7346
Joined: Mon Oct 08, 2007 4:35 pm

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

Post by stan1 » Wed May 01, 2019 7:18 pm

jeffyscott wrote:
Wed May 01, 2019 1:02 pm
It just defers the taxes until you actually sell shares of the fund. Since you don't get capital gains distributions, your cost basis is not changed.
It becomes permanent non-taxable gains if the appreciated shares you never paid capital gains distributions on are left to your heirs and they get stepped up cost basis.

User avatar
LadyGeek
Site Admin
Posts: 56460
Joined: Sat Dec 20, 2008 5:34 pm
Location: Philadelphia
Contact:

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

Post by LadyGeek » Wed May 01, 2019 10:09 pm

This is a "no politics" forum. I removed several off-topic posts complaining about tax policy (the "fairness" of capital gains taxes, etc.). As a reminder, see: Non-actionable (Trolling) Topics
If readers can't do anything with the content of a topic other than argue about it, it does not belong here. Examples include:
  • US or world economic, political, tax, health care and climate policies
  • conspiracy theories of any type
  • discussions of the crimes, shortcomings or stupidity of other people, whether they be political figures, celebrities, CEOs, Fed chairmen, subprime mortgage borrowers, lottery winners, federal "bailout" recipients, poor people, rich people, etc. Of course, you are welcome to talk about the stupid financial things you have done.
Wiki To some, the glass is half full. To others, the glass is half empty. To an engineer, it's twice the size it needs to be.

User avatar
abuss368
Posts: 15165
Joined: Mon Aug 03, 2009 2:33 pm
Location: Where the water is warm, the drinks are cold, and I don't know the names of the players!

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

Post by abuss368 » Wed May 01, 2019 10:36 pm

Interesting. Thank you for sharing.
John C. Bogle: "Simplicity is the master key to financial success."

rks
Posts: 27
Joined: Fri Mar 21, 2014 1:54 pm

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

Post by rks » Wed May 01, 2019 11:11 pm

Can someone clarify if this tax advantage is only applicable to Vanguard ETFs? If someone has invested in Vanguard mutual fund, will they also avail the same advantage?

tj
Posts: 2535
Joined: Thu Dec 24, 2009 12:10 am

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

Post by tj » Thu May 02, 2019 1:57 am

rks wrote:
Wed May 01, 2019 11:11 pm
Can someone clarify if this tax advantage is only applicable to Vanguard ETFs? If someone has invested in Vanguard mutual fund, will they also avail the same advantage?

Did you read the article? :mrgreen: :oops:

typical.investor
Posts: 1115
Joined: Mon Jun 11, 2018 3:17 am

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

Post by typical.investor » Thu May 02, 2019 2:26 am

alex_686 wrote:
Wed May 01, 2019 12:46 pm

First, ETFs found a loophole around this via the Unit Creation Processes. Meaning that 2 identical portfolios will have a different rate of taxation if it is a ETF or a mutual fund. I think this is unfair and that the tax code should be harmonized so the tax drag is the same regardless of the type of wrapper around the portfolio. My opinion, which is similar to the author's.
Opinions aside, these "wrappers" as you call them are very distinct and separate legal vehicles. They simply aren't the same.

Use ETFs if you don't like how mutual funds are treated. Is it really all that difficult? Everyone surely can.

Mutual Funds on the other hand, due to their particular legal structure, are not available for purchase by many law abiding, tax paying and patriotic Americans. So while holders of Wellesley® Income Fund (VWINX) might complain that it doesn't function the same tax wise as an ETF, I say yeah I can't buy it because it of its tax structure which apparently means requiring purchasers to physically reside in the US.

Actually, I have news for you. 2 identical portfolios will continue to have different rates of taxation even if you make all wrappers the same. It is a reflection of the differing availability of tax sheltered vehicles.

CEFs, Mutual Funds, ETF are all wrappers. It's clear they are not the same vehicles though. Vanguard has a way to offer dual class shares. So what? Many companies have multiple share classes. Same wrapper but different cost to hold. Why isn't that on trial here too???
Last edited by typical.investor on Thu May 02, 2019 5:56 am, edited 1 time in total.

jpsc
Posts: 124
Joined: Sat Feb 10, 2018 11:05 pm

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

Post by jpsc » Thu May 02, 2019 4:11 am

If the mutual funds doesn't sell, it doesn't have to pay income tax - just like you and me
so they can only buy individual stock, not trade options or buy LP?

User avatar
F150HD
Posts: 2302
Joined: Fri Sep 18, 2015 7:49 pm

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

Post by F150HD » Thu May 02, 2019 5:46 am

this thread was posted a few weeks ago:

How ETFs use "Heartbeats" to wash-out gains

Pigeye Brewster
Posts: 381
Joined: Thu Oct 05, 2017 7:33 pm

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

Post by Pigeye Brewster » Thu May 02, 2019 8:33 am

Matt Levine, opinion blogger with Bloomberg, wrote about this yesterday.
https://www.bloomberg.com/opinion/artic ... uber-stock

His conclusions:
Those investors, I should disclose, include me: A lot of my money is in Vanguard index funds, including this one, and (basically out of laziness) none of it is in ETFs. So like a chump I expose myself to having to pay capital-gains taxes every year despite not selling any of my funds, but my friends at Vanguard are working hard to save me from that fate.

So I am biased, but I think this is fine? My reaction to the story about the heartbeats was, well, if you think ETFs should pay taxes, this is bad, and if you think “ETFs are mutual funds that don’t pay taxes,” it’s good, and if you are totally agnostic about whether ETFs should pay taxes then it does look a little tricky, sure. But in fact in our actual world the proposition that ETFs are, and should be, mutual funds that don’t pay taxes is really popular and widely accepted: A lot of middle-class people love investing in ETFs and not paying taxes until they sell their shares, and politicians and regulators seem pretty happy to let them do it. It is also quite reasonable: People who buy ETFs pay taxes on their gains when they sell the ETFs and actually realize the gains, which feels like the right time to pay taxes, whereas people who buy mutual funds have to pay capital gains taxes at random times that have nothing to do with their own investment decisions or cash flows. From that perspective, the heartbeat trades are not an evil tax dodge but just a sensible mechanical use of the rules to achieve the logical result that everyone wants.

If you believe that, then Vanguard is just taking the logical next step: If “mutual funds that don’t pay taxes” are a widely accepted superior product, then why not just use the same mechanical procedure to make sure that your other mutual funds don’t pay taxes? Once you accept that it’s good for some kinds of mutual funds to defer capital gains taxes, then it’s only fair to let other kinds of mutual funds do the same thing. Really Vanguard is just rationalizing the tax system. My only complaint is that Vanguard has patented this method, so nobody else can immunize a mutual fund from taxes by bolting on an ETF; as a Vanguard customer I’m fine with that personally but it does undercut the fairness argument. Fortunately Vanguard’s patent is “valid until 2023,” so soon enough no mutual funds will pay taxes and the world will make sense.

talzara
Posts: 791
Joined: Thu Feb 12, 2009 7:40 pm

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

Post by talzara » Thu May 02, 2019 11:07 am

sarabayo wrote:
Wed May 01, 2019 3:31 pm
Why is this a benefit specifically to index mutual funds? Couldn't any mutual fund, including an active one, benefit from this strategy if it had an ETF share class?
Any mutual fund can benefit from the dual-class structure.

However, an actively-managed fund would have to use an opaque ETF to avoid front-running. Opaque active ETFs have been unpopular with investors: https://www.bloomberg.com/opinion/artic ... don-t-want

sarabayo
Posts: 314
Joined: Fri Jun 29, 2018 6:59 pm

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

Post by sarabayo » Thu May 02, 2019 4:33 pm

talzara wrote:
Thu May 02, 2019 11:07 am
sarabayo wrote:
Wed May 01, 2019 3:31 pm
Why is this a benefit specifically to index mutual funds? Couldn't any mutual fund, including an active one, benefit from this strategy if it had an ETF share class?
Any mutual fund can benefit from the dual-class structure.

However, an actively-managed fund would have to use an opaque ETF to avoid front-running. Opaque active ETFs have been unpopular with investors: https://www.bloomberg.com/opinion/artic ... don-t-want
Thanks, that makes sense. (By the way, the article you linked is paywalled.)

Elena
Posts: 268
Joined: Mon Nov 21, 2016 5:42 pm

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

Post by Elena » Thu May 02, 2019 5:06 pm

alex_686 wrote:
Wed May 01, 2019 12:46 pm
Maid of the Mist wrote:
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?
They just go away. Not delayed, they just go away. A portion, anyway.
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.”
So, what makes a good tax? Fairness, probably. You have a portfolio of stocks. Should the taxes on those stocks be different if you held them directly or if you held them indirectly via a mutual fund? No. Hence why mutual funds make distributions at the end of the year. Having worked the desk I can tell you it makes no economic sense. It only reason it is done is to generate tax reporting transactions.

Now, 2 things.

First, ETFs found a loophole around this via the Unit Creation Processes. Meaning that 2 identical portfolios will have a different rate of taxation if it is a ETF or a mutual fund. I think this is unfair and that the tax code should be harmonized so the tax drag is the same regardless of the type of wrapper around the portfolio. My opinion, which is similar to the author's.

Next, Vanguard alone forged another loophole so a mutual fund can get the same tax benefit, then patent the loophole so they are the sole owner. Once again, why does Vanguard have this unfair advantage? I can see a limited time frame for this patent. The scuttlebutt is that Vanguard thinks it can keep this patent indefinitely. So, once again, unfair. At some point this loop hole should either be closed or opened to all.
I recall the patent was about to expire. It was mentioned in one of Rick Ferri's podcasts, I forget which one. Fidelity approached Vanguard to pay for it, then discarded the idea. Just from memory.

User avatar
asset_chaos
Posts: 1594
Joined: Tue Feb 27, 2007 6:13 pm
Location: Melbourne

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

Post by asset_chaos » Thu May 02, 2019 7:33 pm

Never forget that newspapers and television have so many column-inches and so many minutes of airtime to fill every day. (Update the units for the digital age as you please.) This might have been a story in 2004 when vipers were launched, but today it seems like just so much recycled news filler.
Regards, | | Guy

NYCwriter
Posts: 256
Joined: Thu Sep 17, 2015 12:46 am

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

Post by NYCwriter » Sat May 04, 2019 8:56 am

Another article, but on Vanguard's "dialysis machine" to avoid taxes

https://www.bloomberg.com/graphics/2019 ... endreading

User avatar
AtlasShrugged?
Posts: 696
Joined: Wed Jul 15, 2015 6:08 pm

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

Post by AtlasShrugged? » Sat May 04, 2019 9:41 am

Wait...Can a really smart Boglehead explain WTH a 'heartbeat' transaction is, so a second grader could understand it?

This just seems like a financial 'sleight of hand' where value somehow just disappears. Poof! The value is gone. Wouldn't the IRS get irritated?

If it is such a good thing, why doesn't every investment house do this? Or a variation of it? How can an individual investor do it? Now THAT would make this thread actionable. :happy
“If you don't know, the thing to do is not to get scared, but to learn.”

NYCwriter
Posts: 256
Joined: Thu Sep 17, 2015 12:46 am

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

Post by NYCwriter » Sat May 04, 2019 9:54 am

AtlasShrugged? wrote:
Sat May 04, 2019 9:41 am
Wait...Can a really smart Boglehead explain WTH a 'heartbeat' transaction is, so a second grader could understand it?

This just seems like a financial 'sleight of hand' where value somehow just disappears. Poof! The value is gone. Wouldn't the IRS get irritated?

If it is such a good thing, why doesn't every investment house do this? Or a variation of it? How can an individual investor do it? Now THAT would make this thread actionable. :happy
It's currently patented, that's why. Nobody else can do it until that patent expires. It's also viewed as a market manipulation strategy, which raises other concerns.

From the May 1 article: 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.”

User avatar
AtlasShrugged?
Posts: 696
Joined: Wed Jul 15, 2015 6:08 pm

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

Post by AtlasShrugged? » Sat May 04, 2019 10:19 am

From the May 1 article: Here’s how it works: Vanguard attaches a more tax-efficient ETF to an existing mutual fund.
This is one part I don't understand. Attach? Huh?
“If you don't know, the thing to do is not to get scared, but to learn.”

Slick8503
Posts: 219
Joined: Tue Nov 16, 2010 10:25 am

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

Post by Slick8503 » Sat May 04, 2019 10:29 am

Large investment banks “invest” in an etf by giving representative baskets of stocks of the underlying etf. After a short period of time the inv banks redeem the dollar value of their initial “investment” but instead of receiving the underlying basket of stocks they provided, the investment banks receive specifically chosen appreciated shares of stock from the etf which washes out the cap gains taxes that the etf would’ve owed on those shares.

Etf providers are able to do this because of a quirk in the tax code that allows them to distribute specific shares for redemptions without paying the capital gains on those shares.
Last edited by Slick8503 on Sat May 04, 2019 10:36 am, edited 1 time in total.

Slick8503
Posts: 219
Joined: Tue Nov 16, 2010 10:25 am

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

Post by Slick8503 » Sat May 04, 2019 10:32 am

NYCwriter wrote:
Sat May 04, 2019 9:54 am
AtlasShrugged? wrote:
Sat May 04, 2019 9:41 am
Wait...Can a really smart Boglehead explain WTH a 'heartbeat' transaction is, so a second grader could understand it?

This just seems like a financial 'sleight of hand' where value somehow just disappears. Poof! The value is gone. Wouldn't the IRS get irritated?

If it is such a good thing, why doesn't every investment house do this? Or a variation of it? How can an individual investor do it? Now THAT would make this thread actionable. :happy
It's currently patented, that's why. Nobody else can do it until that patent expires. It's also viewed as a market manipulation strategy, which raises other concerns.

From the May 1 article: 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.”
Vanguard has the patent on etfs being a share class of the corresponding mutual fund but there is no patent on so called “heartbeat” trades.

If you read the article in the OP you will see that many investment houses use this tactic to rid their etfs of cap gains. Really do not see it any differently than tax loss harvesting. It’s just taking advantage of a tax loop hole.

Topic Author
retiringwhen
Posts: 1300
Joined: Sat Jul 08, 2017 10:09 am
Location: New Jersey, USA

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

Post by retiringwhen » Sat May 04, 2019 10:38 am

AtlasShrugged? wrote:
Sat May 04, 2019 9:41 am
Wait...Can a really smart Boglehead explain WTH a 'heartbeat' transaction is, so a second grader could understand it?

This just seems like a financial 'sleight of hand' where value somehow just disappears. Poof! The value is gone. Wouldn't the IRS get irritated?

If it is such a good thing, why doesn't every investment house do this? Or a variation of it? How can an individual investor do it? Now THAT would make this thread actionable. :happy
The "value" does not disappear, it simply does not force the fund to pass on a LTCG or STCG distribution to the shareholder in the year of the transaction. The cost basis for the fund shareholder (you and me) remains the same so there is no tax avoided, only deferred in the sense that the fund shareholder is not subject to a current year capital gain distribution.

Any ETF provider can take advantage of this process and almost all of them do with some providers appearing to be more effective/efficient than others.

Vanguard has a patent on combining an ETF with mutual fund so that this process can essentially be extended to MF share holders as well as ETFs.

Since the tax laws are different between mutual funds and ETFS, no other provider has extended the process to mutuals because they to license the patent from Vanguard or wait until the patent expires in a couple years and them copy the process. There has been a lot of speculation about if anyone will take advantage (several mutual funds licensed/inquired a decade ago, but none of them moved forward). There seems to a stream of thought that most fund providers will not follow in large part because they do not have the behemoth index portfolios in mutual funds that Vanguard has to make this worthwhile. Most of the index funds are now in ETF shares already.

If a large part of the funds are also held in tax-deferred accounts like 401(k) or IRA accounts, this does not provide any advantage either. Basically, it is a very nice solution to a somewhat niche problem, namely, deferring capital gains distributions on index mutual funds held in taxable accounts.

The actionable component of this thread is thus: If you plan on holding Mutual fund shares of an index fund in a taxable brokerage account, Vanguard's structure is by far the most tax efficient in the industry. If you are willing to hold ETF shares, look at the tax efficiency of the ETFs you have available and choose the one that has been most successful in avoiding CG distributions in the last decade, all other things being equal such as the same index. Vanguard and Blackrock iShares for example almost never distribute them.

Topic Author
retiringwhen
Posts: 1300
Joined: Sat Jul 08, 2017 10:09 am
Location: New Jersey, USA

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

Post by retiringwhen » Sat May 04, 2019 10:46 am

AtlasShrugged? wrote:
Sat May 04, 2019 10:19 am
From the May 1 article: Here’s how it works: Vanguard attaches a more tax-efficient ETF to an existing mutual fund.
This is one part I don't understand. Attach? Huh?
Vanguard is unique in the industry in that in almost all cases, their ETF shares are simply another class of shares for their associated mutual fund.

For example, VTSAX and VTI are just share classes of the same fund called the Vanguard Total Stock Market Index Fund.

Any other company, will have two distinct funds one, for the mutual fund and a different one for the ETF even if they track the same index.

One of the things often discussed on BH.org is the ability to convert VTSAX shares to VTI in a one-way conversion that is not a taxable transaction. This is one of the features of the arrangement un-related, but valuable to shareholders in some situations such as making a Vanguard Mutual Fund investment easily portable to a different brokerage house without having to execute taxable transactions. None of this really matters for tax-deferred accounts, BTW.

No one else does any of this, in large part due to the patent.

User avatar
AtlasShrugged?
Posts: 696
Joined: Wed Jul 15, 2015 6:08 pm

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

Post by AtlasShrugged? » Sat May 04, 2019 11:05 am

The actionable component of this thread is thus: If you plan on holding Mutual fund shares of an index fund in a taxable brokerage account, Vanguard's structure is by far the most tax efficient in the industry. If you are willing to hold ETF shares, look at the tax efficiency of the ETFs you have available and choose the one that has been most successful in avoiding CG distributions in the last decade, all other things being equal such as the same index. Vanguard and Blackrock iShares for example almost never distribute them.
Heck....when is that patent up? Would the expiration of the patent allow individual investors to get the same kind of deal?
“If you don't know, the thing to do is not to get scared, but to learn.”

Topic Author
retiringwhen
Posts: 1300
Joined: Sat Jul 08, 2017 10:09 am
Location: New Jersey, USA

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

Post by retiringwhen » Sat May 04, 2019 11:18 am

AtlasShrugged? wrote:
Sat May 04, 2019 11:05 am
The actionable component of this thread is thus: If you plan on holding Mutual fund shares of an index fund in a taxable brokerage account, Vanguard's structure is by far the most tax efficient in the industry. If you are willing to hold ETF shares, look at the tax efficiency of the ETFs you have available and choose the one that has been most successful in avoiding CG distributions in the last decade, all other things being equal such as the same index. Vanguard and Blackrock iShares for example almost never distribute them.
Heck....when is that patent up? Would the expiration of the patent allow individual investors to get the same kind of deal?
There is no such concept for individual investors. It is only for ETF Authorized Participants who can trade 100K share baskets to convert to and from ETFs...

The benefit is accrued to individual ETF investors or Vanguard Mutual Fund holders of dual share class funds whose fund provider uses this scheme to clear from low-cost basis shares from the fund holdings.

I think you may be missing the core of this concept here related to how ETFs work, I suggest you read on up on the concept of Authorized Participant wrt to ETFs.

If you mean how can Fidelity or Schwab mutual fund holder benefit? That is a question to them on if/when they plan to implement this scheme, only time and/or licensing fees to Vanguard hold them back from duplicating Vanguard's solution.

This paper from Blackrock may help, I only skimmed it: https://www.blackrock.com/corporate/lit ... h-2017.pdf

As to when the patent is up, I don't know the exact date, but I believe somewhere between 2021 and 2023 based on previous discussions.

User avatar
LadyGeek
Site Admin
Posts: 56460
Joined: Sat Dec 20, 2008 5:34 pm
Location: Philadelphia
Contact:

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

Post by LadyGeek » Sat May 04, 2019 12:56 pm

I merged MFInvestor's thread into the on-going discussion. I also retitled the thread.

There are two separate articles from Bloomberg.com:

- The ETF Tax Dodge Is Wall Street’s ‘Dirty Little Secret’, bloomberg.com
- Vanguard Patented a Way to Avoid Taxes on Mutual Funds

It's not possible to discuss one without the other, hence the reason for combining the threads.
Wiki To some, the glass is half full. To others, the glass is half empty. To an engineer, it's twice the size it needs to be.

rakamaka
Posts: 130
Joined: Tue Feb 28, 2012 2:32 pm

Can't believe, Vanguard is leader of Heartbeat tradings?

Post by rakamaka » Fri Jun 07, 2019 8:20 am

According to this bloomberg article Vanguard is leader of so called Heartbeat trading, aka manipulating transactions between a mutual fund and its equivalent ETF at a very big scale. A legal loophole/shortcoming is being exploited in the name of tax efficiency. Never expected this from Vanguard fund managers or organization, but it is true. Now I understand rise of Vanguard ETFs in last 10 years..
Legally right. Financially profitable. And not quite like HFT. But does it adhere to core principals of passive indexing at Vanguard? Especially when $1 billion is pumped in-out in Vanguard ETF just for 2-3 days to avoid taxes on monsanto holdings?
https://www.bloomberg.com/graphics/2019 ... tax-dodge/
Gone are days of buy and hold.
Last edited by rakamaka on Fri Jun 07, 2019 8:36 am, edited 1 time in total.

AlohaJoe
Posts: 4723
Joined: Mon Nov 26, 2007 2:00 pm
Location: Saigon, Vietnam

Re: Can't believe, Vanguard is leader of Heartbeat tradings?

Post by AlohaJoe » Fri Jun 07, 2019 8:23 am

The article is over a month old so it seems quite likely it has already been posted & discussed on Bogleheads.

A quick search of the forum turns up the previous discussion: viewtopic.php?t=280097

Silk McCue
Posts: 2885
Joined: Thu Feb 25, 2016 7:11 pm

Re: Can't believe, Vanguard is leader of Heartbeat tradings?

Post by Silk McCue » Fri Jun 07, 2019 8:25 am

It is well known that VG has a patent on this and it is viewed as being a favorable benefit to those that hold these VG funds. No idea why you think this is a bad thing.

Cheers

User avatar
vineviz
Posts: 5149
Joined: Tue May 15, 2018 1:55 pm

Re: Can't believe, Vanguard is leader of Heartbeat tradings?

Post by vineviz » Fri Jun 07, 2019 8:29 am

rakamaka wrote:
Fri Jun 07, 2019 8:20 am
According to this bloomberg article Vanguard is leader of so called Heartbeat trading, aka manipulating transactions between a mutual fund and its equivalent ETF at a very big scale. A legal loophole/shortcoming is being exploited in the name of tax efficiency. Never expected this from Vanguard fund managers or organization, but it is true. Now I understand rise of Vanguard ETFs in last 10 years..
Gone are days of buy and hold.
https://www.bloomberg.com/graphics/2019 ... tax-dodge/
As mentioned, this has been much discussed.

Short version: it’s not manipulation, not a legal loophole, and not exploitative.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

Topic Author
retiringwhen
Posts: 1300
Joined: Sat Jul 08, 2017 10:09 am
Location: New Jersey, USA

Re: Can't believe, Vanguard is leader of Heartbeat tradings?

Post by retiringwhen » Fri Jun 07, 2019 8:30 am

rakamaka wrote:
Fri Jun 07, 2019 8:20 am
... Now I understand rise of Vanguard ETFs in last 10 years..
Gone are days of buy and hold.
I don't think you understand what heartbeats do. They make it much MORE attractive for the investor (you and me) to buy and hold forever as we are in complete (nearly) control of when capital gains tax will be paid as a result of their efficient use of this mechanism.

Heartbeats are completely legal (without question) so not unethical, In fact, I could argue it is Vanguard's duty as a fiduciary to optimize investor taxation.

Vanguard has a stated policy and history of being as tax-efficient as possible within the scope of each fund's investing strategy, not doing heartbeats would against that policy.

I see it as enlightened and savvy execution resulting in superior returns (after-taxes) for investors.

If you don't like the law, send a letter to your Congressman.

Topic Author
retiringwhen
Posts: 1300
Joined: Sat Jul 08, 2017 10:09 am
Location: New Jersey, USA

Re: Can't believe, Vanguard is leader of Heartbeat tradings?

Post by retiringwhen » Fri Jun 07, 2019 8:33 am

Silk McCue wrote:
Fri Jun 07, 2019 8:25 am
It is well known that VG has a patent on this and it is viewed as being a favorable benefit to those that hold these VG funds. No idea why you think this is a bad thing.

Cheers
They have no patent on heartbeats. It is available to any ETF and has been since the law specified this feature in 1969.

multiple share classes of a fund is what is patented.

Silk McCue
Posts: 2885
Joined: Thu Feb 25, 2016 7:11 pm

Re: Can't believe, Vanguard is leader of Heartbeat tradings?

Post by Silk McCue » Fri Jun 07, 2019 8:34 am

retiringwhen wrote:
Fri Jun 07, 2019 8:33 am
Silk McCue wrote:
Fri Jun 07, 2019 8:25 am
It is well known that VG has a patent on this and it is viewed as being a favorable benefit to those that hold these VG funds. No idea why you think this is a bad thing.

Cheers
They have no patent on heartbeats. It is available to any ETF and has been since the law specified this feature in 1969.

multiple share classes of a fund is what is patented.
Thank you. I was referring to the overall process of mitigating taxes in mutual funds.

Cheers

Topic Author
retiringwhen
Posts: 1300
Joined: Sat Jul 08, 2017 10:09 am
Location: New Jersey, USA

Re: Can't believe, Vanguard is leader of Heartbeat tradings?

Post by retiringwhen » Fri Jun 07, 2019 8:36 am

Silk McCue wrote:
Fri Jun 07, 2019 8:34 am
retiringwhen wrote:
Fri Jun 07, 2019 8:33 am
Silk McCue wrote:
Fri Jun 07, 2019 8:25 am
It is well known that VG has a patent on this and it is viewed as being a favorable benefit to those that hold these VG funds. No idea why you think this is a bad thing.

Cheers
They have no patent on heartbeats. It is available to any ETF and has been since the law specified this feature in 1969.

multiple share classes of a fund is what is patented.
Thank you. I was referring to the overall process of mitigating taxes in mutual funds.

Cheers
:sharebeer

Broken Man 1999
Posts: 3062
Joined: Wed Apr 08, 2015 11:31 am

Re: Can't believe, Vanguard is leader of Heartbeat tradings?

Post by Broken Man 1999 » Fri Jun 07, 2019 9:22 am

Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one's taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands. - Judge Learned Hand

I agree wholeheartedly with this distinguished judge! :thumbsup :thumbsup

Tax avoidance = good, legal.
Tax evasion = bad, illegal.

Broken Man 1999
“If I cannot drink Bourbon and smoke cigars in Heaven than I shall not go. " -Mark Twain

Post Reply