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

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

Post by HEDGEFUNDIE » Fri Jun 07, 2019 9:29 am

Yes it is a loophole, but it’s a loophole that everyone accepts, so there’s not much to wring one’s hands about.

An analogy is frequent flier miles or credit card points that should probably be reported as income but aren’t.

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

Post by MichCPA » Fri Jun 07, 2019 9:34 am

HEDGEFUNDIE wrote:
Fri Jun 07, 2019 9:29 am
Yes it is a loophole, but it’s a loophole that everyone accepts, so there’s not much to wring one’s hands about.

An analogy is frequent flier miles or credit card points that should probably be reported as income but aren’t.
Totally different, those are a rebate on spending and rebates are a negative expense and not revenue.

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

Post by MichCPA » Fri Jun 07, 2019 9:35 am

Broken Man 1999 wrote:
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
+1 on the Learned Hand quote, I haven't come across this one since Advanced Taxation Class

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

Post by HEDGEFUNDIE » Fri Jun 07, 2019 9:47 am

MichCPA wrote:
Fri Jun 07, 2019 9:34 am
HEDGEFUNDIE wrote:
Fri Jun 07, 2019 9:29 am
Yes it is a loophole, but it’s a loophole that everyone accepts, so there’s not much to wring one’s hands about.

An analogy is frequent flier miles or credit card points that should probably be reported as income but aren’t.
Totally different, those are a rebate on spending and rebates are a negative expense and not revenue.
The law is not as clear as you imply:

https://www.fusiontaxes.com/thought-lea ... ard-points

Just like ETF heartbeats, lots of this is driven by convention and accepted norms rather than consistency under first principles.

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

Post by barnaclebob » Fri Jun 07, 2019 9:50 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..
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.
This is a good example of not forming a strong opinion until you fully understand the situation. I'm not trying to rip on you either, it happens to just about all of us at one point or another, especially in an era of ever increasing clickbait fear mongering headlines.

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

Post by Broken Man 1999 » Fri Jun 07, 2019 10:05 am

barnaclebob wrote:
Fri Jun 07, 2019 9:50 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..
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.
This is a good example of not forming a strong opinion until you fully understand the situation. I'm not trying to rip on you either, it happens to just about all of us at one point or another, especially in an era of ever increasing clickbait fear mongering headlines.
OP, you mentioned this: Gone are days of buy and hold. This activity actually rewards buy and hold investors, as they aren't hit with capital gains generated in their investments from those selling their shares.

Broken Man 1999
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Re: Can't believe, Vanguard is leader of Heartbeat tradings?

Post by MichCPA » Fri Jun 07, 2019 10:42 am

HEDGEFUNDIE wrote:
Fri Jun 07, 2019 9:47 am
MichCPA wrote:
Fri Jun 07, 2019 9:34 am
HEDGEFUNDIE wrote:
Fri Jun 07, 2019 9:29 am
Yes it is a loophole, but it’s a loophole that everyone accepts, so there’s not much to wring one’s hands about.

An analogy is frequent flier miles or credit card points that should probably be reported as income but aren’t.
Totally different, those are a rebate on spending and rebates are a negative expense and not revenue.
The law is not as clear as you imply:

https://www.fusiontaxes.com/thought-lea ... ard-points

Just like ETF heartbeats, lots of this is driven by convention and accepted norms rather than consistency under first principles.
I think we are dealing with two different issues here.

You seem to be making the assumption that the IRS could simply change convention without enabling legislation and treat all rewards as revenue. Rebates are not revenue under any accounting or tax model because they require an expenditure to 'earn' it is basically the same thing as a discount on a sale. But getting 50% off on clothes or shoes isn't income.

Second, and I think this is the exception you are pointing to not the general situation, an account opening bonus is considered interest, and the substance doesn't change just because the form of payment is in miles. In other words, the taxation is driven by the principles used to define revenue. The 2014 Citi case used the substance over form doctrine to establish this bifurcated treatment.

Finally, you assume that there are no principles that underlie this conclusion, but the tax rules follow the generally accepted accounting principles under FASB ASC 605-50-25-3. The rebate issue isn't really a point of legal controversy, neither is interest paid as miles.

I get admittedly touchy when people assert that there is some basis for taxing CC rewards earned by purchasing a good. There really isn't a good case for the IRS support that.

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

Post by rakamaka » Fri Jun 07, 2019 10:51 am

OP, you mentioned this: Gone are days of buy and hold. This activity actually rewards buy and hold investors, as they aren't hit with capital gains generated in their investments from those selling their shares.

Broken Man 1999
Buy Hold is good for preaching general public. But do fund manages actually follow it principally? If they do, then might not have engaged in those heartbeat activities, and creation of ETFs itself. I think mutual fund managers got lured by success of HFT firms(which dont have down quarter or week or a day!, as compared to buyhold investor drawdowns and tensions). So MF managers decided to morf those trading strategies into a traditional mutual fund. The result is explosive growth of ETF inflows.
Warren Buffett should buy this patent from Vanguard and create a BRK.ETF to save on 50+ years of taxes, right?

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

Post by vineviz » Fri Jun 07, 2019 11:03 am

rakamaka wrote:
Fri Jun 07, 2019 10:51 am
Buy Hold is good for preaching general public. But do fund manages actually follow it principally? If they do, then might not have engaged in those heartbeat activities, and creation of ETFs itself.
This line of reasoning is completely fallacious, and logically inconsistent.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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

Post by whodidntante » Fri Jun 07, 2019 11:04 am

You should be glad they are doing it. There are no tax shenanigans here.

People who realize capital gains in taxable accounts will pay tax as normal. What ETFs do for the investor is allow for improved tax deferment and less internal trading cost and cash drag. And long-term investors will pay more at the LTCG rate instead of the STCG rate. Or if you buy and die, your estate will not owe any capital gains tax.

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

Post by Geologist » Fri Jun 07, 2019 11:10 am

rakamaka wrote:
Fri Jun 07, 2019 10:51 am
OP, you mentioned this: Gone are days of buy and hold. This activity actually rewards buy and hold investors, as they aren't hit with capital gains generated in their investments from those selling their shares.

Broken Man 1999
Buy Hold is good for preaching general public. But do fund manages actually follow it principally? If they do, then might not have engaged in those heartbeat activities, and creation of ETFs itself. I think mutual fund managers got lured by success of HFT firms(which dont have down quarter or week or a day!, as compared to buyhold investor drawdowns and tensions). So MF managers decided to morf those trading strategies into a traditional mutual fund. The result is explosive growth of ETF inflows.
What is the turnover? The Vanguard Large-Cap Index (Monsanto is a large-cap stock) had a turnover of 4% in 2018. Vanguard Total Stock Market had a turnover of 3%. These seem like basically buy and hold to me. Some of the index funds will have higher turnovers but that is a function of their index.

Just citing “$1 billion” of one stock is meaningless if you don’t consider that (for example) the Total Stock Market Index fund has assets above $600 billion.

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

Post by pward » Fri Jun 07, 2019 11:15 am

Of course they are, as they use their ETF heartbeats to clear cap gains on their mutual funds as well. I don't know if this should be interpreted as a bad thing though. This is perfectly legal and the IRS is aware of it and chooses to not change anything to make it illegal. So why worry?

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

Post by retiringwhen » Fri Jun 07, 2019 11:48 am

rakamaka wrote:
Fri Jun 07, 2019 10:51 am
Warren Buffett should buy this patent from Vanguard and create a BRK.ETF to save on 50+ years of taxes, right?
Please read about how ETFs work, this is very off-base. Seriously every word is off base.

BRK does not pay capital gains distributions since it is a common stock. Use of the AP system and heartbeats, simply puts an ETF on the SAME footing as Berkshire Hathaway or Amazon or Alphabet or Proctor and Gamble from an investor tax perspective.

The investor, in the end when they sell BRK or an ETF like VTI, will still pay capital gains taxes on the gains the investor has realized. Heartbeats only allows the investor to choose WHEN they incur capital gains (aka when they sell vs. some internal actions of the fund), not IF.

All Vanguard has done is patent a way that, as a by-product of a larger goal, easily extends the favorable tax system to mutual funds. Note, if mutual funds were able to create a market for their shares with participants who wanted to make in-kind trades, they could do achieve the same result directly. But, unlike ETF's there is little fiscal incentive to create such a market for mutual fund shares (APs act as something like market makers for ETFs and thus are compensated via their own trading spreads and arbitrages).

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

Post by Iridium » Fri Jun 07, 2019 12:34 pm

rakamaka wrote:
Fri Jun 07, 2019 10:51 am
Buy Hold is good for preaching general public. But do fund manages actually follow it principally?
As a fund manager, it is impossible to be truly 'buy and hold'. Every single day, they need to either buy shares with net inflows or sell shares to satisfy net outflows. That mutual funds are liquid fundamentally means that the fund manager cannot control when s/he sells, as that is driven by redemptions by investors in the fund. In addition, funds need to periodically update their holdings so that their holdings reflect the purpose of the fund. The company that moves its HQ out of the US needs to be sold by US equity funds, the company that grows will eventually need to be sold by small cap funds, etc. In a broad index fund, the average share has likely been owned by the fund for over a decade. That is good enough in my book, and minor tweaks not based on trying to time the market are fine by me.
rakamaka wrote:
Fri Jun 07, 2019 10:51 am
If they do, then might not have engaged in those heartbeat activities, and creation of ETFs itself.
No. Heartbeat is made desirable by index reconstitution. If a fund literally never reconstituted, small caps funds would hold Microsoft, Apple, etc. and every fund would be overweight in companies that buy back their stock.
rakamaka wrote:
Fri Jun 07, 2019 10:51 am
I think mutual fund managers got lured by success of HFT firms(which dont have down quarter or week or a day!, as compared to buyhold investor drawdowns and tensions). So MF managers decided to morf those trading strategies into a traditional mutual fund. The result is explosive growth of ETF inflows.
While nobody can know for certain why fund managers start ETFs, jealousy of HFT firms seems unlikely. An ETF manager trades even less than an index fund manager (because the ETF manager does not need to trade daily to handle fund flows). An ETF manger trades only quarterly and only a small portion of assets each quarter. It is hard to imagine someone more dissimilar to an HFT than an ETF manager. In fact, I would say that ETF managers exploit the existence of HFTs in order to 'buy and hold' even better than an index fund can.
rakamaka wrote:
Fri Jun 07, 2019 10:51 am
Warren Buffett should buy this patent from Vanguard and create a BRK.ETF to save on 50+ years of taxes, right?
Don't think it would do him any good. Pretty sure that a corporation like Berkshire has to account for delivering stocks the same way it would any other distribution. It is just the weird way that ETFs are taxed that allows the patent to be valuable to Vanguard and other ETF managers.

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

Post by barnaclebob » Fri Jun 07, 2019 12:43 pm

rakamaka wrote:
Fri Jun 07, 2019 10:51 am
OP, you mentioned this: Gone are days of buy and hold. This activity actually rewards buy and hold investors, as they aren't hit with capital gains generated in their investments from those selling their shares.

Broken Man 1999
Buy Hold is good for preaching general public. But do fund manages actually follow it principally? If they do, then might not have engaged in those heartbeat activities, and creation of ETFs itself. I think mutual fund managers got lured by success of HFT firms(which dont have down quarter or week or a day!, as compared to buyhold investor drawdowns and tensions). So MF managers decided to morf those trading strategies into a traditional mutual fund. The result is explosive growth of ETF inflows.
Warren Buffett should buy this patent from Vanguard and create a BRK.ETF to save on 50+ years of taxes, right?
You are confusing the complicated mechanics of efficiently running a fund with personal investment philosophy.

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

Post by jbranx » Fri Jun 07, 2019 3:21 pm

{Topic merged into this ongoing thread on "heartbeat trades."} Moderator Jbranx

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

Post by Elena » Fri Jun 07, 2019 3:55 pm

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?
2023.

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

Post by Taylor Larimore » Thu Oct 17, 2019 10:40 am

Bogleheads:

I ran across this article that gives a good explanation of how Vanguard's patented "heartbeat trades" allows Vanguard investors to pay less tax than investors in other mutual fund companies.

Heartbeat Trades

Best wishes.
Taylor
Jack Bogle's Words of Wisdom (12-15-09): "I’m still left with a very substantial estate tax of what remains and I’m proud and pleased to pay it."
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Re: "Vanguard Patented a Way to Avoid Taxes on Mutual Funds"

Post by CFM300 » Thu Oct 17, 2019 10:52 am

Hmm. Not sure how I feel about this.

Minimizing taxes by minimizing churn is one thing. Minimizing taxes by engaging in heartbeats trades to exploit a loophole is another.

[Edited to add: When I made the comments above, I was responding to Taylor's post directly above mine, which at the time, was the lone post in a new thread started on Oct 17th. I hadn't read any of the other posts in this now merged thread, just the article.]
Last edited by CFM300 on Fri Oct 18, 2019 12:04 am, edited 1 time in total.

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

Post by RadAudit » Thu Oct 17, 2019 10:58 am

I was shocked, shocked that Gabelli was shocked that Vanguard would employ such a scheme. But, the approach fits in to the Boglehead philosophy of keeping costs (taxes) low. As for it being a loophole, I think the tax code is full of them - otherwise, what are tax accountants for?

But, to keep it actionable, I would guess this might be one reason to go with some VG funds vs other firms.
Last edited by RadAudit on Thu Oct 17, 2019 11:04 am, edited 1 time in total.
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Re: "Vanguard Patented a Way to Avoid Taxes on Mutual Funds"

Post by unclescrooge » Thu Oct 17, 2019 11:02 am

CFM300 wrote:
Thu Oct 17, 2019 10:52 am
Hmm. Not sure how I feel about this.

Minimizing taxes by minimizing churn is one thing. Minimizing taxes by engaging in heartbeats trades to exploit a loophole is another.
If Congress didn't like loopholes our tax code would not be 1 million lines long.

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

Post by Gill » Thu Oct 17, 2019 11:04 am

Hate to see this technique discussed in print and on the Internet. It was such publicity on this forum and elsewhere that killed credit card purchases of I-Bonds and other tax reduction schemes over the years. Why don't we lock this thread now.
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Re: "Vanguard Patented a Way to Avoid Taxes on Mutual Funds"

Post by jhfenton » Thu Oct 17, 2019 11:12 am

This is not new. This is not a secret. All well-managed ETFs do this to avoid recognizing net capital gains.

The only thing unique to Vanguard is that they have a patented method that allows them to extend the benefit to mutual funds that have an ETF share class.

Also, the article has been discussed previously: viewtopic.php?t=280097

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

Post by anon_investor » Thu Oct 17, 2019 11:23 am

My wonder is whether other companies will take up this structure once the patent expires...

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

Post by randomguy » Thu Oct 17, 2019 11:31 am

jhfenton wrote:
Thu Oct 17, 2019 11:12 am
This is not new. This is not a secret. All well-managed ETFs do this to avoid recognizing net capital gains.

The only thing unique to Vanguard is that they have a patented method that allows them to extend the benefit to mutual funds that have an ETF share class.

Also, the article has been discussed previously: viewtopic.php?t=280097
Yeah. You can debate if allowing tax deferral is good or bad, but saying it is bad for mutual funds but good for ETFs is a stretch. What vanguard really needs is to find a way to only pay dividends to mutual fund holds in tax advantaged accounts while people in taxable get extra shares tax free instead:)

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

Post by Spirit Rider » Thu Oct 17, 2019 11:41 am

CFM300 wrote:
Thu Oct 17, 2019 10:52 am
Hmm. Not sure how I feel about this. Minimizing taxes by minimizing churn is one thing. Minimizing taxes by engaging in heartbeats trades to exploit a loophole is another.
This is not fundamentally any different than the tax gain harvesting and tax loss harvesting any taxpayer can do. I have reaped massive rewards from being able to use TLH carry forward losses from 2000-2002 and 2007 - 2009. This has allowed me to save almost $20K/year in ACA premium tax credits and cost sharing subsidies over the last 5 years.

Call them loopholes if you wish, but I call them legal provisions of the tax code that congress could close anytime they want. Until then, myself, Bogleheads, other investors, Vanguard and other ETF companies are free to take full advantage of every tax avoidance provision in the tax code. A significant portion of posts on this forum are about legally using the tax code for tax efficient tax avoidance.

The only difference is that an ETF has a vastly greater magnitude of opportunities than an individual does. As @jhfenton pointed out, almost all ETFs do this and have been doing it long before Vanguard's patented process of making an ETF a share class of a mutual fund.

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

Post by Longtermgrowth » Thu Oct 17, 2019 11:47 am

My understanding, from past discussions, is this can actually be a slight disadvantage to the Vanguard ETF share class in some market conditions; especially in less liquid sectors (small caps for example).

I wonder if that's part of the reason Vanguard has been pushing clients to ETF's (per what I've seen mentioned on this forum), in an attempt to curb possible large mutual fund redemptions in the wrong market conditions?

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

Post by alex_686 » Thu Oct 17, 2019 11:56 am

randomguy wrote:
Thu Oct 17, 2019 11:31 am
jhfenton wrote:
Thu Oct 17, 2019 11:12 am
This is not new. This is not a secret. All well-managed ETFs do this to avoid recognizing net capital gains.

The only thing unique to Vanguard is that they have a patented method that allows them to extend the benefit to mutual funds that have an ETF share class.

Also, the article has been discussed previously: viewtopic.php?t=280097
Yeah. You can debate if allowing tax deferral is good or bad, but saying it is bad for mutual funds but good for ETFs is a stretch. What vanguard really needs is to find a way to only pay dividends to mutual fund holds in tax advantaged accounts while people in taxable get extra shares tax free instead:)
Oh, good heavens no. Bad, bad, idea.

First, Collective Investment Trusts already exist, so there is that option.

Second, calculating dividend distributions and the various fiddly details of share class is tricky enough. Why add another layer of complexity on top of that. One of the reasons why ETFs have a lower cost structure than mutual funds is because they can dodge this headache. For context, I used to work as a fund accountant and had to deal with this. A move in the wrong direction.

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

Post by garlandwhizzer » Thu Oct 17, 2019 1:50 pm

From the article:

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.”
These morally upright words come from an active fund manager whose net worth has grown to 1.7 billion dollars and whose annual salary in 2014 (last year I found records for) was 88.5 million dollars. Not exactly the best guy to be complaining about gaming the system. Good example of the hypocrisy of Wall Street, getting obscenely rich from clients paying their high fees and then complaining about Vanguard for saving their clients money. If you're looking for injustice in the tax system perhaps it's more fruitful for Mr. Gabelli to consider the "carried interest loophole" which allows hedge fund managers sometimes getting hundreds of millions of dollars of income in one year and counting it all not as income but as capital gains for income for tax purposes.

https://www.cnbc.com/2017/12/21/indefen ... s-d-c.html

It bothers me when the fat cats on Wall Street who have for decades been soaking investors with high fees to line their own pockets start preaching ethics and morality to Vanguard.

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

Post by mighty72 » Thu Oct 17, 2019 6:02 pm

[merged Taylor's thread here to keep the discussion in one place]

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

Post by asset_chaos » Thu Oct 17, 2019 6:07 pm

I can't see any legitimate complaint here about Vanguard. Any complaint I see would be a vague question about why do exchange traded funds have a structural tax advantage over mutual funds in the first place.

The part I don't understand, however, is what the facilitators of heartbeat trades get out of it. From the article, how did the entity that put a billion dollars through the creation/redemption process for a day or two benefit? Is it just a relationship exercise to service Vanguard's brokerage and banking business? And this isn't just a question about Vanguard; again the article noted that all the ETF providers do this, so all the providers need entities to facilitate their heartbeat trades as well. What's in it for the facilitators?
Regards, | | Guy

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

Post by randomguy » Thu Oct 17, 2019 11:08 pm

alex_686 wrote:
Thu Oct 17, 2019 11:56 am
randomguy wrote:
Thu Oct 17, 2019 11:31 am
jhfenton wrote:
Thu Oct 17, 2019 11:12 am
This is not new. This is not a secret. All well-managed ETFs do this to avoid recognizing net capital gains.

The only thing unique to Vanguard is that they have a patented method that allows them to extend the benefit to mutual funds that have an ETF share class.

Also, the article has been discussed previously: viewtopic.php?t=280097
Yeah. You can debate if allowing tax deferral is good or bad, but saying it is bad for mutual funds but good for ETFs is a stretch. What vanguard really needs is to find a way to only pay dividends to mutual fund holds in tax advantaged accounts while people in taxable get extra shares tax free instead:)
Oh, good heavens no. Bad, bad, idea.

First, Collective Investment Trusts already exist, so there is that option.

Second, calculating dividend distributions and the various fiddly details of share class is tricky enough. Why add another layer of complexity on top of that. One of the reasons why ETFs have a lower cost structure than mutual funds is because they can dodge this headache. For context, I used to work as a fund accountant and had to deal with this. A move in the wrong direction.
Computing power is dirt cheap and this would be simple book keeping chore that computers are really good at. For another couple tenths of point of return it would be well worth it. I have no clue if you could legally set it up though.

I am not sure how CITs would allow me to avoid paying taxes on dividends in my taxable account. I thought they were only available in tax deferred accounts?

Spirit Rider
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Re: "Vanguard Patented a Way to Avoid Taxes on Mutual Funds"

Post by Spirit Rider » Thu Oct 17, 2019 11:22 pm

randomguy wrote:
Thu Oct 17, 2019 11:08 pm
I am not sure how CITs would allow me to avoid paying taxes on dividends in my taxable account. I thought they were only available in tax deferred accounts?
CITs can only be used for an employer tax-advantaged account.

There is no way for an ETF or mutual fund to avoid distributing dividends received on securities they hold without a change in the tax code.

Vanguard's patented method did not change the fact that capital gains from securities held in mutual funds must be distributed.

It was a way to use ETF share class transactions to minimize capital gains from security sales that must be distributed.

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

Post by CFM300 » Fri Oct 18, 2019 12:00 am

Spirit Rider wrote:
Thu Oct 17, 2019 11:41 am
This is not fundamentally any different than the tax gain harvesting and tax loss harvesting any taxpayer can do.
You might be right. I don't know enough to agree or disagree. However,
Spirit Rider wrote:
Thu Oct 17, 2019 11:41 am
Call them loopholes if you wish, but I call them legal provisions of the tax code that congress could close anytime they want. Until then, myself, Bogleheads, other investors, Vanguard and other ETF companies are free to take full advantage of every tax avoidance provision in the tax code. A significant portion of posts on this forum are about legally using the tax code for tax efficient tax avoidance.
Just because a tax avoidance scheme is legal doesn't mean one can't find it objectionable. But as I said, I don't understand the details well enough to have an informed opinion on this particular practice.

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Klewles
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Re: "Vanguard Patented a Way to Avoid Taxes on Mutual Funds"

Post by Klewles » Fri Oct 18, 2019 4:06 am

For reference, here is an excerpt from a legal article that illustrates how in-kind redemption works tax-wise. (The article regards it as an unfair loophole; whether one agrees or disagrees, the article is well-researched and provides good information.)
The following example demonstrates this phenomenon. Assume that the ETF tracks the return of index A by holding a portfolio of the shares of index A (portfolio A1, A2, etc.), the shares of portfolio A1 all increase or decrease by the same percentage, and an AP can create a single share of the ETF.

Example 1. AP contributes portfolio A1 with a value of $100 to an ETF in exchange for a share, which is sold to a retail shareholder for $100. Over the year, portfolio A1 appreciates by $100 to $200. At the end of the year, AP contributes portfolio A2 (basis = $200; FMV = $200) to ETF in exchange for a share with a NAV of $200. AP later requests to be redeemed, and the ETF distributes portfolio A1, which has a basis of $100 and a FMV of $200, to AP in redemption of its share.

The ETF does not recognize gain on the distribution of portfolio A1 under § 852(b)(6), and AP recognizes gain or loss based on the difference between the adjusted basis ("AB") of its ETF share ($200) and the FMV of portfolio A1 ($200), or $0. This example also demonstrates that a redeeming shareholder's gain has no necessary relationship to the BIG [built-in gain] in the distributed securities. Because the redeeming shareholder takes a FMV basis in the distributed property, the BIG in portfolio A1 disappears at the fund level.

The retail shareholder, however, still owns his ETF share with a basis of $100 and a FMV of $200, but the $100 of economic gain that gave rise to the increased NAV is not matched by the taxable BIG at the fund level. In fact, in Example 1, after portfolio A1 is distributed, there is no remaining BIG in the fund. Thus, even if the ETF immediately sold all its assets (in this case, portfolio A2) for $200, it would not recognize any gains, and the retail shareholder would not have any taxable income. The retail shareholder will not recognize any gains until he disposes of his share.
Last edited by Klewles on Sat Oct 19, 2019 1:24 am, edited 1 time in total.

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Klewles
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Re: "Vanguard Patented a Way to Avoid Taxes on Mutual Funds"

Post by Klewles » Fri Oct 18, 2019 4:31 am

Spirit Rider wrote:
Thu Oct 17, 2019 11:41 am
CFM300 wrote:
Thu Oct 17, 2019 10:52 am
Hmm. Not sure how I feel about this. Minimizing taxes by minimizing churn is one thing. Minimizing taxes by engaging in heartbeats trades to exploit a loophole is another.
This is not fundamentally any different than the tax gain harvesting and tax loss harvesting any taxpayer can do.
Sorry to disagree -- it is fundamentally different. If an individual investor wishes to swap shares in Company A for shares in Company B, he/she must first sell A and thus realize gain or loss. But an ETF can swap A for B without realizing gain or loss -- that's what the heartbeat trade is about.
Spirit Rider wrote:
Thu Oct 17, 2019 11:41 am
Call them loopholes if you wish, but I call them legal provisions of the tax code that congress could close anytime they want. Until then, myself, Bogleheads, other investors, Vanguard and other ETF companies are free to take full advantage of every tax avoidance provision in the tax code. A significant portion of posts on this forum are about legally using the tax code for tax efficient tax avoidance.
I wholeheartedly agree!

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vineviz
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Re: "Vanguard Patented a Way to Avoid Taxes on Mutual Funds"

Post by vineviz » Fri Oct 18, 2019 6:10 am

Klewles wrote:
Fri Oct 18, 2019 4:31 am
Spirit Rider wrote:
Thu Oct 17, 2019 11:41 am
CFM300 wrote:
Thu Oct 17, 2019 10:52 am
Hmm. Not sure how I feel about this. Minimizing taxes by minimizing churn is one thing. Minimizing taxes by engaging in heartbeats trades to exploit a loophole is another.
This is not fundamentally any different than the tax gain harvesting and tax loss harvesting any taxpayer can do.
Sorry to disagree -- it is fundamentally different. If an individual investor wishes to swap shares in Company A for shares in Company B, he/she must first sell A and thus realize gain or loss. But an ETF can swap A for B without realizing gain or loss -- that's what the heartbeat trade is about.
This glosses over some important distinctions.

Mutual funds (including ETFs) don’t pay taxes, which is why a mutual fund selling A and buying B isn’t a taxable event for the fund itself.

Investors pay taxes, of course, and a general principle of the tax code is that taxes on capital gains are owed when the gain is realized.

The investor doesn’t own shares in Company A or Company B: they own shares in Company M (the investment company operating the mutual fund). If the investor doesn’t sell their shares of M, they have no realized gain.

Heartbeat trades do nothing except ensure that the mutual fund investor owes taxes based on THEIR economic activity, not the activity of other economic agents over which they have control.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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

Post by jeffyscott » Fri Oct 18, 2019 6:44 am

Spirit Rider wrote:
Thu Oct 17, 2019 11:22 pm
randomguy wrote:
Thu Oct 17, 2019 11:08 pm
I am not sure how CITs would allow me to avoid paying taxes on dividends in my taxable account. I thought they were only available in tax deferred accounts?
CITs can only be used for an employer tax-advantaged account.

There is no way for an ETF or mutual fund to avoid distributing dividends received on securities they hold without a change in the tax code.

Vanguard's patented method did not change the fact that capital gains from securities held in mutual funds must be distributed.

It was a way to use ETF share class transactions to minimize capital gains from security sales that must be distributed.
I may be mis-rembering, but I thought this article or maybe a different similar one had indicated that a mutual fund could do this on it's own, without an ETF share class. It's just that mutual funds traditionally have not been set up for these sorts in kind redemptions...and maybe it's more difficult to do so without ETF shares?
Time is your friend; impulse is your enemy. - John C. Bogle

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

Post by Silk McCue » Fri Oct 18, 2019 6:56 am

jeffyscott wrote:
Fri Oct 18, 2019 6:44 am
I may be mis-rembering, but I thought this article or maybe a different similar one had indicated that a mutual fund could do this on it's own, without an ETF share class. It's just that mutual funds traditionally have not been set up for these sorts in kind redemptions...and maybe it's more difficult to do so without ETF shares?
If it could be done cost effectively others would already being doing so bypassing the patent. That would suggest that it can't because why wouldn't you.

Cheers.

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retiringwhen
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Re: "Vanguard Patented a Way to Avoid Taxes on Mutual Funds"

Post by retiringwhen » Fri Oct 18, 2019 8:04 am

Silk McCue wrote:
Fri Oct 18, 2019 6:56 am
jeffyscott wrote:
Fri Oct 18, 2019 6:44 am
I may be mis-rembering, but I thought this article or maybe a different similar one had indicated that a mutual fund could do this on it's own, without an ETF share class. It's just that mutual funds traditionally have not been set up for these sorts in kind redemptions...and maybe it's more difficult to do so without ETF shares?
If it could be done cost effectively others would already being doing so bypassing the patent. That would suggest that it can't because why wouldn't you.

Cheers.
The article states:
The rule applies to both ETFs and mutual funds, but mutual funds rarely take advantage of it because their investors almost always want cash.
I understand that in some cases, Mutual Funds have allowed in-kind redemptions for large shareholders, but as the article states, since there is no Authorized Participants who are in the business of creating and destroying Mutual Fund shares, there is no ready market to support the heartbeat.

BTW, Vanguard implies this with their policy that allows very large ETF share-holders to do in-kind conversions from ETF -> Mutual Fund Shares. I believe this process uses the same rule to be made legal. They just won't do it for small potatoes.

Bottom line Vanguard's patent was a very innovative way to transition users from Mutual Funds to ETFs that had a nice side benefit.

As is mentioned in another thread, Schwab is about to start letting trades of fractional shares (including ETFs.) I predict in 10 years that will be the norm (if not sooner) meaning that Mutual Funds will literally be dinosaurs and mass ETF conversions will be underway with the traditional funds disappearing since they last major hurdle for ETF acceptance will be removed. In fact, Vanguard's patent may be the only hindrance to that move now.

Fidelity's private label Zero funds will be looking pretty exotic (and unattractive as well) due to their lack of portability. This is also going to put a world of hurt on companies like DFA who depend on Mutual Fund shares to lock in a distribution channel.

The disruption will be complete and total. ETF's are washing away 100 years of Financial arrangements pretty darn quickly.

The Mutual Fund Supermarket is dead, the free brokerage is in! Where are the croupier's going to make their money? The pickings are getting pretty slim. Especially if interest rates continue their nearly half century march to zero.

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

Post by randomguy » Fri Oct 18, 2019 1:10 pm

Spirit Rider wrote:
Thu Oct 17, 2019 11:22 pm
randomguy wrote:
Thu Oct 17, 2019 11:08 pm
I am not sure how CITs would allow me to avoid paying taxes on dividends in my taxable account. I thought they were only available in tax deferred accounts?
CITs can only be used for an employer tax-advantaged account.

There is no way for an ETF or mutual fund to avoid distributing dividends received on securities they hold without a change in the tax code.

Vanguard's patented method did not change the fact that capital gains from securities held in mutual funds must be distributed.

It was a way to use ETF share class transactions to minimize capital gains from security sales that must be distributed.
That is my understanding of CITs.

I am not saying that the mutual fund shouldn't distribute dividends. I am saying they should just give them to certain customers who don't care and give other customers something that doesn't cause a taxable event of equal value. How to do that legally is what you pay your accountants for:) Obviously I have no clue if that can actually be done but it would be the obvious next step in reducing taxes.

You could also imagine some crazy in kind redemption for retail investors to l/??et people do donations of the highly appreciated stocks and selling the high cost basis one. Now that would be a really niche product:)

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