Wow! Pretty crazy! And brilliant I might add, although as Gabelli points out: "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."
From Bloomberg:
Vanguard Patented a Way to Avoid Taxes on Mutual Funds
By Zachary R. Mider, Annie Massa and Christopher Cannon May 1, 2019
Like flipping a light switch, Vanguard Group Inc. has figured out a way to shut off taxes in its mutual funds.
The first to benefit was the Vanguard Total Stock Market Index Fund. Investors' end-of-year tax forms abruptly stopped showing capital gains in 2001, even as the fund went on to generate billions of dollars of them. By 2011, Vanguard had flipped the switch in 14 stock funds. In all, these funds have booked $191 billion in gains while reporting zero to the Internal Revenue Service.
This astounding success gives Vanguard funds an edge over competitors. Yet the world's second-largest asset manager has avoided drawing attention to it. Top executives at the Malvern, Pennsylvania-based firm don't want U.S. policymakers looking too closely at how they're doing it, according to a former insider.
But a review of financial statements and trading data shows that Vanguard relies substantially on so-called heartbeat trades, which wash away taxes by rapidly pumping stocks in and out of a fund. These controversial transactions are common in exchange-traded funds—a record $98 billion of them took place last year, according to data compiled by Bloomberg News—but only Vanguard has used them routinely to also benefit mutual funds.
Here's how it works: Vanguard attaches a more tax-efficient ETF to an existing mutual fund. Then the ETF siphons appreciated stocks out of the mutual fund without incurring taxes, often using heartbeat trades. Robert Gordon, who has written about the concept and is president of Twenty-First Securities Corp. in New York, calls it a tax "dialysis machine."
Rapidly pumping money into and out of the exchange-traded portion of the Vanguard Small-Cap Index Fund removes taxable gains for the benefit of the mutual fund's shareholders.
Beginning in 2017, outflows stretched over five days.
▼
Vanguard even got a patent on the design, valid until 2023, so competitors can't copy it.
Rich Powers, Vanguard's head of ETF product management, acknowledged the design's tax advantages. But he said in an interview that they're not the driver of the company's strategy and that all of its trading complies with the law.
"We agree the Vanguard funds have been extremely tax efficient, enabling us to provide higher after-tax returns to our shareholders and better their chances of achieving long-term investment success," Freddy Martino, a spokesman for the company, said in an email.
Although the dialysis treatment shut off taxable gains in the 14 stock funds, it didn't completely neutralize them in a separate real estate index fund, which invests in trusts that aren't taxed like stocks.
Taxable Gains Begone
Unlike competitors that follow similar indexes, Vanguard mutual funds stopped saddling investors with ◼ taxable gains once ETF share classes were added.
Total stock market
ETF class added
▼
Vanguard Total Stock Market Index Fund
Wilshire 5000 Index Fund
Fidelity Total Market Index Fund
ETF class added
▼
Vanguard Small-Cap Index Fund
iShares Russell 2000 Small-Cap Index Fund
Schwab Small-Cap Index Fund
ETF class added
▼
Vanguard Mid-Cap Index Fund
Dreyfus Midcap Index Fund
Federated Mid-Cap Index Fund
The main benefit of avoiding taxable gains in a mutual fund is tax deferral. Funds distribute their taxable gains to investors, who pay income taxes on them in the same year. By avoiding tax events within the fund, investors get to delay taxes until they sell the fund, which could be years or decades later. It's akin to a zero-interest loan from the IRS.
The stakes for the U.S. Treasury are significant. While heartbeats already help eliminate taxable-gain distributions in the $3 trillion U.S. equity ETF industry, the mutual fund market is more than three times as big. When Vanguard's patent expires four years from now, other mutual fund managers may have the chance to build their own dialysis machines.
To understand how the process works, consider an investor who owns a portfolio of stocks. If one is sold for more than what it cost, capital-gains tax is due on the difference.
Theoretically, owning stocks through a mutual fund or ETF works the same way. If the fund sells a stock for a profit, the taxable gain shows up on each investor's end-of-year Form 1099.
But thanks to an obscure loophole in the tax code, ETFs almost always avoid incurring taxable gains.
The rule says that a fund can avoid recognizing taxable gains on an appreciated stock if the shares are used to pay off a withdrawing investor. The rule applies to both ETFs and mutual funds, but mutual funds rarely take advantage of it because their investors almost always want cash.
ETFs use it all the time, because they don't transact directly with regular investors. Instead, they deal with Wall Street middlemen such as banks and market makers. It's those firms, not retail investors, that expand the ETF by depositing assets or shrink it by withdrawing. These transactions are usually done with stocks rather than cash. The middlemen, in turn, trade with regular investors who want to buy and sell ETF shares.
Trading with middlemen presents ETFs a tax-cutting opportunity. Whenever one of these firms makes a withdrawal request, an ETF can deliver its oldest, most appreciated stocks, the ones most likely to generate a tax bill someday.
If the ETF wants to cut its taxes further, it can generate extra withdrawals just to harvest the tax break. A heartbeat is when an ETF asks a friendly bank or market maker to deposit some stock in the fund for a day or two, then take different stock out. Some critics call these trades an abuse of the tax code. But with the help of heartbeats, most stock ETFs, even ones that change holdings frequently, are able to cut their capital-gains taxes to zero.
Customer-owned Vanguard, founded in 1975 by John Bogle, built a reputation for low fees and tax efficiency by offering simple buy-and-hold funds that follow broad indexes such as the S&P 500. It now has about $5 trillion of assets under management.
In 2000, after Bogle had stepped down as chief executive officer, the firm unveiled a novel strategy to enter the ETF business, a market dominated by State Street Corp. and iShares, now part of BlackRock Inc. Rather than establish new, freestanding ETFs, Vanguard proposed to add an ETF share class to existing mutual funds. ETF and mutual fund investors would jointly own the same underlying pool of stocks.
The concept made sense for Vanguard. Investors who preferred ETFs could easily convert without selling. And the Vanguard ETFs would have a head start in the marketplace. They'd be able to point to decades of performance history and benefit from the existing mutual funds' scale, ensuring low fees.
To keep competitors from copying the idea, Vanguard filed the plan with the U.S. Patent Office in 2001.
Heartbeat Leader
Vanguard funds made more use of heartbeat trades than those of any other ETF manager, a Bloomberg News analysis of trading data from 2000 to 2018 shows.
Taxes weren't a big part of the investor pitch. In fact, some observers thought taxes were a drawback to Vanguard's plan. Investors expect ETFs to be more tax-efficient than mutual funds. Why buy a Vanguard ETF if it might get burdened with the tax bills of its sister mutual fund?
"The fund will exhibit little of the ETF's characteristic tax efficiency," one skeptical ETF consultant told Investment Management Weekly in 2004.
In hindsight, it's clear that those fears were misplaced. Rather than getting dragged into a tax abyss, the ETFs lifted up their sister mutual funds.
Vanguard's Dialysis Machine
Once an ETF share class was added to a mutual fund, 
taxable-gain distributions fell to zero while ◼ non-taxable gains from stock withdrawals shot up.
taxable-gain distributions fell to zero while ◼ non-taxable gains from stock withdrawals shot up.
Share of
total assets
⟵ Years before ETF creation
Years after ETF creation ⟶
Although the dialysis machine has attracted little notice outside Vanguard, it has been controversial within the firm, according to two people with knowledge of the matter. Some employees have raised questions about whether it's appropriate to use ETFs to wipe away capital gains built up years earlier in mutual funds.
"What I can share with you," Powers said, "is that we have reviewed that topic and feel comfortable with our approach to portfolio management."
Vanguard's trading in Monsanto Co. in June showed the dialysis machine in action. The agrochemical giant had agreed to be sold to a German rival for $56 billion in cash, and the Vanguard Total Stock Market Index Fund was one of Monsanto's biggest shareholders. It had owned shares since the early 1990s and, over the decades, the stock had risen more than 25-fold. That meant Vanguard probably faced a big taxable gain.
On June 4, an unidentified investor pumped $1 billion into the fund's ETF. Two days later, when Monsanto was scheduled to exit the index, the same investor took $1 billion out.
It looked like a classic heartbeat trade, except it was five times too big. The ETF portion of the fund had only $184 million of Monsanto to get rid of, and no other large stock was leaving the index that day.
The size of the deal makes sense, though, considering that the entire fund had $1.3 billion of Monsanto to unload. The ETF didn't just dispose of its own small stake in the company—it got rid of most of the mutual fund's much larger stake as well.
Monsanto Magic
An outsize heartbeat trade in June helped Vanguard remove taxable gains from one of its mutual funds.
① On June 4, 2018, an unidentified investor pumped $1 billion into the fund's ETF.
③ The ETF's share of Monsanto stock was worth only $184 million.
② Two days later, the day Monsanto was due to exit the index, the same investor took $1 billion out.
④ But the whole fund was shedding enough Monsanto to explain the size of the trade.
Thanks to winnings on stocks like Monsanto, the fund reported $6.51 billion of capital gains in 2018. But for the 17th straight year since it got an ETF share class, the fund distributed no taxable gains to investors. The ETF ensured that the vast majority of the gains, $6.49 billion, weren't taxable. The balance was probably canceled out by tax losses from earlier years.
There are dozens of similar examples of outsize heartbeats in Vanguard ETFs, an indicator of how hard the dialysis machine is working for mutual fund investors. They help explain why Vanguard's heartbeats are so much bigger than those of other firms. The company has completed heartbeats worth $130 billion since 2004, according to a Bloomberg News analysis based on fund-flow data, compared with $75 billion by BlackRock's iShares, the world's largest ETF manager.
In addition to the 14 stock mutual funds that added a dialysis machine, Vanguard has created dozens of new stock investment pools as ETF-mutual fund hybrids. These funds have realized tens of billions of dollars of additional gains without burdening shareholders with taxes.
In some Vanguard funds, heartbeats are so large and frequent they outweigh regular stock withdrawals. The Vanguard Small-Cap Index Fund had about $37 billion of stock withdrawals over the past seven years, about $20 billion of which were from heartbeats, the fund-flow data show.
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.
Phil Bak, CEO of Exponential ETFs in Ann Arbor, Michigan, said he expects other firms to mimic the Vanguard model once the patent expires.
"If you want to operate both vehicles, and you want to transfer some of the tax advantages of an ETF into the mutual fund investors, it's a very efficient way to do so," Bak said.
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."
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