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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.
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Vanguard even got a patent on the design, valid until 2023, so competitors can't copy it.