How Vanguard Patented a System to Avoid Taxes in Mutual Funds

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How Vanguard Patented a System to Avoid Taxes in Mutual Funds

Though few investors are aware of it, The Vanguard Group has used a smart strategy to minimize the capital gains reported yearly on IRS Forms 1099-DIV provided to owners in some of its most popular mutual funds since 2001. The procedure is entirely legal, and it is even covered by a US patent that prevents rivals from replicating it until 2023, but Vanguard has opted not to promote it.

According to a recent significant piece in Bloomberg, the table below summarizes the essentials of Vanguard’s capital gains mitigation strategy.

Vanguard’s Capital Gains Tax Reduction Machine

  • Started in 2001, and patent protected until 2023
  • Six related patents are set to expire in 2021.
  • It takes use of an obscure federal tax law loophole adopted in 1969.
  • 14 mutual funds and ETFs owning the same equities are involved.
  • There are also hundreds more mutual fund-ETF hybrids that own equities.
  • Reduce reported capital gains by a total of $191 billion through 2018.
  • Other investing businesses may be granted access to the system.

Source: Bloomberg

Significance for Investors

No capital gains tax is required if a mutual fund meets a redemption request by handing the investor shares of appreciated stock in place of cash, according to an obscure provision of the federal tax law established by Congress in 1969. However, since regular investors demand cash redemptions, mutual funds seldom adopt this method. ETFs, on the other hand, make extensive use of it.

According to Bloomberg, this is because the number of shares outstanding of an ETF expands or contracts depending on deposits and withdrawals made by intermediaries such as banks and market makers. Such transactions are often conducted in-kind with stock shares rather than cash, and ETFs may reduce capital gains reported to investors by settling withdrawals with shares of appreciated stock.

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ETFs commonly have these intermediaries deposit some stock for a day or two, then make a withdrawal paid out with shares of a different, highly valued stock, to lower their reported capital gains even more, often to nothing. These so-called “heartbeat transactions” (which, when tracked, display huge trading blips like a heart monitor) enabled the 183 biggest US stock ETFs to decrease their reported realized capital gains by around $203 billion in 2018.

Vanguard joined the fast developing ETF industry in 2000, primarily by introducing an ETF share class to several of its most popular existing equity mutual funds. Investors might exchange their mutual fund shares for shares in the sibling ETF with no present tax implications. Vanguard has also employed heartbeat transactions to withdraw appreciated stock from ETFs and its sister mutual funds, minimizing capital gains tax implications for both types of investors.

According to Bloomberg, Vanguard topped all ETF managers in heartbeat transactions with $129.8 billion from 2000 to 2018. With $74.5 billion, iShares from BlackRock is the world’s biggest ETF participant, followed by all others with $125.6 billion. Vanguard has $6.2 trillion in worldwide assets under management (AUM) across all of its products as of January 31, 2020.

Looking Ahead

When Vanguard’s patent expires in 2023, other mutual fund firms are anticipated to replicate its approach to lower the tax obligations of their clients. Expect more investigation from the US Treasury Department, given the significant ramifications for tax collections. While US equities ETFs manage over $3 trillion in assets, US equity mutual funds manage more than quadruple that amount.

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