How Vanguard Patented a System to Avoid Taxes in Mutual Funds

Though few investors know about it, since 2001 The Vanguard Group has utilized a clever scheme to reduce the capital gains reported annually on the U.S. Internal Revenue Service (IRS) Forms 1099-DIV sent to shareholders in some of its most popular mutual funds. The process is completely legal and is even protected by a U.S. patent that blocks competitors from copying it until 2023, but Vanguard has chosen not to publicize it.

The table below outlines the basics of Vanguard’s capital gains reduction scheme, per a recent major story in Bloomberg.

Significance for Investors

Under an obscure provision of the federal tax code, passed by Congress in 1969, if a mutual fund honors a redemption request by giving the investor shares of appreciated stock in lieu of cash, no capital gains tax is due. However, since retail investors expect to receive redemptions in cash, this alternative is rarely used by mutual funds. On the other hand, ETFs employ it aggressively.

The reason, as Bloomberg explains, is that the number of shares outstanding of an ETF expand or contract based on deposits or withdrawals made by intermediaries such as banks and market makers. Such transactions typically are made in-kind with shares of stock, rather than cash, and ETFs can cut the capital gains reported to investors by settling withdrawals with shares of appreciated stock.

To reduce their reported capital gains even more, often to zero, ETFs frequently have these intermediaries deposit some stock for a day or two, then make a withdrawal that is paid out with shares of a different, highly appreciated, stock. These so-called “heartbeat trades” (when charted, they show big trading blips reminiscent of a heart monitor) allowed the 183 largest U.S equity ETFs to reduce their reported realized capital gains by about $203 billion in 2018.

Starting in 2000, Vanguard entered the rapidly-growing ETF market mainly by adding an ETF share class to some of its most popular existing equity mutual funds. Investors could swap their mutual fund shares for shares in the sister ETF with no tax currently due. With this structure, Vanguard also has used heartbeat trades to remove appreciated stock from ETFs and their sister mutual funds alike, reducing capital gains tax liabilities for investors in both.

Vanguard led all ETF managers with $129.8 billion of heartbeat trades from 2000 through 2018, per Bloomberg. The largest ETF player worldwide, iShares from BlackRock, is second with $74.5 billion, while all others combined for $125.6 billion. Across all its products, Vanguard had $6.2 trillion in global assets under management (AUM) as of Jan. 31, 2020.

Looking Ahead

When Vanguard’s patent expires in 2023, other mutual fund companies are expected to copy its process to reduce their investors’ tax liabilities. Expect increased scrutiny from the U.S. Treasury Department since the implications for tax revenues are massive. While U.S. equity ETFs control about $3 trillion of assets, U.S. equity mutual funds have more than triple that amount.