Vanguard, the world’s second largest fund management house, continues to astound. Not contend with becoming a giant in index funds, Vanguard has found a new innovation – avoiding capital gains taxes for its clients: “…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.”
So how is this miracle performed? “…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.””
The article contains a useful chart which shows how “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.”
Just in case you are thinking about doing this for your fund as well, you need to know that “Vanguard even got a patent on the design, valid until 2023, so competitors can’t copy it.”
The article goes onto show that Vanguard uses heartbeat trades more than any other American fund manager. So, how meaningful is the benefit to Vanguard’s American clients from this clever tax manoeuvre: “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.”
Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this email in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services and as an Investment Advisor.
Copyright © 2018 Marcellus Investment Managers Pvt Ltd, All rights reserved.
If you want to read our other published material, please visit https://marcellus.in/blog/
Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services. Marcellus Investment Managers is also regulated in the United States as an Investment Advisor.
Copyright © 2022 Marcellus Investment Managers Pvt Ltd, All rights reserved.
Get weekly insights on our investment strategies and more...