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Vanguard

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  • To me this just smells bad. Are they saying that all I need to do to avoid paying capital gain taxes on my stock holdings I wish to get rid of is transfer them into my own personal ETF that I'd better get started on creating?
  • Nice find Gary.
    Derf
  • anyone own any of these funds and if they got audited by IRS?
  • This is ridiculously old news.

    Many Vanguard index funds come in three classes: Investor (now closed), Admiral, and ETF. Two of those are purchased directly from Vanguard (or from Vanguard via a brokerage), one is purchased the same as a stock.

    They are just different ways of owning, buying, and selling the same underlying fund.

    VT, VOO, VTI, etc. are merely share classes of Vanguard World Stock Fund (VTWAX), Vanguard 500 (VFINX, VFIAX), Vanguard Total Stock Index (VTSAX), etc.

    If you think the idea of wiping out cap gains by dumping them off on authorized participants and in the process making them disappear is fishy, according to the article, so does Gabelli.
  • edited May 2019
    @msf - I understand that but the question remains, are the capital gain taxes not being paid? To my uneducated eyes, someone, somewhere should be paying them whether the sale happens in a heartbeat or over coffee. The article seems to say that the gains are evaporated. Please refer me to the old news you speak of. Thank you.
  • I did got taxed from 1099s from vanguard. Don't know if the tax are accurate but I think the less maybe the better. Vanguard probably have more IRS BASED lawyers than POTUS so not too worried
  • Virtually everything in the article is simply a description of how ETFs make cap gains magically disappear. This is why ETFs are marketed as "tax efficient".

    All that Vanguard did was make an ETF that owns the same underlying portfolio as Admiral class and Investor class shares. So when the ETF shares make cap gains disappear from the portfolio, there are no cap gains to distribute among the shareholders - none to the ETF class shareholders, none to the Admiral class shareholders, none to the Investor class shareholders.

    A very quick search (for Vanguard VIPER patent) turned up this article. Not great, but it does cover what I wrote above, and was published in 2005.
    http://www.exchangetradedfunds.com/news/190905Vanpatent.html
    Unlike other ETFs, the Vipers, or Vanguard Index Participation Equity Receipts, are separate share-classes of Vanguard's index funds. In contrast, rival firms' ETFs are "stand-alone" funds. ...

    Vanguard claims a symbiotic relationship exists between the Vipers ETFs and the index funds. ...

    The way in which all ETFs create and redeem shares provides tax benefits. ...

    First, ETFs are not forced to sell stock and raise cash to meet investor redemptions, which can result in distributing capital gains to remaining shareholders. Plus, the in-kind redemption process enables the manager to offload stocks that have risen in price, allowing the ETF "to flush out unrealized capital gains from the portfolio on an ongoing basis, assuming there are sufficient redemptions to do so," ...

    As a result, the Viper ETF share class enables the manager of the corresponding index-fund class to "wash out" potential capital gains in the mutual fund.
  • Agree with msf. The article is non-sense. Blackrock and State Street Advisors would be guilty too with their iShares and Powershares ETFs for not paying out capital gain and only dividends. Vanguard patent describes how their ETFs are created while invest in the same underlying stocks in their respective index funds (Admiral and Investor shares).

  • Unless I read the article wrong, which is entirely possible by the way, this isn't about ETF's performing this magic, it's about Mutual Funds doing it. Two different breeds of cats.
  • this is the second article on tax wash out- it also leaves a lot to be explained but more than the first
    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

    "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.”

    If I personally did a wash sale I would get wacked. Still don't understand!

    "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."

    "Rich Powers," ( YOU SLY DOG) "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."

    "Taxable Gains Begone
    Unlike competitors that follow similar indexes, Vanguard mutual funds stopped saddling investors with ◼ taxable gains once ETF share classes were added."

    "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."

    "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."

    Any one else know about this loophole???

    "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."

    What is the charges of fees by the middlemen surely they are not doing this out of the kindness of their hearts??

    Does the VANGARD and the middlemen eat all your capital gain?

    To me it looks like Vanguard has found a way to feast on your cap gain so you don't have to pay taxes on them. How sweet a deal------ For Vanguard and the MIDDLEMEN!!!

    THE DEVILS IN THE DETAILS

    QUOTES FROM Bloomberg

    JUST MY 2 CENTOVOS!!
  • msf
    edited May 2019
    I'll try this another way. What follows is simplistic, but should suffice.

    It's Jan 2; there's a new ETF. It wants to invest in stock ABC, trading at $12. So it sells its first share to an authorized participant (AP) in exchange for one share of ABC. The ETF share now represents 100% of a fund portfolio holding one share of ABC.

    It's Dec 15; ABC is trading up 25%, at $15. Another two APs come along and each exchanges a share of ABC for a share of the ETF. There are now three ETF shares outstanding. Each represents a 1/3 ownership of the portfolio of 3 shares of ABC.

    The unrealized gains in the portfolio are: $3 + $0 + $0 since the first share appreciated.

    It's Dec 18; the ETF manager wants to swap all of the fund's ABC shares, trading at $15, for shares of XYZ, also trading at $15. He could sell ABC, realize a $3 gain, and buy XYZ. Then later in the month, when cap gains are distributed, whoever owned each of the ETF shares would get a $1 cap gain div. ($3 portfolio gain divided among three shares.)

    But an AP holding one ETF share decides to sell back its one share. Using redemption in kind, the AP is handed one share of ABC. Not just any share, but the original, lowest cost-basis share.

    Now you might think that, like gifting shares, that ABC share would carry with it its original $12 cost basis. Oh, lucky day. There's a tax law that says when you redeem in kind, the cost basis resets. So the AP has one share of ABC with a cost basis of $15. Cap gain? Poof, gone!

    The ETF swaps the other two shares of ABC (with cost basis $15/share) for two shares of XYZ. No gain is realized by the ETF, and no gain is realized by the AP when it sells the share it just received.

    -------------

    Same example, but with a Vanguard fund.

    It's Jan 2; there's a new fund. It wants to invest in stock ABC, trading at $12. It sells an Admiral class share to an investor for $12 in cash, and uses that cash to buy one share of ABC. The Admiral share now represents 100% of a portfolio holding one share of ABC, so it's worth $12. Exactly what the investor just paid for it.

    It's Dec 15; ABC is trading up 25%, at $15, so the fund (with one share outstanding) is also trading at $15. A second investor comes along and buys one Investor class share at $15. The fund uses that cash to purchase a share of ABC. There is now one Admiral class share outstanding and one Investor class share outstanding, each representing a 50% interest in a portfolio of two shares of ABC (worth $30 total).

    Same day; an AP comes along and exchanges one share of ABC for one ETF share of the fund. There are now three shares outstanding (one each of ETF, Admiral, Investor class), each representing a 1/3 interest in a portfolio holding three shares of ABC.

    It's Dec 18; the fund manager wants to swap all of the fund's ABC shares, trading at $15, for shares of XYZ, also trading at $15. He could sell ABC, realize a $3 gain, and buy XYZ. Then later in the month, when cap gains are distributed, whoever owned each of the various shares would get a $1 cap gain div. ($3 portfolio gain divided among three shares.)

    But an AP holding the one outstanding ETF share returns and sells back the share. Using redemption in kind, the AP is handed one share of ABC. Not just any share, but the original, low cost basis share.

    Once again, the cap gains associated with that ABC share goes poof! Meanwhile, the fund is left with two shares of ABC (with cost basis $15/share). It swaps those for shares of XYZ. No gain is recognized by the mutual fund, and no gain is recognized by the AP when it sells the ABC share it just received.

    -------------

    All the magic is with the ETF. The OEF shares are simply along for the ride.
  • edited May 2019
    What and how are the costs to do this allocated. Does anyone know??
  • So what it looks like you're saying is that only AP's are allowed (able) to pull off this stunt and not your average everyday investor. True?
  • Mark I would say that would be a true statement.

    Last part of MSF's statement uses a term OEF that I do not comprehend.
  • edited May 2019
    OEF = open end fund or shares in a mutual fund
  • Mark said:

    So what it looks like you're saying is that only AP's are allowed (able) to pull off this stunt and not your average everyday investor. True?

    Any time a fund redeems shares in kind, it can dump the lowest cost basis (highest gain) shares. This tax maneuver not limited to ETFs, and anyone can buy/redeem open end fund shares.

    Whether the fund will redeem in kind is another matter, but it is usually "allowed". For example, from FCNTX's prospectus:

    "In addition to paying redemption proceeds in cash, a fund reserves the right to pay part or all of your redemption proceeds in readily marketable securities instead of cash (redemption in-kind). Redemption in-kind proceeds will typically be made by delivering the selected securities to the redeeming shareholder within seven days after the receipt of the redemption order in proper form by a fund."

    As an investor, do you really want to get a basket full of securities instead of cash when you sell your mutual fund shares?



  • Thank you Shadow
    OPEN END FUND - have to do more in-depth study.
    A little knowledge comes out at a time.

    This link gives more history and description to a unfamiliar function!

    https://www.bloomberg.com/graphics/2019-etf-tax-dodge-lets-investors-save-big

    I posted it a month ago.
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