Vanguard Has Figured out How to Avoid Taxes on Mutual Funds

An article in Bloomberg reports that Vanguard Group Inc. has figured out how to avoid taxes on its mutual funds.

According to the article, a review of Vanguard financial statements and trading data reflects that the firm “relies substantially on so-called heartbeat trades, which wash away taxes by rapidly pumping stocks in and out of a fund.” The mechanics are explained as follows: 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.” Some refer to the strategy as a tax “dialysis machine.”

Vanguard’s head of ETF product management, Rich Powers, said in an interview that while there are tax advantages to these transactions, they don’t drive the company’s strategy and that all of the firm’s trading complies with the law.

The article reports however that, according to a former insider at Vanguard, the firm is trying to downplay the move to avoid scrutiny from U.S. policymakers. The strategy has also reportedly triggered some controversy within the firm: “Some employees have raised questions about whether it’s appropriate to use ETFs to wipe away capital gains built up years earlier in mutual funds.”