Vanguard Investors Get Control of Paying Taxes

Here is the sexy tax part of this: During creation or redemption, the fund issuers themselves aren't buyers or sellers. Instead, they exchange shares of the ETF for shares of underlying stocks (creation) or they exchange shares of stocks for shares of the ETF (redemption). These are in-kind transactions, swapping one tradable security for another. It is not considered a cash transaction, so the great beauty of this to the ETF investor is there's no pass-through capital-gains tax bill.

For this reason, ETFs have a huge structural advantage over traditional mutual funds. Not being hit with capital-gains taxes on funds you didn't sell is part of the reason ETFs have seen such enormous growth. According to BlackRock Inc., the world's biggest asset manager, at the start of the century ETF assets amounted to less than $100 billion. Today that figure stands at $4.7 trillion. The company estimates that ETF holdings will increase fivefold during the next decade.

Given all of this, what did Vanguard Group do that was so innovative?

Instead of just creating a new family of ETFs, it decided to create them as a new share class within its existing mutual funds. It was such an inventive solution to the capital-gains tax problem that Vanguard and former Chief Investment Officer Gus Sauter were awarded a patent.

ETF buyers would get access to Vanguard's legendary cost-consciousness. The new products didn't have the usual startup struggles of high overhead costs spread out among few owners. Instead, they were instantly part of an enormous pool of existing assets. Thus, they received the full benefits of Vanguard's economies of scale, including operating and trading costs. Not only that, but Vanguard got to tout the longstanding track records of the new ETFs. They were, after all, identical to the rest of the asset pool — just a new class of the same investments.

The biggest advantage, obviously, was the deferral of capital gains taxes for mutual-fund holders. As the company itself noted, "To meet cash redemption requests from non-ETF shareholders, Vanguard can sell high-cost-basis securities to generate a capital loss. These losses offset any current taxable gains and, if not exhausted, can be carried forward to offset future capital gains — a recycling that is not likely within stand-alone ETFs." The ETF share class with a corresponding mutual-fund class effectively swaps shares to "wash out" or offset capital gains in the mutual fund.

Note that this is not tax avoidance, but rather tax deferral— investors must pay taxes on any gains made from selling the ETF shares for more than they paid. But fund investors get to make this decision themselves, based on when they choose to sell — not when someone else does.

Vanguard's corporate structure as a mutual owned by its shareholders is unique in the asset-management business. So too is this ETF as a share class. It's no wonder it won a patent.