Last week’s big story about Vanguard Group’s patented tax dodge raised some interesting legal and tax issues. Our charge today is to try and take a slightly deeper look at what Vanguard has been doing and why.

Let’s start with some basics about the differences between mutual funds and exchange-traded funds, or ETFs. The obvious feature is that open-end mutual funds are priced once a day based on prices at the market close, while ETFs (and closed-end mutual funds) trade all day. This is a remnant of the pre-computer era, when it would have been impossible to get a quote on all of the underlying holdings in any given fund during market hours. If you have to execute buys or sells by hand, then end-of-day pricing data was what you used.

Investors in mutual funds buy or sell them directly from the mutual-fund companies themselves; ETF purchasers simply go to the market and buy ETFs at the quoted prices. This simple but important structural legal difference has significant tax ramifications for fund investors.

Mutual funds (and most ETFs) are governed by the Investment Company Act of 1940. This legislation treats them like a pass-though company. When a mutual-fund investor wants to sell, the fund sells shares of appreciated stock to generate cash, but also creating a taxable capital gain. Since most funds operate as simple pass-through vehicles, those tax liabilities from the gains accrue to investors in the fund — even to holders of the fund that were not sellers.

It feels inherently unfair that sellers of a fund are the ones who generate capital gains for nonsellers. Thus, the nonselling holders owe capital-gains taxes based not on when they decide to sell, but upon the vagaries of random fate.

Enter the ETF.

ETFs avoid the tax issue because, unlike traditional mutual funds, they are not direct buyers or sellers of shares on behalf of a pool of investors. Instead, when a buyer of an ETF comes to market, a so-called authorized participant — a market maker with a special contract with the ETF provider — will create a block of shares of the ETF by buying all of the holdings in the underlying ETF. They then hand this off to the ETF issuer, and receive newly created ETF shares, which they can then sell to the market. When a seller comes along, it’s the same process in reverse.

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?

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