Behind Vanguard’s ‘Heartbeat’ ETF Flows

August 01, 2018

By using the in-kind redemption process unique to ETFs, wherein fund shares can be swapped for their underlying securities rather than sold, portfolio managers can wash out appreciated, high-tax-burden stock positions and minimize an ETF's overall capital gains.

To do so, an anonymous donor (usually a market maker) provides an injection of short-term capital in advance of rebalance dates to fund share creations. That capital can be returned as soon as those shares are redeemed, usually within the week (read: "The Players Behind ETF Tax Efficiency").

This inflow/outflow pattern most often happens in high-turnover products, such as smart-beta funds and actively managed funds, which can't always find enough opportunities to wash out capital gains through the course of day-to-day trading. But it can also appear when funds experience significant changes to their underlying indexes.

Vanguard's Indexes Change

On May 3, VGT, VCR and VOX all changed their underlying benchmarks to custom transitionary MSCI indexes, in advance of the impending GICS change.

"The transition to the new benchmarks is not expected to result in material capital gains distributions to shareholders," wrote Vanguard in a March press release announcing the index changes.

During the transition, VGT and VCR will lose constituent stocks to the new communications services sector, tracked by VOX. That means VGT and VCR will need to get rid of relevant stocks, while VOX will need to acquire them.

A good way to avoid realizing capital gains in VGT and VCR, then, would be for Vanguard to use the special ETF redemption process to swap out, rather than sell, those stocks whose classifications are changing. If that trade were made, then a heartbeat pattern should show up in the flows data for both VGT and VCR—just as we have seen.

VOX, meanwhile, can simply purchase the new stocks as needed, or use in-kind creations in much the same way. No heartbeat pattern should show up in its flows data, and indeed, none exists.

The evidence suggests, then, that the heartbeat pattern that has emerged in VGT and VCR's flows data since May is Vanguard's way of minimizing capital gains as those funds make a sector transition that will affect upward of 15% of the stocks in VGT and 12% of the stocks in VCR.

Hidden Costs To The Heartbeat

Yet there is one caveat to all this: Trading activities around rebalancing are not free, as Kashner found. The expense of rebalancing adds up, resulting in a cost passed on to investors that, in some cases, can be equivalent to a substantial portion of the fund's usual annual expenses.

In any rebalance trade, Kashner said in an email statement to, there will be winners and there will be losers.

"Winners include investors in taxable accounts, who avoid capital gains, including all share classes that jointly own the portfolios of VGT and VCR. Market makers and the broker-dealer who works the trade are also winners,” she said.

"Losers include investors in tax-sheltered accounts. Also, all shareholders lose by the amount that the market makers and broker-dealers win," Kashner added, though this has more to do with timing of a market trade than the heartbeat flow pattern, specifically.

Vanguard declined to comment for this article.

Contact Lara Crigger at [email protected]

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