Vanguard’s Not-So-Secret Tax Loophole is Coming to the $28 Trillion Mutual Fund Industry

How $10T in unrealized capital gains is about to go poof

The most transformative story in asset management is not about AI, and it’s not about bitcoin. It’s about taxes. Product structuring, taxes, and regulatory approvals.

I’m telling you guys, all the good stuff happens in the most boring places.

A decades-old IRS Private Letter Ruling led to a structural quirk that has allowed ETFs to wash out cost-basis for shares held. This little letter is the basis for the key ETF feature: tax efficiency. It is perhaps the biggest reason we have seen over $2T in mutual fund outflows since 2020, while ETFs have had over $4T inflows.

To put it simply, ETFs have been eating the mutual fund structure’s lunch. And it is only exacerbating. 76% of all active equity mutual funds saw outflows over the past year.

It is critical to understand that when mutual funds have redemptions and the fund portfolio manager sells stock to free up cash, the resulting capital gains within the fund are not assigned to whoever redeemed. It is distributed to the remaining investors.

It’s a system that punishes the loyal and rewards those who reach first for the lifeboats.

ETF redemptions are done in kind by handing low-cost basis stocks to market makers. No sale. No gain. No tax.

For 20 years, only one firm - Vanguard - was able to apply that ETF magic to its mutual funds.

And now, the SEC is on the verge of opening the floodgates to the rest of the $28 Trillion category.