An obscure provision of the federal tax code enacted in 1969 by a Democratic Congress and signed into law by a Republican president is proving to be a lucrative "dirty little secret" exploited by savvy traders in the $4 trillion U.S. ETF market, according to a recent major article in  Bloomberg Businessweek. So-called "heartbeat trades" represent transactions in which an investor first puts money into an ETF, then makes a quick withdrawal that is paid out in shares of the stocks held by the ETF, rather than in cash.

Normally, a fund that sells a stock that has appreciated in value will trigger a capital gains tax liability for its shareholders. However, if it hands appreciated shares of stock to an investor in lieu of cash to settle a redemption, no tax is due. In 2018, there were more than 548 such "heartbeat trades," worth a record $98 billion, per Bloomberg, and they shielded all ETF investors from significant capital gains taxes. In 2018, investors in the 183 largest U.S. equity ETFs avoided taxes on about $203 billion of realized capital gains through this mechanism, per Bloomberg. The table below breaks out this figure by ETF sponsor.

The Biggest Winners From Heartbeat Trades

(2018 Realixed Capital Gains Shielded From Tax)

  • State Street, $64 billion
  • BlackRock, $59 billion
  • Vanguard, $57 billion
  • Others, $23 billion

Source: Bloomberg

Significance for investors

The 1969 law was designed to help the mutual fund industry, then still in its early growth stages, to weather a temporary flood of redemption orders by honoring them with payments-in-kind (PIK), in the form of stocks held in their portfolios. When the first ETF was devised by the American Stock Exchange (AMEX) in 1993, its designers saw this law, rarely utilized by mutual funds, as a means to increase the appeal of their new product, Bloomberg says.

Today, ETF managers reduce the tax liabilities for their investors by recruiting banks to make large purchases and then quickly withdraw them in-kind in the form of appreciated stock. These transactions are perfectly legal, in keeping with the letter of the 1969 law, and involve major firms such as BlackRock, State Street, and Vanguard among fund sponsors, and Bank of America, Goldman Sachs, and Credit Suisse among banks, the article indicates.

The term "heartbeat" was coined in a Dec. 2017 report by Elisabeth Krasner, an analyst with FactSet Research Systems. Looking at a chart of ETF fund flows, the blips reminded her of a cardiac monitor.

"It's removing a negative from the investment process," as Bruce Bond, the founder and former CEO of ETF sponsor PowerShares, told Bloomberg about heartbeat trades, which he also helped to popularize in the industry. "We were the ones to first really utilize its to its full potential," he added.

While heartbeat trades are entirely legal, some believe that they might not survive closer scrutiny. "If the IRS were looking at it, they would say its a sham transaction," as Peter Kraus, former CEO of fund management firm AllianceBernstein, told Bloomberg.

Based on a wider universe of more than 400 ETFs investing in U.S. stocks, Bloomberg calculates that they collectively reduced the 2018 capital gains recognized by investors by $211 billion through in-kind redemptions. Since 2000, Bloomberg has identified 2,261 heartbeat blips in ETF trading.

Looking Ahead

With federal deficits mounting, and Congressional Democrats eager to strike populist blows against Wall Street, it is possible that heartbeat trades may come under political fire, now that they have been publicized.