Tax-loss harvesting is a popular idea this time of year.
You can sell securities that have lost value in your portfolio this year to offset any taxes you might have incurred on capital gains from securities that performed well.
ETFs are tax-friendly vehicles that rarely report capital gains to begin with, but there are still opportunities to implement tax-loss harvesting within ETF portfolios, and here, five ETF strategists share how they do it, and why.
Gary Stringer, president and chief investment officer; Memphis, Tennessee-based Stringer Asset Management
While most of our business is “model delivery,” we take advantage of tax-loss harvesting where we can. We try to harvest losses throughout the year rather than wait until the last minute. Market volatility gives us opportunities to harvest losses as the year progresses.
For example, market volatility in January and February offered plenty of opportunities to harvest losses. We might sell a sector ETF that is down and replace it with our next best idea, or just hold a broad equity ETF through the wash-sale period.
Harvesting losses in this way gives us greater flexibility when managing our tactical allocations because we don’t have to worry as much about realizing short-term gains if the market already gave us the opportunity to harvest losses earlier in the year.
Having the additional freedom to move is an important advantage of harvesting losses throughout the year.
Dave Haviland, managing partner and portfolio manager; Needham, Massachusetts-based Beaumont Capital Management
Historically, in some of our strategies—such as the BCM Sector Rotation and BCM Income—we do tax-loss harvesting, but in the others suites, no. However, as a tactical manager, our three rules-based systems tend to realize the losses as a matter of course.
Does it add to returns? For taxable accounts, yes, especially if you’re negating a short-term capital gain.
Tax-loss harvesting can be important, especially for high-income earners and residents of states like Massachusetts, where the short-term capital gains tax is 7% higher than the long-term rate. Obamacare adds another 4%. In a worst-case scenario, the total tax rate on short-term gains could be as high as 58%.
There’s not really a “proper” way to do tax-loss harvesting. At the strategist level, we have to be cognizant of tax-deferred accounts and the costs of trading into an alternative. Therefore, we only take relatively large unrealized gains, and are quite judicious about it.
Scott Kubie, chief strategist; Omaha, Nebraska-based CLS Investments
CLS regularly engages in tax-loss harvesting for its clients. ETF strategists should be aggressive harvesters of tax losses, because ETFs make tax-loss harvesting less risky than other vehicles.
Harvesting losses in individual stocks often involves swapping one firm in an industry for another. A common example is to sell Coke and buy Pepsi. While managing the sector risk, there is always the possibility that something will change in the competitive environment, and one will prosper while the other falters.
ETFs offer the opportunity to swap between broadly diversified pools while still harvesting the losses. The risk of one company benefiting from another’s misfortune nearly disappears, and the important costs are brokerage fees and the bid/ask spread.
Will Wall, head of portfolio management; Richmond, Virginia-based RiverFront
We don’t do any tax harvesting per se in the portfolios from an investment management or portfolio decision-making perspective, but since our business is underpinned by roughly 15,000 retail [separately managed accounts] and [unified managed accounts], we do offer the ability to harvest gains or losses on an individual account basis based on the client’s individual wishes or needs.
And while we don’t harvest losses on the portfolio level, our portfolio managers are at least tax sensitive or tax aware in the sense that they might choose to wait an extra few days before selling a security if it means realizing long-term over short-term gains for that particular position.
Michael McClary, chief investment officer; Akron, Ohio-based ValMark Advisers
As the asset manager, we typically leave the tax-loss harvesting decision up to the client and the advisor. We feel tax-loss harvesting should be based on each individual client and their particular tax situation.
We offer tax-loss harvesting and feel it can add value, but we recognize it doesn’t always add value. While taxes are an important consideration in managing taxable accounts, we caution investors from making them the only consideration and having the tail wag the dog. We see many investors afraid to realize a gain or be overly concerned with harvesting.
Tax-loss harvesting can be a very valuable tool. However, like any tool, it should be the right tool for the job. We find many investors implement tax-loss harvesting blindly, similar to just swinging a hammer, regardless of the circumstances.
There are many situations where tax-loss harvesting is a no-brainer, adding sizable value for investors. For example, a client may be entering the end of the year with a large realized gain in an energy stock and decide to harvest some tax losses to offset gains in the same year. This would have a near-term cash payoff with low risk. Likewise, they could use the Vanguard Energy ETF (VDE) as a way to remain invested with the proceeds of the tax-loss sale.
On the other hand, there are situations where a systemic tax-loss harvesting strategy might just create smoke. For example, let's assume a client has a significant realized tax loss already banked from previous years; for the sake of this example, let's say $500,000.
Now assume they have an unrealized tax loss of $50,000 in a broad-based index fund or ETF and it's getting to year-end. Some investors would sell out to realize the basis, invest in another index fund or ETF tracking a similar index, then repurchase the original position after 30 days. What has this accomplished?
- It’s added another $50,000 to an already-large bank of realized losses, which might take a decade (or longer) to use up.
- The basis has been reset lower on the asset class exposure. Instead of the next $50,000 in growth simply being tax free until the position rises to its original basis, now you’ll have to track an unrealized gain and the realized tax-loss bank.
- Some transaction costs were realized.
- There’s potential that some small market loss occurs on the swap.
So, was it worth it? Well, it didn't really hurt anything, but it didn't really add any value either.
Contact Cinthia Murphy at [email protected]