How Advisors Harvest Tax Losses with ETFs - The Basics By John Spence October 31, 2002

Financial advisors often use index fund tax-swap strategies as a way to maintain equity exposure while offsetting realized or unrealized gains in a portfolio, which is the closest thing to a free lunch in investing. Exchange-traded funds are becoming a popular choice for implementing tax-harvesting strategies because of their trading flexibility, low costs, and inherent tax efficiency. Since broad domestic indexes have taken a beating this year, now might be a reasonable time for ETF investors to harvest losses for future gains when (we hope) the market does recover. The goal here is to not miss out on a potential rally following a market bottom.

Under tax laws, the "wash sale" rule prohibits investors from taking a loss on a stock if "substantially identical" stock is repurchased within 30 dales of sale. The danger in taking the loss and waiting to repurchase the stock is that it could experience a run-up, and the investor sitting on the sidelines would not be able to participate in those gains.

Some advisors use ETFs (and mutual funds) to harvest portfolio losses while maintaining exposure to broad market segments or sectors. This is possible because different ETFs tracking similar sectors are not considered by some advisors to be substantially identical because they follow different indexes and are managed by different fund families.

Again, the wash sale rule disallows the repurchase of substantially identical stock within the 30-day period. The rule was initially adopted for securities, and there is no clear precedent so far for how it applies to mutual funds - as always investors should consult a tax advisor before using tax-harvesting strategies.

ETFs provide nice opportunities for tax-swap strategies because in many cases there are several funds tracking similar sector indexes (calculated by different providers) with high correlations. For example, there are two technology ETFs offered by different fund managers, as is the case for most sectors or asset classes. The iShares Dow Jones U.S. Technology (IYW) is managed by Barclays Global Investors, while the Technology Select Sector Index SPDR (XLK) is managed by State Street Global Advisors. Although they are both tech ETFs, they track different benchmarks. Since May of 2000, the daily closing prices of these two ETFs have had a correlation coefficient of over 0.99.

Source: Reuters data

Investors who had the unhappy experience of investing in these funds since the tech bubble burst in 2000 can at least by swapping take the losses if they wish to maintain exposure to the sector. To sift ETFs by sector or asset class, check out our handy ETF screener.

The eternal S&P 500 question

Many investors have asked if taking a loss on an S&P 500 index fund and immediately purchasing an S&P 500 ETF from a different provider violates the wash sale rule - an interesting test scenario. Some have even made the case that two S&P 500 ETFs are not substantially identical. For example, let's take a look at the SPDR 500 (SPY) and the iShares S&P 500 (IVV). Although they both track the S&P 500, they have many differences. They are run by different managers. They have different structures - SPY is a unit investment trust (UIT) while IVV has a management investment company (or open-ended) structure. They have different dividend reinvestment policies. UITs (like SPY) do not reinvest portfolio dividends; instead UITs hold them in cash until the quarterly distribution to shareholders. Open-ended management companies (like IVV) may reinvest the dividends in the portfolio until the quarterly distribution to shareholders.

Furthermore, the open-ended structure allows for more flexibility in managing the portfolio. For example, ETFs with the open-ended structure can use a representative sample of the index and derivatives, while UITs cannot employ those strategies.

Although some might argue that all these differences show these two funds are not substantially identical, who really wants to split hairs with the IRS? After all, it's obvious they do track the same index - could be on shaky ground here. Fortunately, the issue can be reasonably avoided because of the existence of other ETFs that have a high correlation with these popular S&P 500 funds, yet track different indexes. The correlation matrix below shows that the Russell 1000 has an almost perfect correlation with the S&P 500 since 1997 (every index in the matrix has an ETF tied to it, with the exception of the Nasdaq Composite).

Source: Morgan Stanley Equity Research, data from June 1997-September 2002

Tax-swaps with index funds are still a murky subject, but most advisors that we spoke to agreed that different indexes are not substantially identical. Obviously, advisors who pursue this strategy look for ETFs tracking different indexes that have high correlations.

Although tax harvesting can be beneficial, it does involve fund trading and therefore additional expenses. For example, ETFs have premiums and discounts, broker commissions, and bid-ask spreads that increase the cost of switching between funds. Therefore, investors are always better off consulting a tax advisor.

References

"Use ETFs to Harvest Tax Losses Before Year-End." Paul J. Mazzilli, Dodd F. Kittsley, CFA, and John Duggan. Morgan Stanley Equity Research, October 24, 2002.

Exchange Traded Funds. Jim Wiandt and Will McClatchy. John Wiley & Sons, 2002.

  
Happy Halloween!