While taking a loss on an investment is never an enjoyable activity, many financial advisors tap exchange traded funds in year-end strategies designed to harvest those losses, which can be used to offset taxes on future capital gains.
Financial advisors may follow two strategies when using ETFs for tax-loss harvesting. Either exchange a losing investment for an ETF with similar holdings or shift the money into an ETF that shows a high correlation to the security sold.
For instance, some investors may be facing losses on financial stocks or sector funds this year. Not to pick on banks, but they were the market's whipping boy for much of 2011 as the Eurozone debt crisis and global economic concerns lingered. Investors can sell the financial stock or fund and take a loss, and if the investors are afraid of missing a sector rally, they could maintain their exposure by purchasing a financial sector ETF such as SPDR Financial Select Sector Fund (NYSEArca: XLF) and iShares Dow Jones U.S. Financial Sector (NYSEArca: IYF).
Under the "wash-sale" rule, investors can book the loss only if they don't repurchase a "substantially identical" security within 30 days.
Furthermore, an advisor may opt to fine-tune the exposure even more with bank ETFs such as PowerShares KBW Bank (NYSEArca: KBWB) or SPDR S&P Bank ETF (NYSEArca: KBE).
Investors can look at how closely a financial or bank ETF tends to correlate with a particular stock. Some fund providers have a correlation tool that helps investors examine how closely correlated ETFs are with other securities.
Using ETFs in tax-loss harvesting strategies is not limited to the equities market. Many investors have typically held an active fixed-income mutual fund in hopes of outperforming the broader fixed-income markets. This year, though, most active intermediate fixed-income funds have largely underperformed the Barclays Capital U.S. Aggregate Bond Index, a common reference benchmark or this category.
Advisors seeking to swap out the underperforming active intermediate fixed-income funds may, instead, choose from ETF options, including: the iShares Barclays Aggregate (NYSEArca: AGG), SPDR Barclays Capital Aggregate Bond ETF (NYSEArca: LAG) or Schwab U.S. Aggregate Bond ETF (NYSEArca: SCHZ). Each of the three ETFs try to reflect the performance of the Barclays Capital U.S. Aggregate Bond Index, with subtle difference such as management styles, holdings, expenses, among others. In addition, some advisors and investors have focused on low-cost ETFs as a temporary replacement for securities for tax-loss harvesting purposes.
While an investment portfolio may be entirely revamped for tax-loss harvesting, advisors should focus on which areas show the most unrealized losses, or at least enough to take advantage of. For example, in the U.S. markets, financials, as mentioned earlier, have shown the most losses, followed by materials stocks. Overseas, both developed and emerging markets show negative returns for most of the year, and investors may utilize tax-loss harvesting techniques for this portion of an investment portfolio.
"Talking about losses is never much fun," Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research, said in a recent conference call. "We all have losses from time to time in the best market environments. The good news is losses can be used to lessen the tax bill and position for next year."
While there is no limit to the amount of capital losses that may be applied to potential capital gains, only a maximum of $3,000 net loss can be taken out of ordinary income for a fiscal year, but the leftover losses may be carried over into the next tax years.