Swapping ETFs to harvest losses can make a lot of sense.

    When we think of taxes, we think of April. But while clients may "do" their taxes in April, there's really nothing left to be done at that point. Sure, filling out those 1040s and Schedule Ds can be time consuming, but the amount clients owe Uncle Sam are more or less set in stone come April. The time to actually do something about taxes is now.
    Do what? Minimize them, of course. And at year-end, that means one thing: harvesting your losses.
    Tax-loss harvesting is one of those great Wall Street euphemisms, like negative growth, one-time items and market-based compensation policies. But in this case, the euphemism is accurate, because harvesting your losses really pays off.
    According to a seminal study by Rob Arnott (Arnott, Rob, Berkin, Andrew and Jia Le, Loss Harvesting: What It's Worth To The Taxable Investor, First Quadrant, 2001, Volume 1), aggressive tax-loss harvesting is one of the most effective active portfolio management strategies available to most investors. Arnott's study found that the typical "alpha" for a tax-loss harvesting strategy can be as large as 7% for money invested in the previous year. That figure quickly falls off as a portfolio accumulates gains over time, falling below 1% per year after five years. Nonetheless, that's real money.
"Harvesting" your losses is as easy as selling your losers. Like most things involving the Internal Revenue Service (IRS), however, there are complications. In this case, the core issue is the so-called "wash sale" rule. In order to claim a loss, you cannot buy a security that is "substantially identical" to the one you sold within 31 days.
    That's where things get tricky. Good investors know that they should stick to their asset allocation plans, which means you have to find some way to replace the position you sell with a similar (but not identical) security.
    In the (bad) old days, that often meant swapping into an individual stock. If you held Pfizer, for instance, and sold it at a loss, you might have bought Merck as a replacement. Chances are, however, that you had a specific reason for buying Pfizer, and you may not have been as comfortable with Merck. Imagine, for instance, swapping into Merck immediately prior to the Vioxx scandal.
    The alternative was to swap into a pharmaceutical mutual fund, but that option often came with high expenses and possible short-term trading "penalties" from the fund itself. Many investors would simply sit with an empty position for 31 days, until they could invest again in the original security, risking a major move in the sector.
    Fortunately, the bad days are over, and we have entered the golden age of tax-loss harvesting. Exchange-traded funds (ETFs) have emerged as tax-loss harvesting tools non-pareil, combining low costs, easy trading and liquidity, and solid diversification. With the explosion of ETF offerings (there are now more than 350 ETFs in the United States), you can now fine-tune tax swap strategies to a degree never possible before.
    "The combination of the inherent tax efficiency of the ETF structure and the tax-aware management possibilities with ETFs is even better than supporters claimed when the products were introduced," says Matt Forester, who helps manage $150 million in client assets in four ETF portfolios for Cumberland Advisors. "Everybody said ETFs were great, but they are really even better than we hoped."
    Returning to our earlier example, imaging that you owned Pfizer and sold it for a loss. Rather than replacing it with Merck and taking on corporate risk, you could replace it with the Health Care Select Sector SPDR Fund (AMEX: XLV). Pfizer is the largest single holding in XLV, at 13.37%, so even after swapping into XLV, you retain significant exposure to Pfizer stock. More important, you gain diversified exposure to the pharmaceutical/health-care sector, without the corporate risks that come with holding a single stock. Studies show that the bulk of returns are attributable to asset allocation rather than stock selection. With ETFs, it's possible to harvest your loss and stay within your asset allocation plan for the cost of one round-trip trade and annual expenses of just 25 basis points.
    If you don't like XLV, you could also choose the Pharmaceutical HOLDR (AMEX: PPH), the PowerShares Dynamic Pharmaceuticals Portfolio (AMEX: PJP) or the iShares Dow Jones Pharmaceuticals ETF (NYSE: IHE); all provide solid exposure to the health-care arena. Your cup runneth over.
The same rules apply if you already hold sector, style or broad-market funds. Simply swap into an ETF covering the same area and you're done. With the proliferation in ETFs, you can even take a loss in one fund and swap into another. "If you change from one broad-based fund to another, you've very likely to get a highly correlated return, plus the tax asset," says Forester.
    One caveat, of course, is to steer clear of the "wash-rule" requirement. Unfortunately, the IRS hasn't issued explicit rules or rulings that clarify what qualifies as a "substantially identical" security, so it is up to the individual investor to decide how far to push the envelope.
    For instance, if you sell a traditional mutual fund tied to the S&P 500 Index, can you replace it with the iShares S&P 500 ETF (NYSE: IVV)? ETFs and traditional mutual funds have many different characteristics, of course, but whatever their structure, two products tied to the S&P 500 will hold substantially similar securities at substantially similar weights, and will deliver substantially similar returns to investors. An unscientific sample of seven financial advisors who use ETFs found none who would engage in a fund-for-ETF swap of this sort, although it has been discussed in the tax literature.
Don't expect the IRS to clear things up, either. "I don't expect the IRS to come out with any definitive rulings on the gray areas," says Chuck Carlson of Horizon Investment Services. "But it is safe to swap between indexes in the same area."
    Carlson's on the right track. The monthly tracking error between the S&P 500 and other large-cap indexes like the MSCI 750, Russell 1000 and Morningstar Large Core Index is very small, and there is at least one ETF tied to all of these indexes. For an investor selling an S&P 500 fund, the answer may be to swap into a different large-cap index for the 31-day holding period, and then reevaluate.
    Swapping can become difficult for certain types of investments, such as gold. Among the best-selling financial products over the past few years have been the two gold bullion ETFs: the streetTRACKS Gold Fund (AMEX: GLD) and iShares COMEX Gold Fund (NYSE: IAU). An investor who bought these funds recently, however, may be sitting on a loss today, as the shiny yellow metal has pulled back from its high.
    It is unlikely that the IRS would allow a swap between the two funds, as they both hold gold bullion as their sole assets, despite differences in structure. You could, however, swap the gold bullion ETF for the new Van Eck Market Vectors Gold Miners ETF (AMEX: GDX), which holds shares in gold mining companies. While the correlation between gold bullion prices and gold mining shares is not perfect, a fully diversified basket of gold mining shares has historically had a strong long-term correlation to the price of gold. Note, however, that GDX has historically had a beta of two against the price of gold, meaning that it rises $2 for every $1 move in the price of gold; as a result, you may only need to buy half the exposure to GDX to achieve full exposure to gold bullion.
    (The use of leverage in tax-loss harvesting strategies is another tool in the ETF investor toolkit. With the recent launch of the ProShares ETFs, investors can now get 2X leverage to the S&P 500, Nasdaq-100, Dow Jones Industrial Average and S&P 400 MidCap Index, perhaps freeing up cash for "portable alpha" strategies.)
    Direct swapping between ETFs can also be more difficult on the international scene, particularly among country-specific funds, where (in most cases) there is currently only one ETF. But more international funds are in the works, and this may not be an issue in the future.
When should you swap? The calculation is easy enough to make. If the loss is small enough or the client's tax rate low enough, swapping may not make sense. But if the loss is relatively large, swapping often makes sense. Remember that harvested losses can be used to offset capital gains, as well as up to $3,000 of regular income.
    The old saying goes that, when given lemons, make lemonade. The lemons in this case are losses-capital losses. But the tax loss lemonade is sweet, with gains every bit as real as the losses themselves. And once you've swapped into ETFs you may just want to stay there. After all, with their inherent tax efficiency, low costs and prudent diversification, clients could be reaping the benefits for some time to come.

Matthew Hougan is editor of IndexUniverse.com and assistant editor of Journal of Indexes.