Rounding up investment laggards to harvest tax losses is a good idea toward the end of any year in taxable accounts, but this year there is added incentive. Since many major indexes are down for 2008, it is likely that new clients with portfolios established in 2007 have fallen into negative territory, as have existing clients with new positions. Those losses can be used to offset capital gains or income for 2008 or "banked" for use in the future, when they could be even more valuable to offset the higher capital gains or income tax rates that some foresee as inevitable in the next decade.

Tax losses can be particularly valuable to investors in higher tax brackets, since the losses can be used to offset gains from investments, or to offset up to $3,000 in ordinary income. For someone in a 35% federal tax bracket, a $3,000 tax loss used against ordinary income translates into $1,050. If someone has $100,000 in losses-not an improbable scenario for someone with a $1 million account established last year-that could materialize into at least $15,000 worth of tax breaks.

To be able to deduct losses from sales or trades of stock or securities, you need to observe the "wash sale" rule. A wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale buy back the same or "substantially identical" stock or securities. If you do that, you can't deduct the loss.

One way to avoid a wash sale but avoid missing an investment bounce-back during the blackout period is to purchase a security that is similar, but not identical, to the one you sold. An investor who sold a stock for tax loss purposes would typically buy a similar stock in the same sector or industry as a "placeholder," and then, after 30 days, he could decide to keep the new stock or sell it and repurchase the old one. While fairly straightforward, the swap-out introduces company-specific risk that may not have burdened the original holding.

Using mutual funds to avoid a wash sale can be fairly complicated. Since most are actively managed, it may be hard to find one that behaves in a similar manner to another. Many also have sales loads and redemption penalties, which make the short-term holding period of the strategy unappealing.

ETFs have a number of attributes that make them uniquely suited for tax-loss harvesting. There are now hundreds of them, so it is often fairly easy to find one that has the look and feel of an individual stock or mutual fund, or is a close cousin to a particular index, without crossing the line into "substantially similar" territory. Although there are trading commissions, they are much lower than mutual fund sales loads and redemption penalties.

"Exchange-traded fund inflows are strongest in the last quarter of the year, and I suspect a lot of that has to do with tax-loss harvesting," says Tony Rochte, senior managing director at State Street Advisors. "A few years ago, a lot of advisors were using ETFs as a temporary substitute for similar mutual funds. Now, more of them are staying in the ETFs after the switch or are doing ETF-to-ETF transactions."

The question of what constitutes a "substantially similar" investment remains open, since the IRS has never provided a specific answer. One question investors often raise is whether you can substitute an index ETF or mutual fund with an ETF based on the same index, since the transaction involves different companies with different expense ratios. The consensus among advisors interviewed for this story is that it's not a good idea. While the two investments might be somewhat different, they provide identical exposure to the exact same set of securities.

The upside of the crowded ETF space is that there are so many offerings based on so many indexes that investors are bound to find reasonably close, though not identical, substitutes they can use. For example, assume a new client with a taxable account comes in with an S&P 500 index mutual fund he bought last year that is down $3,000. Rather than keep the fund as a core holding, you decide to sell it and harvest the tax loss to offset gains in other investments, or up to $3,000 in ordinary income taxes. Instead of waiting 31 days to buy an ETF based on the index as a substitute, you buy one based on another large-cap-dominated index that has performed similarly, such as the iShares Russell 1000 (IWB). Because the new ETF is based on a different index, it is OK to harvest the tax loss and reinvest the proceeds immediately.

Financial advisors who can be a little flexible in their allocation strategies, rather than those with a more structured approach, are more likely to find ETF tax-loss harvesting strategies useful. "I know some financial advisors who adhere to asset allocations religiously, but I don't believe deviating a few percentage points here or there is going to make that big a difference," says Charles Zhang of Zhang Financial in Kalamazoo, Mich. "If I can find something with at least a 90% correlation to the investment I'm selling, that's fine with me."

Since both the broad markets and a number of key sectors are in negative territory for the year, a number of ETF tax-loss harvesting strategies stand out as particularly useful.

ETF to ETF. Joseph Alexopoulos of Aequitas Wealth Management in Los Angeles recently harvested losses from an international small-cap ETF, the WisdomTree Trust International Small Cap (DLS), and used the proceeds to immediately purchase a similar holding, SPDR International Small Cap (GWX). "If you put the two charts next to each other, you can see their returns are highly correlated, but their holdings are different," he says. "And you still get relatively the same fees and the same sector exposure."

He has also switched out Vanguard Value Index ETF (VTV) for the iShares S&P 500 Value Index fund (IVE). While the two have similar performance records and betas, the iShares ETF's price-earnings ratio is slightly higher and it owns 348 stocks, compared with Vanguard's 386. Eight of the top ten holdings are the same, although they are in different order.

Once he reinvests the proceeds in a new ETF, Alexopoulos typically stays in it rather than switch back to the original holding after 30 days. "Usually, the new holding is similar enough to the old one so I can live with it for a long time," he says. The only exception is when the new ETF subsequently declines in value and he decides to harvest its losses at a later date.

Stocks to ETF. You can use an ETF to maintain significant positions in one or more current stock holdings, or to diversify into a larger number of stocks in a particular sector. The former strategy might be useful for someone who bought Brazilian oil manufacturer Petrobras in May of this year, when it was selling at $77 a share. By mid-August, the stock had fallen to about $50 a share. An investor who wants to harvest the loss but still keep a foot in the Brazilian market might purchase iShares MSCI Brazil (EWZ). Because Petrobras common and preferred stock represents 25% of that MSCI index, he'd still maintain a significant presence. After 30 days, he could buy back the stock or stay in the ETF for more diversified exposure to the Brazilian market.

Financial stocks are another area ripe for tax-loss harvesting this year. Someone with one or more stock holdings in the sector could switch into one of many financial sector exchange-traded funds currently available, including Financial SPDR (XLF), Vanguard Financial (VHF), or iShares Dow Jones Financial (IYF) to get better diversity.

Zhang has used the strategy in reverse for health-care stocks, replacing a losing position in Vanguard Healthcare ETF (VHT) with the top half dozen or so stock holdings of that fund. By doing this, he says, the client gets pretty much the same performance as he would with the ETF, only in an individual stock format. While the ETF-to-stock strategy is only useful for larger accounts that use individual stocks, Zhang also does a lot of stock-to-ETF transactions when he wants more diversification.

Mutual fund to ETF. With so many sector ETFs now available, it is a fairly simple matter to sell a sector mutual fund and replace it with a lower-cost exchange-traded fund in the same sector. There are 28 technology sector ETFs on the market, and 11 of them have been around for at least three years. There are 19 financial sector exchange-traded funds, and 37 health-care offerings.

Zhang uses fund-to-ETF transactions for core holdings as well. He recently sold Fidelity Large Cap Growth A shares, replacing them with the iShares S&P 500 Growth Index (IVW). In the small-cap area, he has sold AIM Small Cap Equity and replaced it with the Vanguard Small Cap ETF (VB).