ETFInvestor (88.10)

ETF Tax-loss Harvesting: the Good, the Bad, and the Ugly

November 17, 2008 – Comments (2)

I'll summarize ETF tax-loss harvesting with an example, but a more thorough explanation is at Seeking Alpha.

Suppose you own $5000 shares of SPY (a bad idea, most likely as we'll discuss later) to cover US large-cap stocks.  As I write this in November, 2008, the value of these shares are probably lower than what you paid for them, so let's assume you paid $8000.

You want to continue to cover this asset class - in fact, when you add new money to your portfolio or rebalance, you probably will add more shares - but you would really like to take the tax losses to offset future or current capital gains.

Fortunately, ETFs have a great way to exercise this option.  You sell SPY and immediately buy VV, Vanguard's large-cap ETF which covers the same asset class.  You can claim the $3000 tax losses for this year without falling into the wash-sale rule (Note:  the IRS has not formally ruled on this topic so check with your tax advisor as I have done.) Moreover, you can actually increase your allocation to this asset class by buying additional shares of VV.

ETFs allow you to "have your cake and eat it too."  Following such a strategy is more difficult with index funds since normally you need to transfer money between different firms.
So with that background...

The Good

Obviously ETF tax-loss harvesting allows a savvy investor to get the guaranteed financial return of capital gains savings without incurring the risk of being out of an asset class.  In periods of steep market decline you can also do this same strategy multiple times in a year since you don't know when the market will rebound.

The Bad

Trading costs.  This strategy won't work well if you don't have a deep discount brokerage and enough money invested in the ETF.  For example a $1000 investment in SPY in a discount brokerage account will cost you money on the buy, sell, and spread between the issues.  At $20/trade this could cost you 5% of your investment and, depending on your tax bracket, wipe out the capital gains savings.

The Ugly

You need two good ETFs for each asset class in the taxable accounts of your portfolio.  While this is relatively easy for the broad asset classes like US smallcap stocks, it gets really tough as you start looking at more obscure asset classes, particularly international ones. "Good" ETFs in this case means ones with low fees and enough volume to close the bid/ask spreads.

I learned the Ugly lesson the hard way when I tried to harvest tax losses for international small cap ETFs.  There are not many ETFs available in this asset class and the volumes tend to be lower.  Moreover, I have a smaller amount of my portfolio allocated to it.  When I attempted to harvest tax losses I needlessly lost a good chunk of value in this transaction.  Ouch. 

More Ugly?  This can get pretty complicated when you're trying to rebalance many different asset classes at the same time in different accounts.     

This experience taught me that I need a better ruleset for evaluating when tax-loss harvesting makes sense.  The tax-loss benefits need to be balanced against the trading costs, loss in the spread,  the availability of good ETFs, and the overall complexity of the transaction.