It's that time of year: the articles have started to appear that advocate ETFs as a tool for tax-loss selling. The idea is this. If you own individual stocks that have performed badly this year, sell them before year end to realize the capital loss, and invest the proceeds in the matching sector ETF to maintain your exposure to that sector.
I've tried this in practice, and in truth I have to tell you that I've concluded that it's a lousy strategy. Individual stocks are almost always more volatile than the entire sectors or asset classes represented by ETFs. If a stock you own has tanked, you may find that you've sold into weakness and volatility that the stock will subsequently recover from. A broad based ETF will often fail to mirror the stock's performance. And there's another problem: sector ETFs are often highly concentrated, so in practice you might be switching from one stock to a concentration of a few others without even realizing it.
The real story about tax-loss selling and ETFs is this. ETFs themselves are great for tax-loss selling within an all ETF portfolio. If you own a broad-based ETF that has gone down, it's easy to find a similar but not identical ETF to switch to. You'll be able to realize your capital loss, without moving into an asset uncorrelated with the one you sold. For a full exlanation, check out this chapter in The Radical Guide to Investing.
Here's an example: I was short IWM this year, and it's gone up. So I closed-out my short position and switched to IJR and IWO. Sure, they're not exactly identical (and that's a positive, because otherwise I'd be hit by the wash-sale rule), but if you compare the charts they behave in a very similar way. And given that I can switch back after 31 days, my risk is limited to the transaction costs of the switch.
The bottom line: tax-loss selling is another illustration of why all ETF portfolios are so compelling.
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