The Current Market Is Ideal for ETF Tax-Loss Harvesting

If you have exposure to an asset class, it's important to maintain that exposure and not try to become a fortune-teller, attempting to figure out when to "get in or get out." The famous professors at Yale have proven that asset allocation accounts for 90% of a portfolio's return and that stock picking and market timing account for less than 10%. Many studies also show that large up moves in the market happen quick and just a few days over many years, account for most of the gains that markets achieve. So trying to time a market – particularly in these volatile times – is a fool's errand.

But there is something you can do during a downtown to pick up a little extra return besides shorting stocks. ETFs are unique vehicles for helping with the tax bill in large market downturns such as the one we are experiencing. Did you know that you can sell an ETF for a loss and buy a similar one that gives you substantially the same exposure, and take a tax deduction?

Let's say that in 2007 you decided to build portfolio exposure to emerging market countries. In a taxable account, you purchased the iShares MSCI Emerging Markets Index (EEM) – or you bought an emerging markets mutual fund.

Assume that today your investment is down (10%) from the recent global equities correction. You still want to maintain the emerging markets exposure, not become a market timer, but still benefit from the loss you've incurred.

In our above example, simultaneously sell EEM, take your 10% loss and buy Vanguard's VWO. If you compare EEM and VWO, over the last 2 years, they are substantially similar ETFs. They practically move together, hold many of the same companies, and are allocated amongst the same countries in almost the same proportion. But you've now created a tax loss without triggering "wash sale" rules. The only expense might be $20 of online brokerage fees. If you've come to love EEM and simply can't stomach owning VWO, then reverse the transaction in 31 days!

Before ETFs, getting this type of tax-loss benefit was virtually impossible. You simply can't do it with mutual funds because they are not easy to sell, they are structured as "funds" so you can't easily track tax lots, and you pay taxes based upon the redemptions going on inside the fund. Conversely, ETFs are like any "stock" and you can easily figure out which shares to sell based upon tax lots. One caveat – check with your CPA to confirm that this works for your situation. I'm not licensed to give tax advice.

There are many sites to help you figure out which ETFs are comparable to the ones that you currently own. On my site, MarketRiders, our portfolio engine has easily classified all ETFs but you can find this information on Seeking Alpha, XTF, Index Universe and Yahoo. It takes a little work, but it's clearly worth the effort and might make you feel a little better during the current downturn.

Disclosure: Author is long EEM and VWO.

Comments

[HumbleBee]

Great reminder!
People do forget during these emotional times.