by Matt Hougan
Matt Hougan is president of ETF Analytics and global head of editorial for IndexUniverse, where he oversees content and spearheads efforts to reshape the way investors analyze ETFs.
Since I was invited to write a regular ETF column for the Journal of Financial Planning, I’ve been thinking about what I would write. Should I cover a hot topic like “do bond ETFs really work?” or a new line of products? I decided to lead with my single best idea and one of the things that after 10 years of studying this space continues to separate ETFs from all other forms of investing for me.
I’m not talking about the usual things people offer when they talk about ETFs: low costs, intraday liquidity, etc. Yes, ETFs are low cost, but so are index mutual funds. Yes, you can trade ETFs intraday, but you probably shouldn’t (at least not very often). ETFs get too much credit for those things.
What ETFs don’t get enough credit for is one of the things that is truly special about them: tax-loss harvesting.
I know people hate to think about taxes more than once a year, but in terms of winning and retaining clients—and delivering value for your fee—managing tax is one of the most powerful things you can do, and ETFs are the most powerful tool for managing tax that I know.
Speaking from Personal Experience
As a true believer in diversification, I keep a reasonable bond allocation in my portfolio at all times. Often, it’s simply a broad-based index ETF, like the Vanguard Total Bond Fund (BND). But earlier this year, given the prospect for rising rates and my personal concerns about the bond space, I switched part of that position into PIMCO’s Total Return Bond ETF (BOND).
You might be surprised that a guy who works for IndexUniverse would buy an actively managed product, but my thinking was simple: I was smart enough to realize that things didn’t look good for bonds as a whole, but not smart enough to figure out what to do about it.
Why not hire Bill Gross for 0.55 percent a year to do it for me? Since I bought BOND in May, it has been shellacked by the market as a whole. I’m down roughly 5 percent. That doesn’t sound like much, but it smarts. I could sit on my hands and cry, or I could sell BOND, locking in my loss, and rotating my money into a substitute ETF. I chose the latter path, locking in capital losses that I’ll use at year-end to offset capital gains (and perhaps offset some of my income). It didn’t completely ease the pain of losing money, but it eased some of it.
The basics of tax-loss harvesting are well understood: after you sell a security at a loss, you cannot buy a “substantially identical” security within 30 days. You can, however, buy a similar product and rotate back into the original after 30 days. ETFs make that easy.
ETF critics love to say there are too many funds. They’re right! More than 1,500 ETFs are listed in the U.S., and there is ridiculous redundancy in many areas. There are 61 large cap U.S. equity broad-based ETFs; seven broad-based U.S. health care ETFs; nine U.S. high-yield bond ETFs; and 10 different takes on broad-based U.S. agricultural commodities futures exposure.
How do you choose which fund to use as a replacement? A variety of tools are at your disposal. For example, IndexUniverse classifies ETFs into about 400 segments, with each category reflecting one specific area of the market that ETFs are trying to capture (such as the broad-based agricultural commodity futures space).
If you are sitting on a loss in one ETF, find another that occupies the same segment and chances are you can make the swap. If you want to get fancy, make sure the two funds use the same basic index weighting methodology. Two market-cap weighted biotech funds are likely to be more similar than one market-cap weighted fund and an equal-weighted competitor.
If you want to get really fancy, you can do what we do internally—run regressions and holdings analyses of the funds that compete with the one you’re selling to see which one has the closest fit. Look for tight R-squareds and betas, and make sure the sector and industry exposures are similar.
If you run regressions on the SPDRs S&P 500 (SPY) and the iShares Russell 1000 (IWB) ETF, you’ll see they have an R-squared of 0.99, a very tight beta, and their sectors match up closely. Or you can eyeball a chart and see that over a month they never differ by more than 20 or 30 basis points.
Every time an ETF ticks over into a significant loss, there’s an opportunity to harvest losses with little basis risk and generate substantial “adviser alpha.”