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ETFs May Be Attractive Options During Tax-Loss Harvesting Season

Nov. 28, 2022, 9:45 AM

For financial and tax professionals, the end of the year is the time to consider meaningful opportunities to reduce investors’ capital gains bill before it crystallizes. It’s why the fourth quarter of the year is known as tax loss harvesting season, at least in some circles. And this year, the options for tax loss harvesting and capital redeployment are more compelling than ever.

Tax loss harvesting—a strategy that involves selling an investment at a loss to reduce federal capital gains tax—is one of the strategies financial and tax professionals can deliver to their clients that can lower federal capital gains tax in bullish years. So while we are in bear market territory, and there are more-than-loud whispers of a potential recession in 2023, bullish times will likely return. That has been the nature of markets, as history has shown us.

Against this backdrop of ongoing equity market volatility, paired with the worst sell-off in bond markets since the 1980s, advisers and investors likely face an expanded opportunity set for tax loss harvesting. Typically, investors turn to equity markets as a first source for portfolio losses, given the asset class volatility. After the bond market losses this year, fixed-income should not be overlooked as part of a tax loss harvesting strategy, and active fixed-income exchange-traded funds, or ETFs, might be a helpful option for transitioning assets while harvesting losses.

Reinvestment in ETFs, which have tended to distribute fewer capital gains than mutual funds, can provide an additional layer of tax efficiency to taxable portfolios undergoing this year-end strategy. Indeed, 80% of fixed-income assets in mutual funds are actively managed, as compared to just 13% of fixed-income ETF assets. Vehicle choice is an important component of any comprehensive tax strategy, and investors have been underserved by actively managed options in the fixed-income ETF landscape.

While tax loss harvesting may require temporary divestment from a client’s portfolio, it isn’t necessarily a time to abandon high-conviction portfolio allocations. Remember that capital losses booked today can offset capital gains distributions or be carried forward to offset future years’ capital gains. While reinvested capital gains distributions allow investors to step up their cost basis on an investment, without offsetting losses, they create a taxable event in the current calendar year. Ultimately, tax loss harvesting can help mitigate some of the impact of these compulsory distributions and capitalize on the broader market losses—including the bond market—year to date.

This highlights a second way actively-managed fixed-income ETFs can add value in the tax loss harvesting process. This growing market of ETF offerings can also be useful for investors who are not looking to make broad and lasting changes to their investment lineup but prefer to harvest losses by temporarily exiting their position. To realize capital losses through tax loss harvesting, investors must not purchase the same or a substantially identical fund or security for 30 days after the sale. This 30-day period is considered the wash sale period. During this time, cash raised from the sale of securities can be reinvested in strategies that are different from those that generated the loss.

The differentiation that active ETF strategies can provide relative to other active ETFs (since they are all different), passive ETFs, or mutual funds may make them a compelling investment during the wash sale period as a way for investors to maintain exposure to a changing market while still booking losses. The liquidity that ETFs provide can make them an attractive instrument for cash reinvestment, particularly this time of year.

As investors consider the potential for broad portfolio reallocation across investment vehicles, it might also be time to rethink the role of bonds in a diversified portfolio. Traditionally, the later stages of a market cycle provide an ideal time to rethink and reset asset allocations. Indeed, the recent downturn has led to questions about the value of bonds in a portfolio. Our fixed-income investment group believes there’s still significant value because of where bond markets are today.

Right now, we are speaking with clients about the potential yield uplift available in short duration, high quality bonds as another way to think about investing short- to medium-term cash. History tells us these kinds of bonds can provide meaningful and significant diversification from equities in a portfolio when equity markets decline—along with capital preservation, inflation protection, and income. Given slowing economic growth and predictions by some of a recession next year, these four roles of fixed-income are important to emphasize to clients.

Passive investments are not striving to outpace their benchmarks; they generally seek to replicate a benchmark’s return pattern. In contrast, active managers seek to provide differentiated returns, particularly in high-yield sectors, for example, where we have seen high rates of dispersion among issuers, and which could provide a silver lining in this turbulent market environment. In short, there are many reasons to own bonds today, and ample opportunity for active management to provide meaningful value-add.

As tax and financial professionals consider tax loss harvesting and changing portfolio allocations this year, perhaps rebalancing with a greater exposure to bonds, we encourage them to also evaluate a transition to more tax-friendly vehicles. Active fixed-income ETFs can serve as meaningful building blocks that sit in the core of an investor’s portfolio and help investments weather volatility through income generation, capital preservation, and inflation protection.

Most of the successful tax and financial professionals I’ve worked with say that incorporating tax management services and tax-efficient vehicles in their clients’ portfolios serves as a differentiator for their practice. This end-of-year, tax-loss harvesting conversation can be critical because it provides an opportunity to turn portfolio losses into a reduction in federal capital gains tax for clients. It’s a great way to demonstrate the value-add you can provide your clients, ultimately deepening your relationships.

As you consider the tax impact and potential for tax loss harvesting opportunities in your client portfolios this year, fixed-income should not be overlooked, as well as the role that actively-managed fixed-income ETFs can play in increasing the tax efficiency of your practice moving forward. This is a use-it-or-lose-it moment, as tax loss harvesting comes but once a year.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Holly Framsted is an ETF director at Capital Group, home of American Funds. Capital launched three new fixed-income ETF strategies that began trading on the New York Stock Exchange in late October.

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