ETF Center Sponsor Article State Street The ABCs of ETF Tax Management Strategies
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ETF Center Sponsor Article—State Street: The ABCs of ETF Tax Management Strategies
Issue 4 — February 2009
The ABCs of ETF Tax Management Strategies
Clients with portfolios carrying losses from stocks, exchange-traded funds (ETFs), and/or mutual funds may benefit from tax planning strategies that begin when an investment is sold and a loss is realized. Such losses can then be used to offset any realized capital gains and, in the event that the portfolio in question has no realized capital gains (or the client has offset all capital gains with losses for the applicable tax year), the client can carry forward their losses for capital gain taxes due in future years. The proceeds from such losses may then be used to gain exposure similar to the initial investment subject to wash-sale rule restrictions. Under existing tax laws, the wash-sale rule prohibits clients from taking a loss on a security if a substantially identical security is repurchased within 30 days after the date of sale.
In many cases, ETFs offer a unique opportunity for clients to benefit from the vehicles inherent tax efficiency while gaining exposure to an investment that is potentially more diversified than its predecessor. In all market environments, diversification is a key component to risk management and potential portfolio performance. When swapping out of a stock, mutual fund, or ETF, clients have the opportunity to potentially enhance portfolio diversification while maintaining desired exposure and strategic objectives. Offering broad and narrow exposure to virtually any market segment, both domestically and internationally, exchange traded funds are well suited for replacing poorly performing single stock or concentrated investments with a single, diversified ETF. Such a strategy may serve to improve risk-adjusted performance. Further, a swap and hold strategy using ETFs may be more tax efficient, since their structure is designed to produce low turnover which should result in fewer capital gains when held over the long term.
Tax Swapping Strategies Demystified
A tax swap is defined as the sale of one security followed by the simultaneous purchase of a similar investment. The sale of a security purchased at a higher price may trigger a loss, which can be used to offset gains elsewhere in the portfolio. This may help reduce taxes due for the current year. In addition, losses can be carried forward and used to offset gains in future years. Most importantly, tax swaps provide clients with the opportunity to maintain or alter their desired market exposure when they do take a loss.
Putting it into Practice
There are three primary ways an ETF can be helpful when harvesting portfolio losses to better manage capital gain taxes.
- Benefits of diversification
Most clients have a strong aversion to selling under-performing positions because they believe such holdings will bounce back in time. Industry and sector ETFs often provide a solution to this problem because the investor is able to maintain exposure to a particular market segment while simultaneously generating a tax loss. Many sectors and industries currently have stocks that are trading well below their year-to-date highs. Selling an underperforming stock and replacing it with a comparable ETF can generate losses and provide the added benefit of increasing diversification, thereby mitigating single stock risk.
In a year where the US stock market has experienced unprecedented market turmoil, many clients have looked overseas to improve their investment returns. However, international stocks were also hard hit in 2008, so those clients holding international stocks may have some of the same tax planning opportunities. With the launch of the International Sector SPDR family of ETFs, investors can make similar swaps with under-performing stocks while maintaining somewhat comparable exposure through International Sector ETFs.
With the sharp drop in equity markets in 2008, there are numerous opportunities to utilize losses in mutual fund portfolios. Consider the returns for several major asset classes in 2008. With a few notable exceptions such as bonds and commodities, most asset classes have declined through the first nine months of 2008.
Year-to-Date Return (through 9/30/08)
Large Cap (S&P 500 Index): -19.29%
Large Cap Growth (Russell 1000 Growth Index): -20.27%
Large Cap Value (Russell 1000 Value Index): -18.85%
Small Cap (Russell 2000 Index): -10.38%
Small Cap Growth (Russell 2000 Growth Index): -15.29%
Small Cap Value (Russell 2000 Value Index): -5.37%
International Equity (MSCI EAFE Index): -29.26%
Emerging Market Equity (MSCI Emerging Market IndexSM): -35.54%
BRIC (Bank of New York Mellon BRIC Select ADR Index): -34.34%
China (FTSE/Xinhua China 25 Index): -23.46%
Brazil (MSCI Brazil Index): -30.18%
US REITs (Dow Jones Wilshire REIT IndexSM): -2.29%
Bloomberg, Zephyr StyleADVISOR, SSgA Strategy & Research, as of 9/30/2008. Past performance is no guarantee of future results. It is not possible to invest directly in an index. Index performance does not reflect charges and expenses associated with the fund or brokerage commissions associated with buying and selling a fund. Index performance is not meant to represent that of any particular fund.
Suppose an investor owns shares of a US large cap equity mutual fund that has declined even more than the S&P 500 Index (shown in the table above). In lieu of waiting 31 days to reinvest the proceeds from the sale of the mutual fund, a more effective strategy may be to immediately reinvest the proceeds in an ETF based on an index that offers similar exposure—such as the SPDR S&P 500 ETF [ticker: SPY]. Through this approach, the investor maintains closely comparable market exposure while harvesting losses that can be used to offset gains within the overall portfolio. In most instances, clients can access an array of ETFs that provide similar exposure to most market segments. For example, an investor with a loss on a traditional healthcare mutual fund may sell the position and subsequently purchase a healthcare sector ETF, provided that its underlying portfolio of stocks is not substantially identical.(1)
International funds have seen particularly steep declines in 2008. The MSCI EAFE Index has declined nearly 30% from its high point in 2008. Emerging markets have declined even more, down 36% year-to-date. Specific countries such as China and Brazil are down 23% and 30%, respectively, from their highs. Mutual funds with exposure to these international markets may offer tax swap opportunities.
Similar to the opportunity with mutual funds, the decline in equity markets in 2008 has resulted in unrealized losses in many ETF holdings as well. Examples include ETFs that provide exposure to US equity, international equity, emerging markets and REITs. Many sector ETFs have declined this year as well. Clients may capitalize on such market events by realizing losses incurred from such ETFs and reinvesting the proceeds in another sector fund benchmarked to a different index. Through this process, the investor maintains some exposure to a specific market segment while simultaneously generating a loss. With a broad range of both US and International sector ETFs, clients have more options for selecting a fund that will closely align with their exposure and diversification needs.(2)
Conclusion
The structure of ETFs provides your and your clients with expanded opportunities to improve overall tax efficiency, lower costs and rebalance portfolios. Simply put, the SPDR family of ETFs helps investors maintain desired market exposure and achieve strategic asset allocation targets through their ability to precisely track a vast array of asset classes and benchmarks. With 81 ETFs from which to choose and more than $168 billion in assets under management3, SPDR ETFs span an array of international and domestic asset classes across equity and fixed income markets.
State Street Global Advisors
State Street Financial Center
One Lincoln Street
Boston, MA 02111
866-787-2257
FOR INVESTMENT PROFESSIONAL USE ONLY. NOT FOR USE WITH THE PUBLIC.
(1)The Internal Revenue Service has not released a definitive opinion regarding the definition of substantially identical securities and its application to the wash-sale rule and the utilization of exchange traded funds. The information provided is not intended to provide investors with a complete view of the tax law and/or tax loss strategies and tactics that can be implemented through the use of ETFs. Rather, the information presented in this paper has been presented for educational purposes only. You should always consult the advice of a tax attorney or tax advisor before implementing any such strategy.
(2) An investor would need to consult carefully with a tax advisor to confirm that the ETF in which he reinvests is sufficiently different from the original investment not to trigger a wash sale.
(3) SSgA Strategy & Research, as of 9/30/2008.
Before investing, consider the funds investment objectives, risks, charges and expenses. To obtain a prospectus which contains this and other information, call 1-866-787-2257 or visit spdretfs.com. Read it carefully.
ETFs trade like stocks, are subject to investment risk and will fluctuate in market value. The investment return and principal value of an investment will fluctuate in value, so that when shares are sold or redeemed, they may be worth more or less than when they were purchased. Although shares may be bought or sold on an exchange through any brokerage account, shares are not individually redeemable from the fund. Investors may acquire shares and tender them for redemption through the fund in large aggregations known as creation units. Please see the funds prospectus for more details.
Sector ETF products are also subject to sector risk and non-diversification risk, which may result in greater price fluctuations than the overall market. Past performance is no guarantee of future results. Foreign investments involve greater risks than US investments, including political and economic risks and the risk of currency fluctuations, all of which may be magnified in emerging markets.
REIT funds may be subject to a high degree of market risk due to lack of industry diversification. REIT funds may be subject to other risks including, but not limited to, changes in real estate values or economic conditions, credit risk and interest rate fluctuations and changes in the value of the underlying property owned by the trust and defaults by borrowers.
Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.
Past performance is no guarantee of future results. It is not possible to invest directly in an index. Index performance does not reflect charges and expenses associated with the fund or brokerage commissions associated with buying and selling a fund. Index performance is not meant to represent that of any particular fund.
In general, ETFs can be expected to move up or down in value with the value of the applicable index. Although ETFs may be bought and sold on the exchange through any brokerage account, ETFs are not individually redeemable from the Fund. Investors may acquire ETFs and tender them for redemption through the Fund in Creation Unit Aggregations only. Please see the prospectus for more details.
Information represented in this piece does not constitute legal, tax or investment advice. Investors should consult their legal, tax and financial advisors before making any financial decisions.
This material is for informational purposes only and does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investors particular investment objectives, strategies, tax status or investment horizon. There is no representation or warranty as to the current accuracy of, nor liability for, decisions based on such information. All performance information is historical and not indicative of future results. All investing involves risk. Holdings are subject to change without notice. There is no assurance that any Select Sector SPDR fund currently holds the securities mentioned in the article.
The Russell 1000 Growth Index, Russell 1000 Value Index, Russell 2000 Index, Russell 2000 Growth Index, Russell 2000 Value Index are trademarks of the Frank Russell Company. Russell is a trademark of the Frank Russell Company.
The MSCI EAFE Index and the MSCI Emerging Market Index(SM) are trademarks of Morgan Stanley Capital International. Portions of the balanced financial products described herein are indexed to an MSCI index as noted. The financial products referred to herein are not sponsored, endorsed, or promoted by MSCI, and MSCI bears no liability with respect to any such financial products or any index on which such financial products are based. The Dow Jones Wilshire REIT Index(SM) is calculated and distributed by Dow Jones Indexes pursuant to an agreement between Dow Jones & Company, Inc. and Wilshire Associates Incorporated. Dow Jones and Wilshire are the respective service marks of Dow Jones and Wilshire Associates.
The SPDR trademark is used under license from The McGraw-Hill Companies, Inc. (McGraw-Hill). No financial product offered by State Street Corporation or its affiliates is sponsored, endorsed, sold or promoted by McGraw Hill. Standard & Poors, S&P, SPDR, S&P 500, Select Sector SPDRs, and S&P Composite1500™ are trademarks of The McGraw-Hill Companies, Inc. and have been licensed for use by State Street Bank and Trust Company.
State Street Global Markets, LLC, member FINRA, SIPC is distributor for all SPDR products and is a wholly owned subsidiary of State Street Corporation. References to State Street may include State Street Corporation and its affiliates. Certain State Street affiliates provide services and receive fees from the SPDR ETFs. ALPS Distributors, Inc. a registered broker-dealer, is distributor for SPDR S&P 500, MidCap SPDR and Dow Diamonds, all unit investment trusts and Select Sector SPDRs.
2008 State Street Corporation
For Professional Use Only.
