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Innovation across the exchange-traded universe has brought forth a host of investment strategies to mainstream investors, allowing for access to previously difficult to reach corners of the global financial market. Aside from the well-known benefits of ETFs, like ease-of-use and transparency, the structure of these investment vehicles holds several, often times overlooked, tax benefits as well. Some declines in asset values might have a silver lining, as they present the opportunity for financial advisors and self-directed investors alike to exercise effective tax management and make prudent use of unrealized losses [see 25 Things Every Financial Advisor Should Know About ETFs].

Market downturns provide the unique opportunity for investors to take advantage of losses to lower their tax liabilities. There are potential benefits of selling a “losing” security; investors can use the unrealized losses to offset realized gains in their portfolio, effectively reducing their tax liability. Second, investors can use the sale proceeds to reinvest in a similar position and maintain exposure as desired [see ETFs And Tax-Loss Harvesting].

It is important that investors who wish to employ a tax-loss harvesting strategy be aware of the wash sale rule, which forbids the purchase of a substantially similar security within 30 days of a sale. If an investors sells a security intended as a long-term holding, then repurchases that same security, or one that is nearly identical within 30 days, the tax-loss benefit is lost.

Tax-Loss Harvest Trade Ideas

Hand on tax filings

ETFs allow for investors to work around the wash sale rule and take advantage of a tax-loss harvesting strategy given the extremely diverse product spectrum. Investors who have incurred an ugly loss on a stock position may wish to sell the security and use the proceeds to purchase a sector-specific ETF to maintain exposure to that corner of the market, while also realizing the tax-benefits associated with the incurred loss [see also Ten Commandments Of ETF Investing].

Another option is for investors to sell mutual fund shares and incur a loss or avoid capital gain distributions, and purchase an ETF with a comparable investment objective. Finally, investors may also consider selling a losing ETF position and re-deploying the proceeds to another ETF with a similar, but not identical, investment strategy.

Tax-loss harvesting allows for investors to make the most out of their unrealized losses, while still maintaining the desired level and concentration of exposure to a particular corner of the market. ETFs make it easier for investors to swap positions as the end of the year approaches and realize tax-benefits while remaining fully invested. Investors should note that the IRS has not released a definitive opinion regarding what qualifies as a “substantially identical” security and its application to the wash sale rule and ETFs [see also Ten Myths About ETF Investing].

Below we highlight three past “ETF Swap” examples to give investors a better idea of tax-loss harvesting and how it works in practice:

Emerging Markets Funds

In 2011, shareholders of the ultra-popular iShares MSCI Emerging Index Fund (EEM B+) probably weren’t too happy with the fund’s dismal 2011 performance given the rampant volatility that ripped through emerging markets. Investors may have considered selling their stake in EEM and re-deploying the proceeds to the EG Shares Emerging Markets Low Volatility Dividend ETF (HILO B+), which offered comparable emerging markets exposure with a twist. HILO tracks a unique dividend yield weighted index that aims to deliver a higher level of current income along with lower volatility relative to traditional market cap weighted products in the space, such as EEM and (VWO A).

China Equity ETFs

China natural landscape

The iShares FTSE China 25 Index Fund (FXI B-) was down upwards of 10% from January 2011 to November 2011, and some investors chosn to cope with their unrealized losses by switching over to the Guggenheim China All-Cap ETF (YAO B+). This Guggenheim alternative to the ultra-popular FXI, which features a shallow basket of 25 securities, offers investors access to a deeper, better diversified portfolio of Chinese equities. YAO also offers a broader sector representation of the Chinese economy; FXI is heavily tilted towards the financial sector, while YAO casts a much wider net.

Financials Equities ETFs

Financial stocks all over the globe were hit hard in 2011 and shareholders of State Street Financial Select Sector (XLF A) may have wished to take advantage of any unrealized losses. Investors can have considered reallocating capital from XLF to a different fund targeting the same industry. The PowerShares S&P SmallCap Financials ETF (PSCF A) may be an appealing alternative as it targets the small cap segment within the financial services corner of the U.S. economy.

The Bottom Line

The above examples are just a few of the many opportunities that investors have to utilize this strategy. Be sure to consult a professional tax advisor before implementing any tax-loss harvesting strategies.

Disclosure: No positions at time of writing.

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