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Tax Loss Harvesting: With Volatility Comes Opportunity

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This Insight is not intended to provide tax advice and individuals should consult with a tax advisor about your individual situation.

A STRATEGY FOR STRESSED MARKETS

The spread of COVID-19 throughout the U.S. has brought with it a wave of uncertainty, not only in financial markets but in all facets of our lives. The pandemic has given rise to extreme market volatility, which can feel overwhelming and chaotic, particularly when investors are advised to resist taking action in their portfolios and remain committed to their long-term objectives.

However, while major portfolio moves might not be advisable in volatile markets, there are certain strategies that may have the potential to benefit portfolios during these times. One such example is tax loss harvesting, which takes advantage of market downturns in an effort to improve a portfolio’s tax efficiency.

WHAT IS TAX LOSS HARVESTING?

Harvesting tax losses means selling securities that have experienced an unrealized loss in order to offset taxes on capital gains and income. For example, if an investor performed a transaction that resulted in a realized capital gain of $5,000 in Security A, and then a subsequent market downturn results in an unrealized $4,000 potential loss in Security B, the investor might then want to consider performing another transaction whereby they would sell Security B to “harvest” this loss and potentially offset the gain of the first transaction. As a result, the investor may be able to reduce their tax liability from $5,000 to $1,000.

Reducing the tax burden

THE WASH SALE RULE

Selling securities to harvest tax losses can result in excess cash and material changes to asset allocation. To avoid this unintended outcome, after selling a security to harvest losses, investors often buy another security that offers similar exposure. This can be an effective strategy to maintain a target asset allocation and remain fully invested.

However, when taking this approach it is important for investors to be aware of the wash sale rule. This rule prevents selling and purchasing substantially identical assets within a 30-day window. In most cases, losses from wash sales are not tax deductible.

USING ETFs TO MAINTAIN A TARGET ASSET ALLOCATION

Many investors have found exchange-traded funds (ETFs) to be useful tools in tax loss harvesting strategies. Since ETFs generally track broad indices and trade on-exchange like a stock, they can be effective for maintaining asset allocation after individual securities are sold to harvest losses.

While there may be multiple issues for every investor to consider such as the difference in fees and potential transaction costs, there are times when investors can sell an ETF to harvest a loss and potentially maintain their allocation by investing another ETF that offers similar exposure within the same asset class—but tracks a different index.

Infrastructure allocation

For example, if an investor sells $1,000 of Global Infrastructure Company XYZ shares to realize a tax-deductible loss, the investor may want to consider investing $1,000 into the FlexShares STOXX® Global Broad Infrastructure Index Fund (NFRA) to maintain the same level of global infrastructure exposure.

This can also be a strategy that an investor may want to consider in the fixed-income portion of their portfolio. If after a market downturn an investor sells a high yield bond ETF that tracks the Markit iBoxx USD Liquid High Yield Index at a loss, after considering the various differences between individual funds, the investor may want to consider replacing that investment with the FlexShares High Yield Value-Scored Bond Index Fund (HYGV) in an effort to maintain exposure to the high yield market.

HYGV is just one of several FlexShares ETFs that could be ideally suited for maintaining a target asset allocation after harvesting a loss from a different ETF with similar exposure:

Five FlexShares tickers


FIND OUT MORE

The FlexShares approach to investing is, first and foremost, investor-centric and goal oriented. We pride ourselves on our commitment to developing products that are designed to meet real-world objectives for both institutional and individual investors. If you would like to discuss the attributes of the fund discussed in this report in greater depth or find out more about the index methodology behind it, please don’t hesitate to call us at 1-855-FlexETF (1-855-353-9383).