I’m not sure if this is legal, but it seems like a solid strategy.
Let’s say you are managing a portfolio that has a dedicated 10% allocation to high yield bonds. That allocation is going to remain regardless of whether you believe high yield bonds are a good investment. So, since you need to remain invested at all times, is it legal to rotate allocations to take advantage of unrealized tax gains in mutual funds vs. ETFs?
Since mutual funds tend to wipe the slate clean whenever they can, they generally avoid situations with large unrealized capital gains or losses. This is not true with ETFs, and today’s high yield bond market is a perfect example of that.
Take two generic examples, JNK and VWEHX. The Barclay ETF has a large unrealized capital loss of 21%, while the Vanguard mutual fund has a more reasonable 7% in unrealized loss. The underlying holdings of these funds are somewhat similar (the Barclay fund is a little lower quality), so long term returns should end up being very similar.
However, if I buy JNK today, my first 21% of gains are tax free, while the Vanguard fund only has 7% in potential tax free return. If I’m a wealthy investor with nonqualified dollars, this is an important distinction.
Long term, this could be a viable rotational strategy, buying the ETF after large periods of loss and moving to the mutual fund after those capital losses are fully offset by gains. Essentially you get access to the asset class but do so in a much more tax efficient manner. I just don’t know if that’s legal, since you’d be selling and buying essentially the same investment for tax purposes. Makes me think it’s probably illegal.
i’m pretty sure 0% of gains in the ETF are tax free as your capital gains are dependent on your buy price and sell price, not the inherent portfolio tax situation. you can buy lots of CEFs at a discount to NAV, but that doesn’t mean your taxation changes, compared to CEFs that trade at NAV, and its not like the tax loss is realized within the ETF, unless there is a bankruptcy.
as for MFs, i’m no so sure if investing in MFs versus the individual securities would be beneficial or not. i think MFs are beneficial if they have inherent losses but there’s no way as those who sell claim tax loss when they sell. isn’t that when the MF has to distribute the capital loss?
Galli, you may be unaware but there are certain tax strategies that clients use to their benefit. You have to do this in the appropriate manner so that you don’t break the law. For example, look at the wash sale rules.
My question is similar to the wash sale, but since I’m not repurchasing the same stock, ETF or mutual fund, I believe it’s legal.
Let me rephrase the question. If I can hold a generic ETF or a generic index mutual fund, and they are essentially the same fund, why wouldn’t I purchase the one with the better tax circumstance. Of course I would. In the example above, the ETF has considerable capital losses compared to the mutual fund and therefore will offer better after-tax returns than the mutual fund in the short-medium future (again, assuming their portfolio is relatively similar). As the fund realizes those capital losses, it will offset the gains on coupon payments…at least moreso than the mutual fund, since the mutual fund has less capital losses.
However, I’m unsure if rotating back and forth between the low cost etf and low cost index mutual fund is legal, or if it will be deemed similar to a wash sale.