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Using Active ETFs for Tax Loss Harvesting

Tax loss harvesting may sound like a mouthful, but it’s a surefire way to add a percentage point to your annual returns. So, it’s worth taking the time to understand how it works and the strategies you can use to employ it within your portfolio.

In this article, you’ll learn about tax loss harvesting and how active ETFs can help you efficiently harvest losses while maintaining your asset allocation.

What Is Tax Loss Harvesting?

Suppose you bought a stock or fund that fell ten percent over the past year. While you might plan on holding it long term, you could sell the stock or fund to lock in the losses and offset capital gains or up to $3,000 in ordinary income on your taxes.

Tax loss harvesting is an easy way to add so-called ‘tax alpha’ to your portfolio. According to one study in 2020, the strategy could result in a 0.83% to 1.04% net benefit each year—just for strategically selling and repurchasing stocks and funds.

Many robo advisors offer built-in tax loss harvesting, where they sell under-performing funds and use the proceeds to invest in adjacent (but not too similar) alternatives. For self-directed investors, there is a variety of tools that can help identify opportunities, too.

The Wash Sale Rule Caveat

The only caveat is the Wash Sale Rule, which states you cannot repurchase the same or a ‘substantially identical’ security within 30 days of the sale. Ostensibly, they don’t want the transaction to be for tax purposes only—it should be an economic decision.

This rule can make it a challenge to harvest losses while maintaining your asset allocation. For instance, you cannot sell an S&P 500 index fund and purchase a different S&P 500 index fund within 30 days because they are ‘substantially identical.’

Enter active ETFs. Since these funds don’t track popular indexes, most of them are not ‘substantially identical’ to anything. This makes them an ideal tool for maintaining an allocation to an asset class without mimicking an index.

Harvesting Fixed Income Losses

One of the most obvious places to look for tax loss harvesting opportunities in recent years is fixed income. Rising interest rates and yields have sent bond prices sharply lower since 2020, resulting in steep losses in many bond-focused index funds.

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Investors who purchased bonds or bond funds in 2020 might be sitting on substantial losses in today’s market. Source: MarketWatch

The problem is many bond index funds are similar, making them ineligible for tax loss harvesting (unless you stay out of bonds for 30 days). The solution? Actively managed bond funds offer a distinct alternative that doesn’t run afoul of the Wash Sale Rule.

Actively Managed Bond ETFs

These funds are sorted by their YTD total return, which ranges from 3.7% to 5.5%. They have AUM between $189M and $9.5B and expenses between 0.36% and 0.58%. They are currently yielding between 3.9% and 8.3%.

Harvesting Thematic ETF Losses

Thematic ETFs have become increasingly popular over the past few years, with more than 150 different options in today’s market. These funds make it easy to jump onto trends ranging from electric vehicles to artificial intelligence.

Of course, anyone following NVIDIA’s stock knows these funds can be volatile. And many investors are likely sitting on losses in at least some thematic corners of their portfolio, even in today’s lofty equity markets.

The good news is many thematic funds overlap, meaning there’s an opportunity to harvest tax losses in one fund and find a similar (but not substantially identical) alternative targeting the same broad niche, such as crypto or artificial intelligence.

Popular Thematic ETFs

These funds are sorted by their YTD total return, which ranges from -11% to 5.6%. They have AUM between $950M and $7.8B and expenses between 0.67% and 0.86%. They are currently yielding between 0% and 4%.

The Bottom Line

Active ETFs are extremely useful for harvesting tax losses. While many index funds fall under the Wash Sale Rule’s ‘substantially identical’ classification, actively managed funds are often unique enough to avoid these restrictions.

In today’s market, you might find opportunities to harvest tax losses in both fixed income and thematic subsets of the market (like AI or EV technologies)