Making Lemonade Out of Lemons: Tax-Loss Harvesting and Swapping from Mutual Funds to ETFs

Chief Investment Officer – Model Portfolios
03/19/2020

We have witnessed an almost unprecedented four to five weeks of market disruption, and many investors are wondering what they can do to stem the tide.

We can’t predict what markets will do from here, but what we do know is that the market declines have generated unrealized tax losses in many individual positions.

Tax loss harvesting is a tangible way of adding value for investors by, possibly, putting money in their pockets in the form of tax savings. Investors can swap out of existing positions and into comparable strategies, thereby realizing tax losses while remaining fully invested. Those losses can then be used to offset realized gains elsewhere in the portfolio.

After a 30-day holding period to satisfy the wash-sale rules, investors can then swap back to the original position if they so choose. Please note, however, that there are tax rules regarding which losses need to be matched to which gains, and investors should seek appropriate tax advice before initiating these transactions.

This exercise might be especially useful for investors considering a swap out of active managers, for two reasons:

  1. For many investors, the default tax loss swap might be to a market cap-weighted beta ETF. But by deploying a WisdomTree strategy instead, the investor can maintain a more similar factor tilt to the active manager and, therefore, potentially a more consistent portfolio performance.
  2. Swapping out of a mutual fund and into an ETF strategy with similar active tilts makes sense from a structural perspective. With ETFs, investors get a more transparent, tax-effective and potentially much lower cost investment vehicle compared to mutual funds.

Many investors have refrained from making the advantageous structural move to ETFs because of unrealized embedded capital gains in historical mutual fund positions. But if the recent market declines have altered that situation, investors should seriously consider “making lemonade out of lemons” by harvesting tax losses and migrating to a new investment vehicle (the ETF) while still maintaining their active management factor tilts.

We think this idea is one excellent way to “lean into” these disruptive markets and add tangible and proactive value to investor portfolios.

Important Risks Related to this Article

Neither WisdomTree Investments, Inc., nor its affiliates, nor Foreside Fund Services, LLC, or its affiliates provide tax advice. All references to tax matters or information provided on this site are for illustrative purposes only and should not be considered tax advice and cannot be used for the purpose of avoiding tax penalties. Investors seeking tax advice should consult an independent tax advisor.

Investing involves risk, including possible loss of principal.

Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. U.S. investors only: To obtain a prospectus containing this and other important information, please call 866.909.9473 or go to wisdomtre.com. Read the prospectus carefully before you invest.

WisdomTree Funds are distributed by Foreside Fund Services, LLC, in the U.S. only.

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About the Contributor
Chief Investment Officer – Model Portfolios
Scott Welch is the CIO of Model Portfolios at WisdomTree Asset Management, a provider of factor-based ETFs and differentiated model portfolio solutions. In this capacity he oversees the creation and ongoing management of the WisdomTree model portfolio solution set. He is also a member of the WisdomTree Asset Allocation and Investment Committees. Prior to joining WisdomTree, Scott was the Chief Investment Officer of Dynasty Financial Partners, a provider of outsourced investment research, portfolio management, technology, and practice management solutions to RIAs and advisory teams making the move to independence. He remains an outside member of the Dynasty Investment Committee.  He sits on the Board of Directors of IWI, the Advisory Board of the ABA Wealth Management & Trust Conference, and the Editorial Advisory Boards of the Journal of Wealth Management and the IWI Investments & Wealth Monitor. Scott earned a Bachelor of Science in Mathematics from the University of California at Irvine and an MBA with a concentration in Finance from the University of Massachusetts at Amherst.