I expect some investors’ thoughts are drifting toward their portfolios as they consider the rapidly approaching end of the 2009 tax year. The calendar year end creates a big ticking clock for investors to harvest any capital losses that may be sitting in their taxable portfolios at the same time they are considering rebalancing to reduce risk and position themselves for 2010 and beyond. To the degree these thoughts are your thoughts, it might be an opportune time to remind you of a few things.
First, capital losses have real economic value and so harvesting those losses should be strongly considered any time you are able to do so. At its most basic level, it means selling an asset to lock in the loss but then reinvesting the cash in some way to make sure your portfolio is still properly diversified and there is minimal “cash-drag” in your portfolio. It might mean you find a very similar investment to give you the same exposure as the asset you are selling, or it may be a time to rebalance your portfolio toward an allocation that simply makes better sense. Proper portfolio construction should always be front of mind, but the end of the tax year often gives us that nudge we need to actually execute on those ideas. Tax loss harvesting can be very simple but can also get quite complex, so don’t hesitate to ask if you think you may need to do something along those lines but aren’t sure how to go about it or if there might be a better way.
Second, consider upcoming capital gains distributions for taxable mutual fund holdings. Remember that mutual funds need to distribute their capital gains and losses to investors each year, and often that distribution happens sometime in December. Since 2008 created significant capital losses for many mutual funds, there may in fact be very little in the way of capital gains distributions this year (those mutual funds were able to use the capital losses carried forward from last year to offset gains this year), but I am seeing losses announced by several major mutual fund complexes so it is always good to check. If you are considering selling a particular mutual fund holding, either for tax-loss harvesting, rebalancing, or simply to reallocate those assets into better ideas, you should consider doing so prior to the distribution date of any funds expecting to distribute capital gains. By doing so, you avoid the distribution and therefore the tax associated with the distribution. You might be thinking, “But I don’t want to lose out on my distribution!” It’s important to understand that the distribution itself has no particular value associated with it that is not already reflected in the fund’s net asset value. In fact, the NAV of the fund drops by the exact amount of the distrubution on the date of the distribution, so your overall investment remains exactly the same except the taxes associated with the cap gain are dragged into the current year instead of being realized when you sell the fund. This is one of the major advantages of ETFs over mutual funds since ETF cap gains distributions tend to be considerably less due to their unique accounting rules (ask me to explain, if interested). So, if you are considering selling a fund, try to make the decision before any capital gains get distributed to avoid an unnecessary tax.
Finally, remember that ETFs are extremely important in this discussion because of their ability to fill a hole in your portfolio during tax-loss harvesting as well as for avoiding the onerous capital gains distributions of mutual funds. But, even though ETFs can be useful, they aren’t a no-brainer. The ETF landscape is becoming very crowded and there are an incredible amount of bad ETFs out there. It is important to consult with someone who knows the ETF world very well and can help you avoid costly mistakes while working with your CPA to maximize any tax benefits from carrying out certain portfolio decisions. So, whether you are working with another professional or with Frontier Advisors, please be sure the above topics are discussed and you are getting properly advised.