Tax Selling and ETFs

This article was originally published by Zacks.com.

With 2013 coming to a close, investors have to be thinking about tax implications for their portfolios. Yet, with many markets up significantly on the year, the practice of harvesting losses for tax purposes could be curtailed this time around.

After all, the S&P 500 is up over 25% so far in 2013, meaning that losers are hard to come by. But in foreign markets and some sectors, there are still a handful of funds that are down significantly on the year, and could be great sell candidates for investors looking to reap some tax benefits to close out the year.

But for investors who want to maintain similar exposure, yet also want to obtain some tax loss benefits, a look to the ‘wash sale’ rule could be something to keep in mind. This rule says that if you buy substantially identical securities within 30 days before or after a sale at a loss, you cannot claim the loss on your taxes.

Fortunately, with the advent of many competing ETFs that are tracking similar — but not identical — indexes, investors can swap one fund out for another and avoid hitting this wash sale rule. And best of all, exposure will be pretty close, but likely not close enough to trigger the wash sale rule.

For investors seeking to apply this strategy this year, or examples of how this might work in future years, we have highlighted some of the best candidates for some ETF tax loss harvesting below:

Broad emerging markets

Developing countries were crushed in 2013, with many losing double digits on the year. The culprit for these heavy losses was undoubtedly taper talk in the U.S., which caused hot money to flow from emerging nations, while a variety of political and commodity issues didn’t help matters either.

Two of the most popular funds in this space are the iShares MSCI Emerging Markets ETF (EEM) and the Vanguard FTSE Emerging Markets ETF (VWO). These funds both lost on the year, with each member of this duo falling by at least 5%.

Both of these funds also see extreme amounts of volume, and are quite popular among investors; both have more than $40 billion in AUM. However, while they might appear similar, there are actually some key differences between the funds.

For EEM, the fund tracks the MSCI Emerging Markets Index, and the top sector is financials (24%), followed by technology at 15%. China, South Korea, Taiwan and Brazil make up the four biggest nations in the portfolio, with each accounting for at least 9% of assets.

In VWO’s case, it follows the FTSE All-World Emerging Markets Index, with financials taking up 27% of assets, followed by energy at 13%. For country exposure, China is the biggest at 20%, followed by Taiwan, Brazil, and South Africa.

Thanks to these differences, VWO and EEM don’t appear to be similar enough to be hit by the wash sale rule, and could be interesting substitutes for each other if you are looking to obtain a modest tax benefit but also stay in the emerging market space.

Metal mining

Due to crashing metal prices, metal mining firms were very hard hit in 2013. Metal miners generally act as a leveraged play on underlying metal prices, so given how poor gold and silver were this year, the terrible performances in the metal mining ETF world should be expected.

In fact, the Market Vectors Trust Gold Miners ETF (GDX), which tracks the NYSE Arca Gold Miners Index, lost more than 50% of its value this year. However, there are others in this space which track slightly different benchmarks, but also follow the gold mining space.

These funds include the Global X Pure Gold Miners ETF (GGGG), which follows the Solactive Global Pure Gold Miners Index, and the iShares MSCI Global Gold Miners ETF (RING), which tracks the MSCI ACWI Select Gold Miners Investable Market Index.

All were down significantly in 2013, but if gold prices can stabilize, these might be winners in the New Year, and interesting selections for those looking to cash in on tax losses from GDX while maintaining gold mining exposure.

Single-country ETFs

Many individual countries now have more than one ETF thanks to heavy competition among issuers. This has given many investors a choice when it comes to single country exposure, and it could help for tax loss purposes this year as well.

That is because many countries — and in particular those in the emerging world — have seen weakness on the year. But if you believe a turnaround could be at hand in 2014, it could be a interesting play to swap one of these funds for its counterpart in order to maintain exposure but also harvest some tax losses as well.

In particular, three markets stand out; India, Indonesia, and Brazil. All three have seen poor trading in 2013, but have at least one competing fund that tracks a pretty similar slice of the market.

For India, investors have the Market Vectors India Small Cap Index ETF (SCIF) and the Emerging Global Shares INDXX India Small Cap Fund (SCIN). Both of these have lost more than 21% on the year, but have seen strength in recent sessions, suggesting that things might be looking up for these two in 2014.

In the Brazilian market, two small cap funds also stand out. Both the Brazil Small Cap ETF (BRF) from Market Vectors and the iShares MSCI Brazil Small Cap ETF (EWZS) have stumbled by more than 27% on the year. But for those looking for a rebound in this market ahead of the World Cup, these two, which have a slightly different focus, could be interesting substitutes.

Lastly, Indonesia is also an interesting choice as the country has seen its funds tumble as currency woes have built up. And once again here, Market Vectors and iShares square off with Market Vectors’ (IDX) vs. iShares’ (EIDO).

Both have plunged by more than 25% year to date, but could be due for a bounce in 2014. After all, Indonesia is relatively consumer focused for a developing Asian market, so if developed nations stumble and concerns over tapering stabilize, this might be an interesting selection in the coming year, especially if you take advantage of some tax selling first.

Bottom line

Many of the funds above have had terrible year-to-date performances, and could be solid choices for those looking to harvest losses for tax purposes. However, for investors seeking to maintain exposure in the respective segments, a look to competing — and slightly different — funds could be a great idea.

This is because these funds should get around the wash sale rule for investors, allowing a tax harvest sale, and immediate purchase of the similar — but not identical — security in the same space. This could allow investors to reap the benefits of the losses, but still maintain exposure for a hopeful rebound heading into 2014, potentially getting the best of both worlds with minimal exposure differences.

Eric Dutram is the ETF Strategist for Zacks Investment Research.

This article is not intended as tax advice, please consult your tax advisor before any tax-related purchase or sale of securities.

The information supplied above by Zacks Investment Research Inc. contains opinions based on factual research which may or may not be accurate. Neither Zacks nor Intellisphere will assume any liability for losses from investment decisions based on this information.

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