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Tax-loss harvesting with ETFs can lighten tax burdens

When markets are volatile and aren’t offering much opportunity to make money, it’s a good time to enact a tax loss selling strategy using ETFs to lighten your clients’ tax burden.

The concept behind this strategy, tax-loss harvesting, is simple: an investor deliberately sells securities at a loss in order to realize capital losses. Net capital losses are calculated exactly the same way as net capital gains. Fifty percent of the net capital loss is eligible to be used as a potential deduction when filing a personal tax return.

Many investors are hesitant to sell securities at a loss because tax-loss-selling rules prevent them from reinvesting in the same security for at least 30 days from when it’s sold, potentially resulting in missed upside opportunity.

But investors aren’t entirely helpless during a loss period. ETFs allow them to capitalize on their market losses and reduce their past, present and future taxable income (see sidebar, “CRA rules”). Returning some money to clients during a period of negative market returns can be powerful consolation.

Sell the stock, buy the index

ETFs can be used to maintain broad market or sector exposure while harvesting tax losses from individual equity positions.

Index-tracking ETFs typically offer a high degree of equivalent market beta to mutual funds or stocks. An investor could sell any of those securities at a capital loss for tax purposes, if applicable, to offset capital gains from the previous three years, or apply to current or future gains.

An investor could then purchase an ETF that invests in the same or similar asset class—or even the same index with a similar risk/ return profile and correlation to the original security.That way, he or she can harness capital losses to reduce taxable income while maintaining market exposure when prices are anticipated to rise.

Here’s how it works.

Strategy one
Capital-loss harvesting On Manulife

Manulife Financial has traditionally been a heavyweight in the Canadian financial services index—S&P/TSX Capped Financials Index—representing around 6.25% of the market capitalization of the index, tracked by the iShares S&P/TSX Capped Financials Index Fund (“XFN”).

The stock is even weightier in the Horizons Enhanced Income Financials ETF (“HEF”), with an initial portfolio weight of 8.33%.

Note that this ETF uses a covered-call strategy on all stock holdings (namely, selling a call option while simultaneously holding an equivalent position in the underlier), which may not be suitable for all clients.

From January 1, 2011 to October 31, 2011, Manulife stock lost 23.27% of its value. Investors may be in an unrealized capital loss position on this stock—particularly on a multi-year horizon where Manulife lost 54.21% from November 30, 2008 to November 30, 2011, but still maintained a correlation of 0.81 to the return of the S&P/ TSX Capped Financials Index.

Selling Manulife stock at a loss and making an investment in XFN or HEF could allow investors to realize a capital loss for tax-planning purposes. At the same time, they could remain invested in ETFs that will benefit from a rise in Manulife’s stock price—as well as other financial services companies—over the 30-day period when they’d be prohibited from re-buying Manulife.

This strategy is ideal if the investor is bullish on Manulife over the longer term. The main idea is to get indirect exposure to the stock during the 30-day period when the investor cannot repurchase the stock without negative tax repercussions.

Strategy two
Capital-loss harvesting on RIM

RIM has lost a lot of ground, too: The stock is down more than 65% on a three-year basis, ending November 30, 2011, and fell even further in December. However, the stock still constitutes nearly 15% of the S&P/TSX Capped Information Technology Index Fund (XIT).

RIM’s correlation to the S&P/TSX Capped Information Technology Index has been 0.717 over the three-year period ending November 30, 2011. Again, investors could sell RIM, harvest the losses, and buy XIT to maintain exposure to RIM without being subject to superficial tax-loss rules.

Strategy three
Capital-loss harvesting on S&P/TSX 60 index

The application of tax-loss harvesting strategies is even more powerful with ETFs that essentially have the same investment strategy. In Canada, the iShares S&P/TSX 60 Fund (XIU) tracks the S&P/TSX 60 Index. A total-return version of the same index is also tracked by the Horizons S&P/TSX 60 Index ETF (HXT). XIU lost 7.59% from January 1, 2011 to November 30, 2011. The correlation to both ETFs would be practically the same since they both track the same index of stocks.

In this case, investors with exposure to the S&P/TSX 60 Index through XIU can harvest losses by selling their XIU, and maintain the same market exposure to the index by buying HXT.

Almost every equity strategy, whether it involves stocks or mutual funds, probably has a comparable ETF alternative listed on the TSX that can give an investor similar market exposure, or beta, as the original security.

Keep in mind the last day for tax-loss selling for Canadian-listed stocks is three days before the last business day of the year (so December 26, 2012 this year). Of course, this strategy can be used throughout the year to harvest losses.

Big losers of 2011

National Bank Financial’s Product Research Group released a report highlighting a number of large-cap Canadian stocks that suffered significant losses in 2011. The table includes potential ETF replacements and their stock-related correlations. Advisors can implement a tax-loss-harvesting strategy for clients if they have significant holdings in any of these stocks.

Tax loss strategy as of 28-nov-2011

Sector Stock Ticker YTD Price
Return
ETF Name Ticker Stock Weight
in ETF
Stock-ETF*
Correlation
Basic
Materials
Teck Resources Ltd TCK/B -44.9% iShares S&P/TSX Global Base Metals Index Fund XBM 9.3% 77.1%
Pan American Silver Corp PAA 39.0% Horizons Enhanced Income Gold Producers ETF HEP 6.4% 78.5%
Kinross Gold Corp K 28.4% Horizons Enhanced Income Gold Producers ETF HEP 6.2% 74.3%
Consumer George Weston Ltd WN -22.8% iShares S&P/TSX Capped Consumer Staples Index XST 7.9% 32.6%
Energy Niko Resources Ltd NKO -53.2% Horizons GMP Junior Oil and Gas Index ETF HJE 6.7% 38.9%
Talisman Energy Inc TLM 41.2% Horizons Enhanced Income Energy ETF HEE 6.5% 81.3%
Pacific Rubiales Energy Corp PRE 39.4% Horizons Enhanced Income Energy ETF HEE 6.3% 69.7%
Financial Sun Life Financial Inc SLF -38.7% Horizons Enhanced Income Financials ETF HEF 8.3% 78.9%
Manulife Financial Corp MFC -36.4% Horizons Enhanced Income Financials ETF HEF 8.6% 84.9%
AGF Management Ltd. AGF/B -22.9% Claymore S&P/TSX Canadian Dividend ETF CDZ 5.2% 62.4%
Industrial Celestica Inc CLS -14.7% iShares S&P/TSX Capped Info. Tech. Index Fund XIT 11.8% 66.2%
Technology Wi-Lan Inc WIN -12.7% iShares S&P/TSX Capped Info. Tech. Index Fund XIT 5.2% 47.3%
Utilities Just Energy Group Inc JE -33.5% BMO Covered Call Utilities ETF ZWU 5.5% 40.4%
Atlantic Power Corp ATP 10.5% BMO Equal Weight Utilities Index ETF ZUT 6.4% 45.5%

*Correlation 2011 YTD or since ETF inception; Sorted by sector alphabetically, then by YTD Price Return

Source: National Bank Financial, Bloomberg, Horizons, BMO, Claymore, iShares

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Howard Atkinson, CFA, CIMA, ICD.D, is the CEO of Horizons Exchange Traded Funds and author of four books. He is also chair of the Canadian ETF Association. The opinions expressed in this article are his own and do not necessarily reflect those of Horizons Exchange Traded Funds Inc.

Originally published in Advisor's Edge Report

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