Getting tax back with ETFs

My colleague is always on the lookout for deals and bargains. Growing up in Saint Petersburg during a transitioning Russian economy made everyone resourceful. She and her family have used coupons to clean out stores, with the clerk paying her at checkout! She applies the same frugal approach to constructing core-and-satellite structures for taxable portfolios, and saves money by systematically harvesting tax losses using ETFs.

Core-and-satellite portfolios

Core and satellite refers to a combination of assets originally designed as an alternative to balanced funds (a combination of stocks, bonds and other assets).

Once upon a time, pension funds invested primarily in balanced funds. Larger plans simply added more balanced funds. Then, somebody figured out that this approach inevitably resulted in overlapping holdings, styles, or other factors, which led to index-like performance at full fees.

The economical approach was to build a passive or indexed core portfolio plus a satellite portfolio of individual securities and/or specialty funds seeking to add alpha; that is, returns in excess of the benchmark.

Today, core-and-satellite portfolio construction is well established in the institutional world and, thanks to the cost, liquidity and risk efficiencies of exchange traded funds (ETFs), is rightfully gaining a retail investor following as well.

Born of cost efficiency, core-and-satellite construction is not only an intelligent approach, it can also improve investment results. Lowering costs is the only sure way to increase returns, other than trading on good, material, non-public information — an increasingly scarce commodity and, alas, illegal!

While retail investors can benefit from this innovation, it stops short. Most institutional portfolio managers don’t deal with one aspect of personal investing that’s critical and pervasive: TAX. The largest training grounds for portfolio managers — pension funds, mutual funds and insurance companies — don’t care much about taxes at the investor level. Advisors can add value to their clients’ portfolios by providing what these professional portfolio managers don’t: An effective way to shelter capital gains.

Core-and-sputnik portfolios

The core should reflect the client’s strategic asset mix at low cost. The satellite, meanwhile, should strive to generate excess returns. However, the core could be designed to capture tax losses to be applied to the capital gains of the satellite. We refer to taxable core-and-satellite portfolios as core and sputnik.

A simple example of a 60% equity / 40% bond core portfolio is shown on the left side of the first table (see “Sample core portfolio with tax substitutes,”).

Assume the Canadian equity market fell. Selling HXT would capture a tax loss, but to avoid the superficial loss rule that would void the loss for tax purposes, HXT could not be repurchased for 30 days, leaving the portfolio underexposed to Canadian equities.

So, one could sell HXT and immediately buy an equal dollar amount of XIU (which has the identical underlying index as HXT, the S&P TSX 60), XIC or ZCN, and maintain exposure to the asset class while harvesting the loss to be applied to gains in the current tax year, carried back three years, or forward indefinitely.

Theoretically, with different sponsors and different structures — Horizon Betapro for HXT using swaps and Blackrock for XIU using full replication — this pair are ideal substitutes for each other. However, there are some who feel the Canada Revenue Agency may disallow swaps of identical underlying indices. So ask your tax advisor before executing this tax-loss trade, or any other trade that involves tax.

Tax-loss harvesting is an imprecise science. While the Canadian equity substitutes shown have an R2 of about 98%, indicating they generally move together, short-term returns can be different.

Other ideas

International equity exposure through XWD could be swapped simultaneously for equal parts of ZDM and ZUE. The bond swap out of ZCM into either 50% XCB/ 50% XSB or into CBO illustrates that there are creative ways to replicate exposure using ETFs.

The transparent nature of ETFs and their dampened volatility means finding risk equivalents to swap is easier. The results can be worthwhile. Tax efficiency ranks right up there with insider trading as a certain way of boosting returns, or at least protecting them.