ETF Capital Markets Desk: A Year-End Tradition – Tax-Loss Harvesting

    David Mann

    David MannHead of Capital Markets, Global Exchange-Traded Funds (ETFs), Franklin Templeton Investments

    As we gather with friends and family to celebrate the holiday season and the traditions it brings, David Mann, our head of Capital Markets, Global ETFs, offers his view on another year-end tradition in the world of exchange-traded funds: tax-loss harvesting.

    Although it's perhaps not on par with eating turkey at Thanksgiving or making New Year's resolutions, one of the great end-of-year traditions in the world of exchange-traded funds (ETFs) is a discussion of tax-loss harvesting.

    Tax-loss harvesting refers to a strategy whereby poorly performing investments are sold at a loss, and those losses are used to offset realized taxable gains on other investments. As financial advisors often reach out to their clients in an attempt to transition them out of a product (which is typically at a loss; that is, below the purchase price) and into another ETF with the goal of achieving better return potential and harvesting a loss for tax purposes. Of course, individuals are strongly advised to consult with appropriate financial, legal or tax advisors about specific circumstances and individual goals.

    I have written previously about the best practices around trading new ETFs. Today, with the idea of year-end planning in mind, I wanted to dive a bit deeper into trading new ETFs in a slightly different context, where the starting point of the trade is actually exiting a more established ETF that has a higher assets under management and average daily volume.

    As I have previously discussed, a newer ETF’s price reflects where the parties that act to ensure market liquidity (authorized participants and market makers) can buy the ETF’s underlying basket of securities. This is because in an ETF’s early days, there are not many shareholders looking to sell, and the trading tends to be one directional:  usually new investors buying shares from the seeding counterparties—entities that deliver the underlying basket to the ETF issuer in exchange for the ETF’s first shares.

    More established ETFs tend to trade at prices that are somewhere between where the basket of underlying securities can be bought (if there is a lot of buying pressure) and where that basket of securities can be sold (if there is a lot of selling pressure). These are also known as the ETF’s arbitrage bands, with the creation band being the total costs associated with buying the underlying basket and the redemption band as the total costs with selling the basket. In a “balanced” market with an equal amount of buying and selling pressure, we would expect a liquid ETF to trade somewhere in the middle.

    What does this mean for our transaction, or transition trade? Well, we know that a purchase in the newly listed ETF will be near the creation arbitrage band. Established ETFs with high average daily volumes tend to trade anywhere between the creation and redemption arbitrage band, depending on the market demand that day. Selling a liquid ETF when it is near its redemption arbitrage band would mean investors are paying the full arbitrage band spread on their transitions. This is an additional cost that is often tougher to quantify in liquid ETFs.

    Hopefully, since this is a transition trade, an investor will have some degree of flexibility on implementation timing. Ideally, if the investor can sell the liquid ETF when it is trading closer to its creation band, the actual costs of the transition can be minimized. So as you take stock of your portfolios with year-end approaching, consider talking to your advisor about ETF transition trades.

    David Mann’s comments, opinions and analyses expressed herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy.  It does not constitute legal or tax advice. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

    This information is intended for US residents only.

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    What are the risks?

    All investments involve risks, including possible loss of principal. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF’s net asset value. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.