I'm wondering if recent changes may make it a good idea for some investors to consider abandoning broad index funds/ETFs in favor of more narrow sector MFs/sector ETFs in their taxable accounts. For example, rather than investing 50% of our equity money in the Vanguard 500 Index Fund (VFINX), we might choose to split the same amount among the 9 SPDR sector fund ETFs that cover the same stocks, but by sector (Financials, Energy, Consumer Staples, etc)
Why?
1) Ability to better manage taxable income. The quarterly/annual returns of a broad index will be a lot less volatile than the individual returns of the sectors. So, there will more frequent opportunities to tax loss harvest in taxable accounts.
The chart below (.PDF also at this link) is set up like the familliar Callan Periodic Table of Investment returns, but it is just for the 9 sub-sectors within the S&P 500. Between 2004 and 2013, the overall S&P 500 index year-end share prices had only one year when share prices declined (2008). The table below shows that over the same 10 years there were sectors within the S&P 500 that had losses in 4 of those years. Of course, if we looked at monthly or quarterly results we'd expect to see even more opportunities to harvest tax losses. In all cases, opportunities to harvest losses can be expected to be best if there are frequent new purchases of equities (to assure there are higher-basis shares on hand to allow short "dips" to be harvested)
So, investing in these sectors would have offered much more frequent opportunities to do tax loss harvesting. And this is probably a relatively modest example--more "exotic" asset classes (e.g. foreign equities held in regional sector ETFs rather than a larger, broad foreign index, etc) could be expected to be even more volatile. The >overall< risk won't be any higher (you'd be invested in the same stocks whether you've invested in a broad index or narrow sector ETFs), it's just the tax loss harvesting opportunities are enhanced.
While I keep saying "tax loss harvesting," obviously there is also potential to "reset" the cost basis on "winners" in years where a taxpayer might have some headroom below their expected future tax brackets. This can be expected to help reduce future tax liabilities.
2) It's easier now: With the new requirement that brokers track cost basis, and the very convenient pop-up menus that are common at broker websites for selecting which shares to sell, the "specific ID" basis method is a breeze to use. Gone are the days of manually entering this stuff onto spreadsheets, or writing letters to the fund companies (really for the IRS) to identify which shares are being sold. As lazy as I am, I'm now using the "specific ID" cost basis method in my taxable accounts.
3) It's potentially more important/lucrative to reduce taxable income than it has been in years past. The 0% Cap Gains rate has been made permanent for those of us "fortunate" enough to qualify, the OMAGI limits for qualifying for premium subsidies and assistance with OOP medical expenses, and even the revised qualifying criteria for Medicaid all increase the need to reduce taxable income for some of us. It looks like this might be such a way.
Other: As noted on the S&P marketing literature (at the link above), the SPDR sectors are not "cap weighted"--some are much, much smaller than others. To replicate the S&P 500, an investor would need to rebalance the amount invested in each sector occasionally. As the advertising info at the link shows, overall returns for the last 10 years have been significantly better for investors who didn't cap weight the sectors, but instead just plunked equal amounts (11.1%) into each one:
10 year cumulative return:
................ S&P 500: 107.37%
.......Equal Weighting: 140.76%
Comment: This strikes me as likely a bit of data mining, and possibly the result of the big declines that the heavily-weighted Financials sector took in 2007 and 2008. In effect, "equal weighting" amounts to a "sector bet" on the sectors that just happen to have lower capitalizations, and these are strictly an arbitrary result of the way each sector was defined when it was constructed. It happened to do well over the last 10 years, but I don't see any particular reason to expect that to continue.
Anyway, that's it. We've touched on this idea in previous threads, and I suppose there's nothing especially novel about it. Also, I haven't looked into various smart ways of implementing it (e.g these SPDR sector ETFs are probably the best known, but the very similar Vanguard sector ETFs (VCR, VFH, etc) appear to have slightly lower ERs). Also, I wonder if one could remain effectively fully invested and avoid "wash sales" by using the proceeds from the sale of a Vanguard sector ETF (e.g VHF--Financials) to buy the corresponding SPDR sector ETF (e.g. XLF). They are based on different indexes (MSCI and S&P, respectively), different CUSIPs, etc, so I'm pretty sure that's enough for the IRS.
Why?
1) Ability to better manage taxable income. The quarterly/annual returns of a broad index will be a lot less volatile than the individual returns of the sectors. So, there will more frequent opportunities to tax loss harvest in taxable accounts.
The chart below (.PDF also at this link) is set up like the familliar Callan Periodic Table of Investment returns, but it is just for the 9 sub-sectors within the S&P 500. Between 2004 and 2013, the overall S&P 500 index year-end share prices had only one year when share prices declined (2008). The table below shows that over the same 10 years there were sectors within the S&P 500 that had losses in 4 of those years. Of course, if we looked at monthly or quarterly results we'd expect to see even more opportunities to harvest tax losses. In all cases, opportunities to harvest losses can be expected to be best if there are frequent new purchases of equities (to assure there are higher-basis shares on hand to allow short "dips" to be harvested)
So, investing in these sectors would have offered much more frequent opportunities to do tax loss harvesting. And this is probably a relatively modest example--more "exotic" asset classes (e.g. foreign equities held in regional sector ETFs rather than a larger, broad foreign index, etc) could be expected to be even more volatile. The >overall< risk won't be any higher (you'd be invested in the same stocks whether you've invested in a broad index or narrow sector ETFs), it's just the tax loss harvesting opportunities are enhanced.
While I keep saying "tax loss harvesting," obviously there is also potential to "reset" the cost basis on "winners" in years where a taxpayer might have some headroom below their expected future tax brackets. This can be expected to help reduce future tax liabilities.
2) It's easier now: With the new requirement that brokers track cost basis, and the very convenient pop-up menus that are common at broker websites for selecting which shares to sell, the "specific ID" basis method is a breeze to use. Gone are the days of manually entering this stuff onto spreadsheets, or writing letters to the fund companies (really for the IRS) to identify which shares are being sold. As lazy as I am, I'm now using the "specific ID" cost basis method in my taxable accounts.
3) It's potentially more important/lucrative to reduce taxable income than it has been in years past. The 0% Cap Gains rate has been made permanent for those of us "fortunate" enough to qualify, the OMAGI limits for qualifying for premium subsidies and assistance with OOP medical expenses, and even the revised qualifying criteria for Medicaid all increase the need to reduce taxable income for some of us. It looks like this might be such a way.
Other: As noted on the S&P marketing literature (at the link above), the SPDR sectors are not "cap weighted"--some are much, much smaller than others. To replicate the S&P 500, an investor would need to rebalance the amount invested in each sector occasionally. As the advertising info at the link shows, overall returns for the last 10 years have been significantly better for investors who didn't cap weight the sectors, but instead just plunked equal amounts (11.1%) into each one:
10 year cumulative return:
................ S&P 500: 107.37%
.......Equal Weighting: 140.76%
Comment: This strikes me as likely a bit of data mining, and possibly the result of the big declines that the heavily-weighted Financials sector took in 2007 and 2008. In effect, "equal weighting" amounts to a "sector bet" on the sectors that just happen to have lower capitalizations, and these are strictly an arbitrary result of the way each sector was defined when it was constructed. It happened to do well over the last 10 years, but I don't see any particular reason to expect that to continue.
Anyway, that's it. We've touched on this idea in previous threads, and I suppose there's nothing especially novel about it. Also, I haven't looked into various smart ways of implementing it (e.g these SPDR sector ETFs are probably the best known, but the very similar Vanguard sector ETFs (VCR, VFH, etc) appear to have slightly lower ERs). Also, I wonder if one could remain effectively fully invested and avoid "wash sales" by using the proceeds from the sale of a Vanguard sector ETF (e.g VHF--Financials) to buy the corresponding SPDR sector ETF (e.g. XLF). They are based on different indexes (MSCI and S&P, respectively), different CUSIPs, etc, so I'm pretty sure that's enough for the IRS.
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