Executive Director
Vice President
During the fourth quarter, many investors and advisors increase their focus on managing tax liabilities. ETFs can be an effective tool for executing key strategies in the tax-management toolkit.
Tax-efficient strategy #1: Use mutual fund shares for tax-loss harvesting and reinvest in similar ETFs to maintain exposure
In recent years, strong market performance has led many advisors to overlook tax-loss harvesting, assuming few opportunities exist in rising markets. Yet, even as major indexes reach new highs, sector rotation and pockets of underperformance persist, creating potential to realize losses and optimize client portfolios. ETFs can help advisors unlock hidden tax benefits and enhance after-tax returns, regardless of the broader market’s upward trend.
Tax-loss harvesting involves selling investments at a loss to help offset gains from other investments and reduce taxable income. While the strategy has often been used within a single portfolio—selling some stock positions at losses to help offset capital gains incurred from sales of appreciated stocks—it can also be applied at the fund level. For example, an investor can sell mutual fund shares trading below their purchase price to realize a loss that can be used to offset capital gains from another investment. Investors using this strategy should ensure that the transaction aligns with their overall portfolio objectives.
ETFs provide a convenient option for investors who want to retain the market exposure they had with the mutual fund. The proceeds can be reinvested in an ETF that closely matches the mutual fund’s exposure but is not “substantially identical,” to comply with IRS wash sale rules. The growth of the ETF market provides investors with a breadth and depth of choices to find a suitable replacement for their mutual fund position. Crucially, investors can sell a mutual fund and buy an ETF on the same day, ensuring little or no time out of the market.
Tax-efficient strategy #2: Sell mutual fund shares before capital gains distributions record date
While tax-loss harvesting activity generally tends to ramp up in the fourth quarter as the end of the tax year approaches, another driver is the annual capital gains distribution from mutual funds and ETFs. These funds must distribute net capital gains realized in the underlying portfolio at least once per year to all shareholders, typically in the fourth quarter. Many asset managers will publish capital gains estimates and/or exact distribution in advance so that investors can plan for these distributions, which generally create a tax liability for investors holding the funds in taxable accounts.
However, investors that sell out of the mutual fund shares before the distribution is received will not incur this additional tax liability. That means that some investors may be able to get two tax benefits from one transaction. Investors who can identify a mutual fund they own that 1) will have a capital gains distribution and 2) is trading below the price they bought it, can sell these shares before the capital gains distribution. This transaction will generate a loss that can be used to offset other gains in their portfolio and avoid the tax liability from receiving the mutual fund capital gains distribution.
Similar to the first example, investors can reinvest proceeds in ETFs, which have the potential to offer further tax benefits going forward.
Tax-efficient strategy #3: Stay invested in ETFs for longer-term tax benefits
Once investors have transferred into ETFs, they will likely see the benefits of accessing similar market exposure in a more tax-efficient way. ETFs are designed with tax efficiency in mind. The ability for investors to buy and sell ETF shares on an exchange, also known as the secondary market, provides an extra layer of liquidity that does not exist with mutual funds.
This secondary market liquidity provides another layer of potential tax efficiency. For example, if a mutual fund is experiencing a level of redemptions that exceeds the cash in the fund, the portfolio manager will need to sell securities to raise cash, possibly realizing capital gains and creating a taxable event. For ETFs, the secondary market liquidity means that not all ETF redemptions will require selling at the portfolio level, avoiding a taxable event.
ETFs have a further tax advantage when it comes to creations and redemptions. While mutual funds must complete these processes in cash, many ETFs are created and redeemed in-kind. New ETF shares can be created by Authorized Participants (APs) that deliver an underlying basket of securities into the portfolio of the ETF in-kind. Existing ETF shares can be redeemed by APs and, instead of receiving cash, APs take delivery of the underlying basket securities. Therefore, the in-kind redemption process can reduce capital gains realized within the fund.
ETFs are tools used by investors to manage tax obligations efficiently
By reinvesting in similar ETFs after selling mutual funds, investors can maintain desired market exposure, while benefiting from the potential of lower future capital gains distributions. This structural advantage makes ETFs an attractive option for both immediate tax relief and long-term portfolio efficiency.
J.P. Morgan Asset Management recommends a step-by-step approach to using ETFs for effective tax management, supported by research and tools, to simplify the decision-making and execution for investors.