Tax-Loss Harvesting Opportunities Increase as Market Losses Mount
- Bonds are in their worst drawdown ever1 and 68% of all stocks are in a bear market2 amid elevated cross-asset volatility.
- 94% of all ETFs have losses this year — equating to $5.9 trillion in assets underwater year-to-date.3
- While the losses are painful, they present you with the chance to harvest losses and rotate into more cost-efficient strategies or exposures better aligned to current market trends.
With both stocks and bonds down significantly, you might not feel much like looking at account values. But if you turn away you could miss out on the chance to make the best of a bad situation. Today’s negative returns are an opportunity to harvest losses.
How does tax-loss harvesting work? In taxable accounts, when you sell a position that has lost value, you can use the loss to offset capital gains that result from selling securities at a profit during the year. Your booked losses can also offset funds’ annual capital gain distributions.
At year end, if your capital losses exceed your gains (or if you don’t have any gains), you can use the losses to offset up to $3,000 in non-investment income, even though that is often taxed at a higher rate than capital gains. Losses greater than $3,000 carry forward and can be used to offset capital gains and ordinary income over your lifetime.
Importantly, when reinvesting proceeds from the sale of a losing investment, you must abide by the Internal Revenue Service’s Wash-Sale Rule, which prohibits claiming a loss on the sale of an investment if the same or “substantially identical” investment is purchased either 30 days before or after the sale date.
Why harvest losses now? Because losses are extensive. And if the market rebounds later this year, you could lose your chance.
Stock and Bond ETF Strategies See Large Losses
Analyzing ETF market performance by broad-based strategy profiles underscores how pervasive losses have been. More than 90% of all stock- and bond-focused ETFs have losses, covering $4.7 trillion assets from equity and $1.1 trillion for bonds, as shown in the figure below. And almost 80% of equity funds have a more than 10% loss, totaling $4.1 trillion in assets.4 Given the negative returns of these two asset classes, it’s no surprise that mixed allocation funds have seen similar losses.
Commodity ETFs are the only category where the majority of funds have seen gains – with broad based commodities up 13% this year.5
Percent of ETFs by Fund Category With Losses Year-to-Date
Losses Recorded Across All Equity Categories
As shown in the figure below, 98% of all funds focused on US equities (ex-sectors) are trading at a loss — and no category has fewer than 84% of funds in negative territory.
Across equities, international developed and thematic ETFs have seen the worst drawdowns year to date. Thematic ETFs also have the worst average loss at -35.3%. The silver lining? Because so much investment in thematic funds took place in just the past two and a half years, this category is ripe for harvesting losses.
Losses by Equity Category
Bond ETF Losses Are Even More Widespread
100% of bond ETFs are trading at a loss in five of 11 fixed income segments. Though average bond ETF returns are not as poor as equity returns, in eight of 11 bond sectors returns are worse than -9%.
Bank loan funds, because of their exposure to floating-rate securities that have minimal duration risk, have fared the best amid rising rates — even though every fund is down on the year. Convertibles have the worst return of any bond sector tracked due to their equity sensitivity.
Losses by Bond Category
Longer-Term Losses Less Bleak, Still Significant
The above analysis of year-to-date results assumes every investor bought on December 31, 2021. But we know this is not the case. Of the 94% of funds trading at a loss, only 10% had inflows on the last day of 2021.6 So, is the picture less bleak for longer-term investors?
After normalizing the buying timeframe, our analysis reveals three-quarters of all ETFs are trading below their three-year average price. See the figure below. These losses are on $3.1 trillion of assets, a big field of opportunity for harvesting.7
So while losses are somewhat less bleak when you take a longer term view, they’re still significant. In fact, 67% of all ETFs are trading below their average overall historical price dating back to their inception. This covers $2.3 trillion in assets.8
Percent of Funds With Losses Based on Average Period Price
Shop for Tax Swaps and Know the Rules
Amid elevated cross-asset volatility, the losses continue to pile up — and not just among ETF strategies. Today, 96% of all mutual funds are trading at a loss, covering $16.7 trillion of assets.9
Painful to watch? Yes. No one likes to lose. Make you feel helpless? It could. But you don’t have to feel that way. There is something you can do. Because you may be looking at the largest tax-loss harvesting opportunity in decades.
In addition to potentially reducing your tax burden, harvesting losses offers you the chance to rotate into more cost-efficient strategies or better align exposures to current market trends. After selling a losing position, investors typically use a “tax swap” — a similar but not identical security — as a placeholder to maintain exposure to the asset class for 30 days. After 30 days, you can choose whether to switch back to the original holding.
Keep in mind that if the new investment appreciates and you sell it within a year, those gains will be taxed at the short-term capital gains tax rate, which is higher than the long-term rate. So, it may be advantageous to choose a swap that could become a long-term holding.
Why Harvest Losses Now
Again, if you harvest losses only at year end as many do, investments that were down early in the year could bounce back into positive territory — resulting in missed opportunities to sell losers and book losses to offset realized gains. That’s why it is best to implement tax-loss harvesting throughout the year as losses occur.
And right now, you’d be hard-pressed to find a portfolio ledger or account value unaffected by equity and bond market losses. If you don’t look away, as tempting as that may be, you just might see the subtle shimmer of a silver lining in tax-loss harvesting.
For our latest market insights, check out Is it Next Year Yet? Lean Into Market Risks to Build a Bridge to 2023.