After a terrible first half for 2022, some market observers see a potentially rosier outlook for the exchange traded fund industry if investors cut their losses in mutual funds and switch over to ETFs to capitalize on tax-loss harvesting.
Financial market executives have highlighted the potential for tax-loss harvesting to further support ETF flows ahead, especially in the fixed-income asset class after related mutual funds suffered their worst drawdown in three decades, the Financial Times reported.
Market observers argued that investors who have enjoyed steady gains in active bond funds since the 2008 financial downturn could take the recent losses incurred over the first six months of 2022, combined with embedded gains, and shift over to low-cost investments, like index-based ETFs.
“You can wrapper-swap through tax-loss harvesting from expensive mutual funds into ETFs, which are lower cost and more tax-efficient,” Todd Sohn, managing director of technical strategy at Strategas, an institutional broker-dealer and advisory firm, told the Financial Times.
Tax-loss harvesting is the act of selling securities at a loss, or in this case underperforming mutual funds, to offset the amount of capital gains tax due on the sale of other profitable securities. Furthermore, this helps preserve the value of the investment portfolio since the investor can then use the proceeds to purchase a similar asset, security, or low-cost ETF, which adheres to the IRS rule against buying a “substantially identical” investment within 30 days.
Consequently, U.S. fixed-income fund redemptions have gone up to $205 billion for the first half of 2022, with the $137.5 billion in outflows for the second quarter making up the second-worst quarter in sales since 1993, according to Morningstar data. The outflows were only second to the first quarter of 2020 when the COVID-19 pandemic first struck.
On the other hand, taxable bond ETFs still attracted $53.8 billion in net inflows for the first half of the year.
“Ninety percent of conversations with advisers are on the fixed-income side,” Ryan Barksdale, head of portfolio analytics and consulting at the Malvern, told the Financial Times. “The reality is that tax-loss harvesting in fixed income hasn’t really been a thing or the potential to be a thing until recently.”
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