ETFs Can Be a Part of Your Tax Strategy

Here are two strategies using ETFs for investors who are resolute and smart enough to do their tax planning year-round -- although you should always check with your tax advisor before making any moves:

Strategy 1: Taking Individual Stock Losses While Maintaining Sector Exposure

In this case, let's use a real, but somewhat arbitrary, example. Let's say you are holding too large a position in Wal-Mart(WMT) and your portfolio is dangerously out of balance. Furthermore, the Wal-Mart shares you purchased happen to be trading below your purchase prices. Since Wal-Mart accounts for more than 21% of the Consumer Staples Select SPDR(XLP), an ETF that contains the 37 consumer staples listed in the S&P 500, you can: (1) sell your Wal-Mart stock; (2) realize the loss; and (3) buy the Wal-Mart-heavy ETF to maintain your exposure to Wal-Mart and to that sector in general.

And after 30 days, you can choose to buy back some or all of your Wal-Mart position and sell the ETF.

Dan Dolan, an ETF specialist at S&P, says investors can also use this strategy to take a loss in a mutual or closed-end fund while maintaining exposure to a particular sector. For example, if you are holding a technology fund that is currently under water from where you purchased it, you can sell the fund, realize the loss and buy a tech ETF like the Technology Select SPDR ETF(XLK) to stay exposed to the sector.

Strategy 2: Swapping One ETF for Another

Paul Mazzilli, an ETF strategist at Morgan Stanley, says investors can also swap sector ETFs "if they have similar -- but not exactly the same --- holdings, and are based on different indexes."

Again, let's use actual securities for a hypothetical example. This means that investors staring at unrealized losses in iShares Dow Jones US Healthcare ETF(IYH) can switch into the Vanguard Healthcare VIPER ETF (VHT) or the Healthcare Select SPDR ETF (XLV) for 30 days and still comply with the wash-sale rule.

Mazzilli says the swap is kosher under the wash-sale rule because each ETF corresponds to a different index. The Dow Jones Healthcare ETF tracks the performance of the Dow Jones U.S. Healthcare Sector Index; the Vanguard ETF follows the MSCI U.S. Investable Market Health Care Index; and the Select Spider tracks the healthcare components of the S&P 500.

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