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Hello, ETF Arbitrage!
This very strange year in the world and the financial markets has produced some interesting predicaments. Among them is that some investors may have accumulated a large amount of “realized capital gains” in their taxable investment accounts. And, as investors with hefty sums in their taxable (non-IRA, non-401k) accounts know, taxes can crush investment performance.
It doesn’t have to be that way. Not if you embrace some fairly straightforward, tactical investing techniques.
Here is one I used recently to help cut the capital gains tax burden, without meaningfully changing the reward/risk tradeoff and ultimate pre-tax performance of the account. The after-tax performance can potentially be much higher. And as the old adage goes, it’s not what you make, it’s what you keep.
I will caution you that this is NOT tax advice. It is merely my reporting and communicating to you something that an investor may consider. I am not a tax expert, I am a professional investor. There’s a big difference between those 2 roles. So, you should consult one before going anywhere near something like the process I describe below.
STEP 1: Identify existing “loss-harvesting” positions
If you are looking to reduce your realized capital gains for 2020, the first and most obvious place to look is your existing portfolio. So, do that first. Again, I am not telling you if or what to sell or buy. I am just outlining a process to consider if your end-goal is trying to shave your capital gains tax bill this year, or any year.
STEP 2: Identify one or more “ETF Arbitrage Pairs”
Here is where it gets interesting. It’s also where we take a page out of the hedge fund manager’s script. “Arbitrage” is an investing strategy that seeks to profit from the difference in return between 2 (or more) securities. Simply put, if you buy 2 securities that you expect to move in opposite directions, but similar magnitude, it is much more likely that you make or lose a small percentage amount than larger amount.
A generic example may help. Again, I am not telling you what to buy and sell, just teaching the concept, for you to apply as you wish.
Let’s say you have $100 to work with. You want to earn a positive return, of course. But you also want to generate some capital losses to help offset capital gains you have already realized this year. If you take $50 and invest it in an ETF that invests in large company stocks, and take another $50 an invest it in an ETF that “shorts” large company stocks (e.g. “single inverse ETFs”), you have a pair of securities that can potential represent a mirror image of each other.
There is no rule about the 50/50 allocation I used in the example. It can be more to one or the other. Again, this is not personalized advice, it’s a concept I am introducing.
STEP 3: Monitor
If the market is volatile the rest of the year (and that looks likely), your 2 securities should move by a pretty large percentage. Let’s say that in the next month, the broad stock market went up 10%. One of your ETFs would increase from $50 to roughly $55, and the other would decline from $50 to roughly $45. At that point, you could sell the loser, take $5 in realized capital loss, but your $100 is still worth around $100.
At that point, you could take the $45 in proceeds and buy a different inverse ETF, or whatever else you want to represent that side of the arbitrage position. That would give you the potential to “earn” more realized losses. Keep in mind that the market has shifted, and so you have more “at risk” on the “long” side of things, since the other security is now worth $55, up from $50.
STEP 4: Manage as you see fit
Again, you can vary the allocation to your liking, and choose the securities you want. You can have 1 long and 1 short security, or more than one of either or both. The key is to determine when you want to take the losses.
The other possibility is that the market flops up and down wildly, as it did last February and March. In that case, you might end up capturing losses from both sides of the arbitrage before the year ends. But again, you have the ability to stay as “market neutral” as you want. Just make sure you understand the tax guidelines of doing so.
STEP 5: Turn the calendar
Remember that January 1, 2021, starts a new capital gains tax year. So, anything you do in 2020 counts toward that year, and 2021 is its own beast. That means that for tax purposes, 2020 is when you would want to sell at a loss, and January or later in 2021 is when you would consider selling whatever winning pieces you have in the arbitrage.
You can sell your winning piece in 2020, but you will pay capital gains tax on it now. Selling next year gives you an entire year to navigate that year’s market and tax situation.
Next steps?
I hope this step-by-step explanation helps you understand the potential to manage a “lower volatility” portion of your portfolio, with an eye toward also reducing the amount you may owe in capital gains taxes. Remember, the devil is in the details. But if you use this logic as a starting point, you might just improve your overall return. Specifically, the important part: not the part you make, but the part you keep.
Related: The Investor’s Mantra Through Year-End: Lawyers, Guns And Money