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The Ultimate Guide to Tax-Loss Harvesting and Rebalancing Mutual Funds and ETFs


By Griffin Sheehy, Financial Analyst

With the market’s current state of affairs, tax-loss harvesting and rebalancing have become particularly relevant financial planning topics. Today, we’ll be discussing how these strategies work and the opportunities available in the current market.

Opportunities in the Current Market

Tax-loss harvesting and rebalancing are both part of the disciplined approach that must happen in both bull and bear markets in order to maximize returns.

I’d like to draw your attention to an area of overlap within the trading sphere. The current market has presented opportunities to harvest losses across our models and rebalance. But to take advantage of this marketplace requires more than a snap of the fingers — it takes strategy on the back end that can often go unnoticed.

How Mutual Funds and ETFs Are Priced

The method of pricing strategy can be hazardous if not traded appropriately. For example, ever wonder what the difference between a mutual fund and an exchange-traded-fund (ETF) is? In general, one is active and the other is passive.

But how are they priced differently, and how can they be implemented efficiently within portfolios? Simple differences in the way they are priced can be catastrophic to returns in these volatile times, especially for retail investors unaware of the pitfalls.

How Mutual Funds Are Priced

Mutual funds are priced at the end of the day after markets have closed. They do not fluctuate in price during intraday trading hours as do stocks. This is a function of how mutual funds work as a specific type of basket security.

Investors pool their capital, and the fund managers buy and sell securities as set forth with the objectives in the prospectus. During a trading day, some investors deposit (buy side) money into the fund, some investors redeem money (sell side), and the market prices of the individual securities in the fund fluctuate right up until the closing bell.

At the end of the day, managers take all these actions into account and produce the price per share at net asset value (NAV). The value an individual investor has in a fund is based on this share price.

One of the advantages of mutual funds is that they allow for fractional shares. This means an investor can deposit a dollar amount into the fund and not have to worry about rounding to the nearest number of shares.

How ETFs Are Priced

ETFs, on the other hand, do go up and down with the market activity during the day. They invest capital a little differently than mutual funds.

The Creation/Redemption Process

ETFs work via a creation/redemption process. Because ETFs trade on exchanges (where the name comes from), their prices can fluctuate based on supply and demand of the ETFs, which might not be the same as the supply and demand for the holdings of the ETFs. Thus, the price of the ETF could rise above or fall below the NAV of the ETF’s holdings. ETFs have a genius design to keep the share price very close to its NAV. It’s called the arbitrage mechanism.

When an ETF issuer wants to create new shares of an ETF to meet increasing market demand, it goes to an authorized participant (AP) who will then acquire the securities that the ETF wants to hold. Usually, APs are market makers (MMs) or large financial institutions that trade on the exchanges.

Once the AP has bought the shares in the same proportion as the underlying index, it will deliver those to the ETF sponsor in exchange for an equivalent value in ETF shares called creation units (their NAV). These creation units are formed in blocks of 50,000 or 100,000 shares. The AP or market maker can then resell those shares to investors who want to buy the ETF.

The redemption process works in reverse. When an ETF sponsor wants to reduce the number of ETF shares on the market, the AP will buy those ETF shares in the market and deliver them back to the sponsor in exchange for the same value in underlying securities. This process is also known as ETF primary trading.

The Secondary Market

However, over 90 percent of ETF trading happens in the secondary market. This makes ETFs very liquid instruments, with investors having the ability to buy and sell when they want, even in tough market conditions. Since the price of the ETF gets determined by simple supply and demand on the secondary market, APs can use arbitrage to make a profit.

For example, if there are more buyers than sellers, the price of the ETF will rise, resulting in the ETF trading at a premium to its NAV, which represents the actual market value of the securities held by the ETF.

The AP can then step in and buy the “cheaper” underlying shares — such as Apple (AAPL) or Amazon (AMZN) — on the stock market, deliver them to the ETF sponsor in exchange for newly created creation units, and then sell those ETF shares for a small profit in the secondary market. This increased supply in turn will push the price of the ETF lower, eventually bringing it closer to its NAV.

Strategies We Use to Minimize Complexity and Risk

There are many similarities between mutual funds and ETFs in their concepts. When it comes to the way they are designed, however, they have some fundamental differences.

These reasons are exactly why we use both security types in our portfolios, but it can lead to trading complexities when trading in and out of them, especially in volatile market conditions.

Luckily, we have strategies at our disposal to minimize that complexity and the risk sudden, large market moves can bring in terms of asset pricing when making moves.

Swaps and Exchanges

The like-to-like security transactions tend to be the easier ones to deal with. When going from mutual fund to mutual fund, we have the ability to perform certain trade types called swaps and exchanges. They are exactly how they sound.

When you swap mutual funds for one another, the value of the mutual fund you are swapping out of (priced at the end of the day) buys the corresponding number of shares in the mutual fund you are going into. Because fractional shares are also included, you don’t have to worry about market moves during the day, which could produce account debit or margin problems.

Exchanges are the exact same as swaps, with the added caveat you are exchanging within the same fund family.

When going from ETF to ETF, it gets slightly more complex. You are dealing with securities that are being repriced in the market every second, and you have to be aware of the volume being traded that day; otherwise, you could affect the market. Transactions with large amounts of shares require a certain type of trade to avoid adverse market reactions.

We do these transactions using “block trades.” The typical threshold for utilizing them is anytime the amount of the block trade is above two percent of the daily volume for that ETF.

Example of a Block Trade in Action

To show how it works, here’s an example of a block trade we’ve done in the past:

We were rebalancing into an ETF that was lightly traded and had to do a block trade. The amount of the block trade was roughly 80 percent of the daily volume!

There’s a specific desk on the trading floor that handles these large dollar amount trades for institutions called the block desk, and that’s who we trade through in these instances.

The block desk works with us to get the best deal on pricing from institutions on the other side of the transaction. In this case, we were looking for the lowest price on our buy.

After posting the shares we were looking to buy, the block desk came back to us with quotes and we chose the best one. This is one of the other advantages of block trading besides avoiding adverse market moves: it provides leverage when it comes to pricing.

In this example, we were able to discern between a spread of about 30 basis points (bps) between the quotes that came back to us and choose the lowest offer. This translates into real value just based on the fact that we have access to larger dollar amount trades.

When placing trades going from a mutual fund to an ETF, the same rules apply with added precautions taken. We will leave a little bit of cash as a buffer in case the market gets sporty and we will also place trades later in the trading day approaching market close to minimize the chance of drastic moves.

Have Peace of Mind About Your Portfolio by Working with Shone Wealth Management

With markets seeing daily swings in volatility, this careful approach has been largely effective at providing more consistent outcomes when trading and providing real back-end value to our clients.

If you’d like to learn more about tax-loss harvesting and rebalancing during the current market, reach out to our team today.  

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