Author: Eric Uhlfelder

25 September 2008, Barron’s

More than a clever exercise to pinch pennies, tax loss swapping is a way of adding alpha.

After five decent years, most mutual funds are following stocks into the toilet.

Year-to-date through September 23, Fidelity’s former flagship fund, Magellan [FMAGX], is off 22.4 percent. Brandywine Blue [BLUEX], one of the formerly great stock picking funds, is off by more than 25 percent. And formerly venerated Bill Miller has seen his Legg Mason Value Trust [LMVTX] collapse by nearly 36 percent.

Two things are stunning about these name-brand losses: they are way beyond the S&P 500’s decline of 13.2 percent; and two, they are being realized not by specialized sector funds, but by seasoned managers running diversified portfolios.

If you’re caught in a beaten down fund, perennial solace is granted by Uncle Sam in the tax shelter the IRS avails you when taking a loss. Simply put, the government allows you to avoid paying taxes on investment profits and $3,000 of unearned income, up to the amount of your realized losses.

There are four benefits in swapping out of funds. Investors recoup a cash benefit. If you’re sheltering $10,000 in gains and are in the 30 percent tax bracket, you avoid paying $3,000 in taxes.

Assuming a fund has realized some profits this year, selling out before a distribution avoids paying taxes on money that is retained in the price of the fund before profits are dispersed to shareholders. This means you’ll keep more of that value by selling before the distribution.

Selling out of a dismal market for the purpose of taking a tax loss requires you to remain out of the security for a minimum of 31 days. For investors who keep the proceeds in cash, this is a non-discretionary way to take a breather from the madness. Towards this end, seasoned investment advisor, Jim Lowell, editor of the Fidelity Newsletter, says “there’s no rule saying that an investor has to be fully invested all the time.”

Christine Benz, Morningstar’s director of personal finance, warns that if the bear market persists through the rest of the year [and there are no signs to suggest otherwise], selling out of a loss before the perennial tax harvesting season begins during the last six weeks of the year may help investors avoid being hit by further price declines. Moreover, equity investors will likely add to the woes by also selling out of their positions to lock in losses, further hurting funds invested in these shares.

But [which there always is when it comes to investing strategy] there is the basic investing rule, especially relevant during a bear market, that says to benefit from long-term market exposure, it’s essential to remain fully invested because it’s impossible to time the rebound.

That doesn’t mean you can’t alter your exposure through a tax swap. For mutual fund investors, this means switching out of one fund to realize a loss and replacing it with another comparable holding to sustain specific market exposure.

For an example, Dan Wiener, editor of the Independent Adviser for Vanguard Investors, points to the Vanguard Precious Metal and Mining Fund [VGPMX], which has been on a tear over the past 10 years, averaging annualized gains of 26.29 percent through September 23. But it’s presently suffering through a horrible selloff, which has brought its price down from a late spring peak of $40 to $25. For the year it’s off more than 22 percent.

Wiener recommends investors swapping into the iPATH Dow-Jones-AIG Precious Metals Total Return Sub-Index Exchange Traded Note [JJP]. The underlying index is off less than four percent since the beginning of January. And over the past year, it has trounced Vanguard, gaining 12.59 percent versus Vanguard’s loss of 17.34 percent.

But Wiener warns that when temporarily swapping out of a fund, investors must be mindful of their funds’ status. Because the Vanguard fund is closed to new investors, existing investors need to leave at least $1,000 in their accounts to enable them to return.

Some money managers are looking to use the swap as an opportunity to diversify a position to reduce risk. For instance, in late July Leo Marzen, a manager at Bridgewater Advisors, which Barron’s ranked as the 24th best Independent Investment Advisors, swapped $251,000 out of the First Eagle Overseas fund [SGOIX], where he had a short-term loss of $23,000, for the First Eagle Global fund [SGIIX]. Marzen is betting on improved results by adding US exposure, a market he suspects will rebound from recession before other developed economies.

Jim Lowell is recommending two swaps that are promoting a more conservative posture. The first is the sale of Fidelity Magellan [FMAGX–which is down nearly 27 percent for the year through September 23] and purchase of the Fidelity Four-in-One Fund [FFNOX]—a composite index holding of the S&P 500, DJ-Wilshire 4500, MSCI EAFE, and Lehman Brothers US aggregate Bond Index. This fund is off just 15.2 percent.

The point here is to gain broader, and ostensibly, less volatile market exposure, that includes smaller stocks and the US bond market. Lowell calculates that the two funds are 86 percent correlated, showing that the shift is able to capture much of the upside Magellan offers, with less risk. [Lowell’s website,, enables anyone to determine correlation between funds.]

Lowell cautions investors about the caveats in refusing to part, even temporarily, with their favorite funds. Example: Lowell thinks the Fidelity International Small Cap Opportunities [FSCOX] is the single most desirable fund to own based on global economic trends. It has been a top-performing fund until this year. It’s down nearly 33 percent, and Lowell’s recommending investors take the tax loss and swap into Fidelity Cash Reserves, believing that investors should have time to move back into the fund before it eventually rallies.

“Investors should think of tax-loss swapping as a way of generating alpha,” explains Ronald Weiner, CEO of RDM Financial, which ranked 19th in Barron’s Independent Investment Advisor Survey. He believes this simple exercise can add up to 50 basis points of performance on average per year for a high tax bracket resident of New York. This means that starting with a $100,000 portfolio of equity funds that’s averaging 7 percent annualized returns can be worth $424,785 instead of $386,968 after 20 years.

Now that’s something to think about.


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