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Read This Before Dumping Your Losers

September 28, 2012 - 4 comments

Gordon is a recently converted passive investor who has just realized a $5,000 capital gain while implementing his new portfolio.  The next month, his $100,000 investment in the iShares S&P/TSX Capped Composite Index Fund (XIC) drops by $5,000 – making him regret the day he first stumbled across the Canadian Couch Potato website.  

After he has finished sulking, he considers realizing the loss by selling XIC, and replacing it with the Vanguard MSCI Canada Index ETF (VCE) (a similar but not identical security).  This would offset the $1,150 of tax he would be on the hook for (assuming a marginal tax rate of 46%).  His initial concern is the potential opportunity cost of holding VCE instead of XIC over the next 30 days (he must hold VCE for at least 30 calendar days in order to avoid the superficial loss rule).  If VCE underperforms XIC by a wide enough margin, his attempt at tax management may prove to be futile.  This is one of the risks to consider before engaging in tax-loss harvesting strategies.

Opportunity Costs
Gordon knows that it makes little sense to save $1,150 in tax if he ends up missing out on $1,150 of market growth.  To get an idea of how much VCE could be expected to underperform XIC in any given month, we could examine the monthly return differences between 1970 and 2011 for the S&P/TSX Composite Index and the MSCI Canada Index (which are reasonable proxies for XIC and VCE).  As we can see in the graph below, there has been a wide range of monthly return differences. However, over 90% of the monthly observations were above -1.00%.  He feels comfortable with this probability of underperformance, but wants to have a better understanding of the costs of buying and selling these securities. 

 

Sources:  Dimensional Returns 2.0, MSCI

 

Implementation Costs
Bid-ask spreads can be a significant cost but often take a back seat in the media relative to trading commissions.  Both costs can derail the benefits of tax-loss harvesting.  Gordon estimates the bid-ask spread for these transactions to be around 0.17% (or about $160 in his case).  He adds to this amount four trading commissions of $10 each, resulting in total implementation costs of $200.       

For the example below, we will assume that XIC returned 1% over the 30 day holding period while VCE returned 0% (for an opportunity cost of $950).  We’ll also assume the implementation costs amount to $200.

The example above provides a useful “break-even” scenario.  Even with a relatively bad outcome over the month (missing out on 1% growth), Gordon’s overall situation is arguably not any worse than if he had done nothing.  His decision on whether to harvest his losses could have also been reached by using Larry Swedroe’s rule of thumb (where both conditions listed below must first be met):

  1. There should be a minimum absolute dollar loss on the security of $5,000
  2. There should be a minimum percentage loss on the security of 5%

Marginal Tax Rates
Keep in mind that Swedroe’s rule of thumb appears to be a reasonable one only if the investor is in the top tax bracket.  If the investor is in a much lower tax bracket (such as 23%), they may want to use a more conservative rule of thumb, such as:

  1. There should be a minimum absolute dollar loss on the security of $10,000
  2. There should be a minimum percentage loss on the security of 10%

Conclusion
The decision on whether to harvest your losses is not as straight-forward as it may seem – it will depend on a number of factors, including:

  • Expected opportunity costs of holding a similar but not identical security
  • Implementation costs of buying and selling the securities
  • Marginal tax rate of the investor

 

By: Justin Bender with 4 comments.
Filed under: Strategy, Taxes
Comments
  28/01/2013 12:42:43 PM
Justin Bender
@Que - I wouldn't test my luck. CRA has been very clear in the past that switching from one product that tracks the S&P/TSX Capped Composite Index to another product that tracks the same index would be deemed a superficial loss.
 
  28/01/2013 12:41:04 PM
Justin Bender
@Patrick - in regards to your first point, if you don't crystallize the loss when it is available, it may not be available in a future year.

As you mentioned, it is generally more beneficial to tax-loss harvest if you are already in the higher marginal tax brackets.

For your final point, it is true that you are lowering your ACB (ending up with a larger capital gain in future years). But the tax deferral benefit could easily outweigh any increase in your marginal tax bracket.

I would certainly agree that this strategy is best suited for investors who are receiving professional advice.
 
  25/01/2013 3:54:19 PM
Patrick
I think it's also important to keep in mind that if you're spending $200 (or whatever) to get this tax break this year, you're missing the opportunity to use the capital loss in a future year. There's a chance you could have had a capital gain in a future year anyway from ordinary investing activities, and you could have received your tax break for free.

Moreover, if your salary is generally increasing, you may be in a higher tax bracket in a future year and get more benefit from the capital loss.

Finally, by paying this $200 to get your tax break this year, you also lower your ACB and you'll end up with a larger capital gain in a future year. Again, if you are generally moving up in tax brackets, this future tax liability could cost more than the break you get this year.

I imagine this scheme is only a good idea for folks near retirement, or sophisticated investors who know what they're doing; and in any case, it probably makes some sense to get professional advice first if the amounts in question are large.
 
  24/01/2013 11:16:09 PM
Que
Great post, and excellent explanation of the example. Do you know anyone who has tried going from XIC to ZCN since they have been tracking the same index (I'm guessing it hasn't been long enough for somebody to even want to)? I am just wondering if the CRA would allow this, or if this would "slip through the cracks".
 



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