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Year-end tax strategies can benefit ETF owners

Exchange-traded funds have unique advantages for tax-loss selling. They can also help investors cope with an anticipated tax hike

By: TERRY CAIN

Date: November 29, 2017

The end of the year is a natural time for investors to assess their portfolios. It's also time to look for tax-loss-selling candidates.

The concept is simple: Sell investments that have gone down in value, which results in a capital loss, and then use that loss to offset the capital-gains tax hit for investments that have gone up in value.

But one fact that some investors may not have considered is that this approach can be used for exchange-traded funds (ETFs), too. In fact, ETFs have some unique advantages for tax-loss selling … and positioning your portfolio for the future.

ETFs are like any security held in a non-registered investment account. That means capital gains must be claimed for any funds sold at a profit during the tax year. As well, losses from any fund sold at a loss can be used to offset capital gains.

Most ETFs focus on a specific market sector, or a particular geographic area. So the basic ETF approach to tax-loss selling would be to sell positions in underperforming sectors and regions this year and use them to offset gains.

Investors will find a few wrinkles to that strategy, however, that are unique this year.

Steve DiGregorio, a portfolio manager with Canoe Financial in Montreal, raises an important point about tax-loss selling in 2017.

"Given the rise of the TSX and S&P 500, fewer tax-loss-selling candidates exist," he says. Most investors will have to look beyond the broader market for tax-loss candidates, to specific sectors that have underperformed, such as energy.

As far as ETFs go, that might include the iShares S&P/TSX Capped Energy Index Fund, or ETFs based on international markets that have underperformed, though those have been rare this year.

Larry Berman recommends a variation of that strategy. Mr. Berman is chief investment officer at ETF Capital Management in Toronto. He says if investors are holding energy stocks that have declined in value this year, they should consider selling some of those positions to realize capital losses.

Then, if the investor wants to maintain a weighting in the sector, he or she could buy a fund that reflects the sector, such as the BMO Equal Weight Oil & Gas Index ETF. Similarly, Mr. Berman recommends holders of Barrick Gold Corp. sell at least some of their shares to realize the tax advantage, then pursue broader exposure to the sector by buying units of the BMO Equal Weight Global Gold Index ETF.

Investors should consider other factors as well when contemplating tax-loss selling this year.

Keith Richards, a portfolio manager with ValueTrend Wealth Management in Barrie, Ont., is concerned about a possible increase in the capital-gains inclusion tax rate.

Currently, the capital-gains inclusion rate sits at 50 per cent … meaning that Ottawa taxes half of the profits that Canadians earn on the sale of capital property, such as stocks, bonds, cottages or land. (Capital gains in a registered account, such as a tax-free savings account or a registered retirement savings plan, are either tax-free or tax-deferred.)

"The talk that I have heard from accountants is a possibility for the rate to go from the current 50 per cent to 75 per cent in 2018," Mr. Richards says. If investors believe there is a chance of higher capital-gains inclusion rates in 2018, he says, they may choose to wait to claim their losses until 2018, in order to help offset the higher tax rate on their profitable investments.

Conversely, if a capital gain realized in 2018 could be taxed at a substantially higher rate, it may make sense to realize any built-up unrealized capital gains this year. In ETFs, that may be especially true for funds linked to the NASDAQ and technology stocks.

Mr. Richards also recommends another year-end strategy for investors looking to materialize gains or losses in their ETFs.

He notes that markets tend to be strong in the final month of the year, and the tendency is for the year's big movers to continue to lead until the end of December, while the laggards continue to sell off. Come January, stock market participants start to re-examine the prior laggards in an effort to uncover some oversold or underappreciated bargains.

As a result, there can be a noticeable degree of rotation from leaders to laggards at the beginning of the year. The well-known "Dogs of the Dow" strategy is designed to benefit from this phenomenon.

The strategy Mr. Richards advocates is to take gains on anything you suspect has run too high … and may be vulnerable to a period of underperformance … as year-end approaches.

As far as ETFs go, you might be holding a fund linked to technology stocks or the NASDAQ index that has gone up in value significantly. If you think the sector might take a breather in the new year, you could realize some profit by selling some of the fund as the year comes to an end.

Then you can buy a fund in an underperforming sector that has a good chance to rebound. "It's a game of odds, but odds are somewhat in favour of a rotation of the guard from strong to weak sectors for the first month of the year," says Mr. Richards.

Alternately, if you are still a true believer in the "hot" sector, you can repurchase the ETF after 30 days with no tax implications. In either case, you will materialize your capital gain this year, at the current rate, which may have an added benefit if the capital-gains tax rate does, in fact, rise.

Mr. Richards says his comments are for informational and educational purposes only, and are not intended to provide specific investing or tax advice.

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