Harvesting Losses on Mutual Funds

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Harvesting Losses on Mutual Funds
by James D. Peterson, Ph.D., Vice President, Investment Manager Research, Schwab Center for Financial Research
November 26, 2008

With the S&P 500 Index recently sinking to 11-year lows, even those who've managed to avoid looking at their statements know that stocks have been pummeled. So, what do you do if life gives you lemons? Here's a way to try to make some tax-saving lemonade from your beaten-down portfolio—while also repositioning it so you can benefit when things do finally improve.

Harvesting losses and offsetting gains
Selling investments whose current market value is below your cost before the end of the year enables you to capture a capital loss and use it to offset any capital gains you've accrued—as long as the sales occur in a taxable account. For example, an investor in the 36% federal income tax bracket with an unrealized loss of $10,000 could save $3,600 in short-term taxes by selling the position.

And if your capital losses exceed your capital gains, up to $3,000 can be used to reduce your taxable income for the year (up to $1,500 each for married persons filing separately). Any losses exceeding $3,000 carry into future years without expiration. Capital losses from investments held less than one year are considered short-term and can offset taxable income at the ordinary income rate.

Beware the wash-sale rule
Perhaps you wish to sell an investment to take a capital loss, but you'd like to buy it back again because you want to keep that particular investment in your portfolio. If so, watch out for the wash-sale rule, which says that if you sell a security at a loss and then buy it or a "substantially identical" security within 30 days, the loss is typically disallowed for current income tax purposes.

As much as you may want to realize the loss, you may not want to be out of the market for an entire month. After all, today's volatile markets can shift swiftly. One strategy is to replace the security you sold with a similar (but not "substantially identical") investment that suits your long-term investment plan.

If the security you're selling is a stock, you can sell it and use the proceeds to buy a similar stock. However, such a trade for a mutual fund is a little trickier. Before selling a fund, make sure you don't face redemption fees. If not, here's how to look for a similar fund.

Finding a similar fund
For illustrative purposes, let's look at an example. Suppose you're considering harvesting losses you've incurred in Fidelity Growth & Income (FGRIX). Clients can start their research by logging in to Schwab.com, clicking Quotes & Research > Mutual Funds and entering the fund's ticker. You'll find all the data used in this example throughout the various links and tabs on this page.

Note first that FGRIX is in the Large Blend category. Funds in the same category are generally similar in terms of style and cap size. The next step is to find other mutual funds in the Large Blend category that you expect to do well versus their peers going forward—no small task. But as a Schwab client, you can find funds we believe are well poised for the future on our Mutual Fund OneSource Select List. For this example, we selected the six Large Blend funds as possible alternates. Here are the key data measures we use to help differentiate among the choices:

The fund's beta. This is a measure of how a security moves with the market and is possibly the most important data point. Look for similar betas, suggesting the funds will likely move closely together in response to broad market moves.
The market cap breakdown of the fund is also important, because many funds invest more broadly than FGRIX across the market cap spectrum.

The breakdown between domestic and international stocks can vary. Most domestic stock funds have at least a small allocation to international stocks, so consider this important ratio as well.
Turnover can provide information about fund strategy. For example, low-turnover funds tend to utilize a buy-and-hold approach, while high-turnover funds trade more based on momentum.
The percentage of assets in the top 10 holdings of a fund gives an indication of how concentrated the fund is. Generally speaking, less-concentrated funds more closely follow the market.
Analyzing sector allocations tells you which sectors a fund favors at a given point in time.

Tax efficiency—because this fund will be held in a taxable account—should be considered, as well. We measure tax efficiency with the five-year tax cost ratio—the lower this ratio, the better.

The table below and the two charts above provide a snapshot of these statistics for FGRIX and the other six funds. As you can see, Federated Capital Appreciation (FEDEX) and Parnassus Equity Income (PRBLX) have betas well below FGRIX. Neuberger Berman Socially Responsible (NBSRX) is much more tilted toward mid-caps and is more concentrated. Schwab Core Equity (SWANX) and Janus INTECH Risk-Managed (JRMSX) have no international exposure, whereas FGRIX has about 16%. In addition, SWANX had much lower turnover than FGRIX, while JRMSX uses a higher-turnover strategy and isn't as tax efficient.

Finding a Replacement Fund

Source:Morningstar, as of September 30, 2008.

Although any of these funds might be a good replacement for FGRIX, we believe that the best pick is Neuberger Berman Partners (NPRTX). True, its beta is above FGRIX's, probably because NPRTX holds relatively more technology and fewer financials. But FGRIX and NPRTX match up well in terms of international weights, turnover and concentration. Also, both like out-of-favor stocks and are willing to make large sector bets. And NPRTX appears more tax-efficient.

Clients can find these stats on Schwab.com. The Risk & Tax Analysis tab shows a fund's beta and five-year tax cost ratio. Market cap exposure is on the Mutual Fund Report Card. The remaining items can be found on the Portfolio tab. Further information can be obtained from fund company Web sites or each fund's prospectus.

Watch out for capital gains distributions
Finally, check fund company Web sites for information about estimated capital gains distributions. Managers who know they're going to distribute year-end gains often disclose this in advance. Consider waiting to buy a fund until after it's paid its distribution. Otherwise, you'll owe tax without having participated in any gains.

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

The current and future portfolio holdings contained in a mutual fund is subject to risk you should be aware of prior to making an investment decision.

Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost. See Schwab.com for more recent performance.

Approximately 2,100 funds participate in the Mutual Fund OneSource® service. Only these funds, including Schwab Affiliate Funds, are eligible for the Mutual Fund OneSource Select List. Schwab receives remuneration from fund companies, and/or their affiliates, in the Mutual Fund OneSource service for recordkeeping, shareholder services and other administrative services. Schwab and its affiliates also receive fees from the Schwab Affiliate Funds for investment advisory, administrative and transfer agency services, as well as shareholder and other fund services. The aggregate fees Schwab or its affiliates receive from Schwab Affiliate Funds (see fund prospectuses for more details) are greater than the remuneration Schwab receives from fund companies participating in Schwab’s Mutual Fund OneSource service.

No mention of particular funds or fund families here should be construed as a recommendation or considered an offer to sell or a solicitation to buy any securities. This information is provided for general information purposes only and should not be considered an individualized recommendation or personalized investment advice. The securities listed may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Schwab or its employees may sometimes hold positions in the securities listed here.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to achieve.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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