Do-It-Yourself Index Funds: A Smarter Way to Own the Index?
Index funds are easy, but when you buy them you are giving up your chance to take an important tax break. So, if you're willing to roll up your sleeves and do some work, you could build a better fund yourself using sector ETFs.
Working from home is making my “honey to-do list” a little longer. I am slowly (and back-achingly) becoming a do-it-yourself home improver. Who knew I could lay a brick walkway in one weekend? Do-it-yourself (DIY) home renovations keep the cost down and give you more control over the process. In some respects, do-it-yourself investing is similar.
Managing your own investments costs less and allows for greater control over investment selection. However, if you think DIY investing is simply buying an S&P 500 index fund, you are mistaken, there is a better way.
With any index fund or mutual fund you own, you cannot control the tax-loss harvesting. Tax-loss harvesting is the practice of booking losses in your portfolio to offset a gain elsewhere. For example, if you sold Pepsi with a $10K gain, that gain is taxable. However, if you have a $4K loss in another stock, like Exxon, you can sell Exxon and apply the loss against the Pepsi gain. The taxable gain of $10K is reduced to $6K. There is a $3K limit if you want to use losses to offset ordinary income, but you can always apply losses to offset gains in a portfolio up to the amount of the realized gain.
The less gain, the less income tax. That is a good thing. Though there is more to tax-loss harvesting, this is a good start.
The problem with an index mutual fund is you never get to harvest the losses in the index! In any given year, there can be hundreds of stocks that lost money in the index. However, the index could be up for the year because the other stocks were up more. In 2017 the S&P 500 finished up 21.38% but there were 122 stocks that had a loss during the year! (Source: FactSet 2017). If you had a gain elsewhere in your portfolio, and need losses to minimize that gain, can you sell any of those 122 losing positions in the index fund? You cannot.
The beauty of buying an index fund is the simplicity. However, the simplicity comes with a tradeoff. The inability to harvest losses.
Build your own index instead
One way to harvest the losses in an index is to own all the stocks in the index. That way you can sell the losing positions. However, buying that many stocks is too unwieldy and expensive for the average investor. There are money managers who will do this for you. Another strategy — a DIY project — involves replicating the index by buying sector exchange traded mutual funds (ETFs).
With a DIY index strategy, I buy sectors like the utility, energy, information technology, health care and others in proportionate amounts to the S&P 500 index. By doing this I come close to mirroring the performance of the S&P 500 index but can now harvest losses if a sector is at a loss.
As an example, this year most sectors are in the red. I may sell some of the beaten down sectors to book the loss for a client. Harvested losses are used to offset realized gains elsewhere. As we’ve said, if there are more losses than gains in a portfolio, $3K of losses can be used to reduce ordinary income (wages, earned income). Any losses beyond that are carried forward to future years on the federal tax return and, depending on your home state, may be carried forward on your state income taxes as well. The point is to try and take advantage of what the loss provides you: an ability to reduce your taxable gain. It is like making lemonade out of lemons.
The downside to building your own index, like most DIY projects, is the time commitment. You must stay on top of the sector allocations. If not, one sector may outgrow the other if it performs well, like what technology has done. An overexposure to one sector can lead to more risk if that sector sees a downturn. I use models that automatically trade when sector allocations exceed certain limits.
The other downside is the wash-sale rule. If you sell an Energy ETF, you cannot use the loss if you buy back the same Energy ETF within 30 days. Be careful, the IRS can disallow a loss if you back a security that is not substantially different than the original. It is best to check with a tax or financial professional.
I am all for DIY projects. Buying a mutual fund or index fund may make sense for most investors, like outsourcing some home projects. However, you must understand the tradeoff. Mutual fund investing misses a valuable opportunity to harvest the losses inside the fund. The more you can do to keep the taxes down in a portfolio, the more money you can keep invested.
A penny saved is a penny earned, any DIY’er will tell you that. Now, back to my honey to-do list.
About the Author
CFP®, Summit Financial, LLC
Michael Aloi is a CERTIFIED FINANCIAL PLANNER™ Practitioner and Accredited Wealth Management Advisor℠ with Summit Financial, LLC. With 17 years of experience, Michael specializes in working with executives, professionals and retirees. Since he joined Summit Financial, LLC, Michael has built a process that emphasizes the integration of various facets of financial planning. Supported by a team of in-house estate and income tax specialists, Michael offers his clients coordinated solutions to scattered problems.
Investment advisory and financial planning services are offered through Summit Financial, LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This material is for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting with their independent tax or legal advisers. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. The Summit financial planning design team admitted attorneys and/or CPAs, who act exclusively in a non-representative capacity with respect to Summit’s clients. Neither they nor Summit provide tax or legal advice to clients. Any tax statements contained herein were not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state or local taxes.