Maneuver Violates Investing's Intent

By Chet Currier
Bloomberg News
Sunday, October 16, 2005

Nothing points up the absurd complexity of modern-day financial life better than the idea of "tax-loss harvesting."

The phrase surfaces as a hot topic around this time every year, as consultants, brokers and financial planners keep looking for ways to make their clients happy.

"We've still got time to cut your tax bill for the year," they purr into the telephone. "Let's harvest some losses from your stock and mutual fund portfolio to offset some of the gains you realized when you sold shares earlier in the year."

Blue-ribbon studies have been published attesting that this kind of activity can indeed pay off. From a taxable U.S. investor's point of view, "loss harvesting adds a great deal of value, far more than most active strategies can hope to achieve," reports an oft-cited 2001 article in the Journal of Wealth Management by researchers Andrew Berkin, Jia Ye and Robert Arnott.

Since the harvest encourages commission-generating trades, commission brokers naturally are all for it. So too the creators and issuers of securities such as options and exchange-traded funds that can be used as part of a "sophisticated" approach to loss harvesting.

For both investment adviser and client, there may be a psychological payoff as well. Consider how many festering disappointments and resentments can be assuaged if we stop looking at a loser as an investment that went wrong, and visualize it instead as a useful commodity that can be harvested.

Okay, if everybody's happy, what's not to like? Well, for starters, all parties are living in la-la land. Common sense reminds us that no one can harvest something that didn't grow.

The mere suggestion that losses aren't such a bad thing after all is pernicious, diverting attention and focus from the point of the whole exercise of investing. It's postmodern in the worst sense of the word, all brain and no sense.

What's more, tax finagling consumes time, brainpower and other resources that might otherwise be devoted to activities that enrich the economy at large.

Any tax system that gives people the impression that they benefit from losing investments detracts from the useful functioning of the markets and the economy. The whole point of having markets in the first place is to recognize and reward the creation of real value.

On my desk right now sits a message from a sponsor of exchange-traded funds. It commends to me the use of single-industry sector ETFs as a tool in loss-harvesting strategies.

The problem this addresses: When U.S. investors sell a losing stock or fund before year-end to realize a tax loss, they cannot buy that same stock or fund back within 30 days without violating the "wash sale" rule designed to forestall sham tax-motivated transactions. During that waiting period, they face the risk that the stock might suddenly surge upward without them.

The solution? Buy a sector ETF in the stock's industry and hold it for as long as your money is out of the stock. While the ETF may behave much like the stock, it is not substantially identical to it. Therefore, the Internal Revenue Service presumably will not frown on the maneuver.

Now, let's not quarrel with the logic behind such a stratagem. If coping with our tax system requires such activity, we shouldn't fault anybody who does that in the intelligent pursuit of his self-interest.

My questions are, how much of this sort of wasteful stuff can we as a society afford? And if an investment product such as ETFs is going to flourish, wouldn't we prefer that it do so entirely by adding real economic value instead of functioning as a handy fiddle?

Few reliable ways present themselves to calculate the cost of such dissipative activity, in missed opportunities if nothing else. Since we don't know what we are missing, we may find it easy not to worry about it.

That's too bad, because the cost is bound to be enormous. Each of us ought to wince whenever we spend time, thought and money on anything so palpably idle as "harvesting losses." The day the very idea stops sounding foolish to us is the moment we know we are fooling ourselves.

© 2005 The Washington Post Company