Using single-country ETFs as part of a tax-loss harvesting strategy

Key takeaways

• This year’s pronounced divergence in market performance presents an opportune time for investors to consider tax-loss harvesting strategies with single-country exchange-traded fund (ETF) allocations.
• A key consideration in tax-loss decision-making is whether a comparable or highly correlated ETF exists at a lower cost for those seeking to maintain desired exposures to chosen markets with attractive long-term prospects.
• For many investors, international markets are still underrepresented in their portfolio allocations. Global stocks, however, offer potential diversification benefits and many have favorable characteristics that offer differentiated long-term opportunities. Japan, for example, has seen improving governance boost company profits and attract foreign investors with increased buybacks and dividends.

With U.S. technology mega cap’s dominant role in the S&P 500 Index’s rally this year and the anti-climactic reopening of China from its zero-COVID policy, many investors have shied away from increasing their global equity exposure. As of the end of September, global equity funds saw net outflows of $10.65 billion.¹

However, in our opinion, certain markets benefit from positive macro and geopolitical catalysts, combined with longer-term trends that favor equities abroad, and some of 2023’s underperforming holdings may be prime candidates for tax-loss harvesting.

A silver lining to down markets

To begin with some clarity on tax-loss harvesting, investors should be aware that it is applicable to a variety of investments, including individual equity securities, mutual funds and ETFs. Investors can shed underperforming investments for losses in taxable accounts and incur lower net capital gains—a key consideration for those seeking to maintain desired exposures, including allocations to global markets with attractive long-term prospects. To that end, it’s worth looking into comparable or highly correlated investments available at a lower cost. Keep in mind, however, the Internal Revenue Service’s wash-sale rule prevents a loss being taken on the sale of any security swapped for a substantially identical one within the same 30-day period.

To increase portfolio diversification, one viable approach includes shedding underperforming individual holdings in favor of single-country ETFs. Index-based ETFs are generally low-cost, tax-efficient vehicles that investors buy and sell on a secondary market. Investor redemptions from ETFs generally do not create taxable events for remaining shareholders, which can make a difference in returns over the long term. While ETFs are not entirely without tax drag (the reduction of potential income due to taxes), index ETF managers proactively look for opportunities to minimize capital gains.

Eye on China

If an investor’s portfolio took a hit when China’s property sector was reeling, consider that recent data from the country’s National Bureau of Statistics (NBS) showed two consecutive months of profit gains for Chinese industrial firms, signaling that supportive government measures may be working to stabilize the economy. China’s economy saw a 11.9% year-on-year rise followed an unexpected 17.2% gain in August, alongside September’s stronger-than-expected industrial and consumption activity.²

With the MSCI China Index down about -11% as of the end of October, China’s market seems a prime target for tax-loss selling. However, rather than channeling investment out of emerging markets like China entirely, we believe investors should temper excessive pessimism to such deeply discounted markets. In China’s case, its decades-long story of unprecedented economic success has stemmed largely from its adoption of a market-driven economy, which remains intact as a source of dynamism and opportunity. More direct flights between the United States and China have resumed. And there are encouraging signals of improved goodwill and cooperation as President Joe Biden and President Xi Jinping conclude their Bay Area meeting. We believe this makes for a compelling case for capital redeployment in the tax-loss harvesting process and the compounded cost savings over time when investors switch into a comparable lower-fee product.

China still has vast and still-untapped human capital, capable of producing a highly trained and motivated workforce. It also offers an enormous domestic market that creates strong incentives for investment and innovation with the ability to significantly boost new industries rapidly. We are seeing this with the country’s constructive Generative AI policies—just like the quick rollout of policy frameworks that accelerated its electric vehicle and solar markets.

Maintaining global equity exposure

While the emerging market asset class has lagged developed markets this year, investors should keep in mind that dispersion in the returns of single-country indexes have historically been as wide as 50%, highlighting the potential benefits of a diversified portfolio.

High-growth emerging markets with burgeoning middle-class consumers also have the potential to grow more rapidly than advanced economies. The International Monetary Fund (IMF) forecasts 2023 real gross domestic product (GDP) growth of about 4% for emerging and developing countries, helped by economies such as India, which is expected to grow at a rate of 6.3%.³

And, in our analysis, emerging market equities offer good value—as they are priced at a discount to developed markets. Brazil’s attractive stock valuations are expected to continue luring in foreign capital, while expanding exports may continue to favor its currency. As we recently wrote, we view Brazilian equities as substantially undervalued, with price-to-earnings (P/E) ratios for the last 12 months (LTM P/Es) in the mid- to high-single digits, constituting a material discount to both emerging and developing markets. Tax-loss harvesters should also look broadly at the region and consider how well Latin America has weathered recent global shocks.