When ETFs were introduced in 1993, no one imagined how this type of product would flourish.
State Street Global issued SPY to track the S&P 500. That one security now has more than $180 billion in assets and daily volume of more than $26 billion.
From such a simple beginning, ETFs now mimic many different indexes, and there are ETFs for various research-based strategies.
They can be purchased and held, held as a placeholder until an actively managed strategy replaces them, day-traded and more. ETFs have an unlimited number of uses.
Here is a simple strategy that can provide significant benefits over time.
Because there are 10 economic sectors inside the S&P 500, advisors can select any specific sector for clients. Weighting all 10 sectors with the prevailing respective S&P 500 weightings allows advisors to recreate the S&P 500 in 10 stocks.
This is much more manageable than investing in 500 stocks to replicate the index, and it potentially offers significant tax benefits, versus investing in the S&P 500 in one security.
By breaking up the one security into 10 and replicating the index, that provides at least two advantages over owning the entire index.
Last year, the S&P 500 was marginally profitable. Energy, the worst performer, was down 21.5%.
For those who owned the index in one security, there was no way to take a tax loss. But those who owned the sectors could sell off energy and have a tax loss.
An investor would typically have to be out of the market for 31 days to avoid a wash sale, but this allows buying the energy index fund of one issuer, the Energy Select Sector SPDR Fund (XLE), and swapping into basically the same index fund of another issuer, iShares Dow Jones US Energy Sector (IYE).
What about gifting appreciated shares to charity?
Those who owned the index last year, had no long-term gain to gift. But investors who owned the sector funds, could gift the Consumer Discretionary index, which was up 9.9% last year; they just had to make sure that it was long-term.
Investors can gift shares to a charity, donor-advised fund or foundation, and they sell it. This way there are no long-term capital gains taxes to pay, and because there are no wash sale rules on gifting, the investor can buy the same sector index right back.
ETFs have come a long way. From a simple replication of the S&P 500, they now have myriad uses, and we simply point out two tax strategies above that economic-sector ETFs afford private-client investors.
Kenneth Hoffman is a managing director and partner at HighTower Advisors in New York.
This story is part of a 30-day series on smart ETF strategies.