Exchange-traded funds have simplified allocations by making many asset classes available to advisors in manageable dollar amounts.

But more than that, ETFs make it possible to sell a position for a tax loss without undermining the overall asset allocation strategy of the portfolio and without running afoul of the IRS wash-sale rule. That rule says that if you take a tax loss on the sale of a security, you can’t buy a “substantially identical” security 30 days before or after that transaction.

Planner Ray Mignone of Little Neck, N.Y., used ETFs to lock in a tax loss for clients earlier this year. When emerging markets sold off over the summer, Mignone swapped holdings in the DFA Emerging Markets Portfolio for positions in the Vanguard FTSE Emerging Markets ETF. That kept the portfolio allocation intact. “We weren’t out of the market and since then these funds have come back,” says Mignone.

“There are lots of opportunities to find something that is highly correlated, but not substantially identical,” says advisor John Frankola of Vista Investment Management in Pittsburgh. You can sell a stock and replace it with an ETF in the same sector. For example, Frankola says that coal miner Peabody Energy, down about 30% over the past year, can be replaced with the Market Vectors Coal ETF to keep a position in that industry.

Some indexes track extremely closely. The S&P 500 and the Russell 1000, both capitalization-weighted measures of large domestic stocks, have almost a perfect correlation. But ETFs of the two meet the wash-sale rule because they are based on different benchmarks. But don’t try to substitute the iShares S&P 500 ETF for the SPDR S&P 500 ETF. Although they are from different ETF sponsors, they use the same underlying index and IRS considers them “substantially identical.”

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