Bonds: Total Market

For investors with assets in active bond mutual funds, there has never really been a time to implement tax-loss harvesting. Tax-loss harvesting is the process of selling securities at a loss to offset capital gains tax due on the sale of other securities. Until this year, investors had mostly experienced gains in their fixed income holdings tracing back to the 2008-2009 financial crisis. However, due to significant losses in fixed income this year, an opportunity has arisen for investors to transition their assets to ETFs through tax-loss harvesting. According to Morningstar Direct data, US fixed income funds have seen more than $205 billion in redemptions during the first half of the year. Sales in taxable bond ETFs, on the other hand, while slowing, still generated $53.8 billion in net inflows during the same period. This has set the stage for tax-loss selling out of mutual funds and into ETFs.


Finsum: Losses in active bond funds this year sets the stage for tax-loss harvesting into fixed income ETFs.

Research from Morningstar's annual Global Fund Flows found that actively managed fixed income funds saw $422 billion in outflows during the first half of the year. That figure accounted for 74% of all outflows from active portfolios. Active funds as a whole saw $568 billion in outflows, while index funds generated $432 billion in inflows. The net difference of $136 billion in outflows was the most since June to December of 2008, during the height of the Financial Crisis. The high percentage of active fixed income outflows is partly a result of the automatic rebalancing of model portfolios and target-date funds. Since equity returns have been more negative, automatic rebalancing has been triggering more trades to equity strategies to get allocations back in line. Passive fixed income funds saw $90 billion in inflows.


Finsum: Active fixed income funds accounted for 74% of all outflows from active portfolios during the first half of the year as automatic rebalancing favored equity strategies.

According to a paper published last month by Christopher Reilly of Boston College, corporate bond ETFs listed in the US, on average, pay 48 basis points a year in hidden costs that result from custom creation baskets. Since most fixed ETFs track thousands of individual bonds, custom creation baskets allow issuers and authorized participants to create a sample of the holdings which mirror the performance of the ETF. An authorized participant is an organization, typically a bank, that manages the creation and redemption of ETF shares in the primary market. Without sampling, the authorized participants would have to source every security. However, the custom ETF creation baskets allow authorized participants more flexibility to include securities that could significantly underperform the underlying index. This customization results in hidden costs that investors of ETFs could incur.


Finsum: Corporate bond ETFs are paying an average of 48 basis points a year in hidden costs resulting from customized creation baskets.

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