Does Tax-Loss Harvesting Occur within Funds of Funds?

A reader writes in, asking:

“I’ve read on your blog and elsewhere that funds of funds are not tax efficient because they don’t allow for tax loss harvesting. But doesn’t holding a target retirement fund achieve tax loss harvesting anyway since when one of the funds inside the portfolio goes down it causes a loss, which offsets the gains? And I guess I have the same question with regular index funds. Don’t they achieve tax loss harvesting because some stocks are going down while others are going up?”

In short, the answer to both questions is “no.”

In order for tax-loss harvesting to occur, you have to actually sell the holding that has gone down. That’s what makes for a capital loss in the eyes of the tax code. Simply holding an investment that has declined in value isn’t a capital loss.

Why All-in-One Funds Don’t Usually Tax-Loss Harvest

Let’s look at the Vanguard LifeStrategy Moderate Growth Fund as an example. The fund’s targeted allocation is as follows:

• 36% Vanguard Total Stock Market Index Fund,
• 24% Vanguard Total International Stock Index Fund,
• 28% Vanguard Total Bond Market II Index Fund, and
• 12% Vanguard Total International Bond Index Fund.

For the fund to tax-loss harvest it would have to sell one of these holdings after a decline. But it’s unlikely to do that because:

1. When a holding is down, the fund usually has to buy more of it in order to get back to the targeted allocation, and
2. The fund cannot decide to substitute other similar funds in the way that an individual investor can (e.g., selling Vanguard Total Stock Market Index Fund to tax-loss harvest, then buying Vanguard Large-Cap Index Fund as a temporary substitute).

Why Regular Index Funds Don’t Tax-Loss Harvest (Very Much)

With a regular index fund, buying and selling within the fund happens primarily as a way to either use up cash inflows or satisfy redemptions. And in each case, the buying/selling will generally be approximately proportional to the existing allocation in the fund. For example, if an S&P 500 index fund currently appropriately reflects the S&P 500 and it needs to raise a significant amount of cash, it cannot simply choose to raise the cash by selling one stock that is down recently — otherwise the fund would no longer reflect the index that it is trying to track. Instead, the fund has to sell a little bit of everything.

That said, when the fund does “sell a little bit of everything,” if the fund manager is conscientious about taxes, he/she will usually make a point to sell the shares that have the highest cost basis (thereby realizing the largest loss or smallest gain possible). But this is not the same level of tax savings that an investor could achieve if he/she was willing to sell all of a given holding when it is down and substitute some other similar holding.