Replacement funds
Every investment strategy has a set of primary funds it aims to hold. In addition, many strategies, have replacement funds for some or all of the primary funds.
Replacement funds come into play when a client is either (1) tax-loss harvesting the primary funds or (2) needs to avoid a wash sale because the primary fund was recently recently sold for a loss.
Example of a strategy with replacement funds
This strategy has 7 primary funds (VFIAX, TCIEX, etc.). Each of these primary funds has a replacement fund (e.g. VTI, IEFA, etc.).
The majority of the time an account will only buy and sell the primary funds on the strategy. However, there are a couple scenarios where Symplany will purchase the replacement fund.
Tax-loss harvesting (TLH)
When an account has automatic tax-loss harvesting enabled, Symplany will sell the primary fund if (1) the primary fund is down 5% and has sufficient losses and (2) there is a replacement fund available for purchase.
Wash sales
A wash sale happens when a client sells an investment for a loss and purchases the same investment (or one that is "substantially identical") within 30 days of the sale. The IRS has not given clear guidelines about what would make one ETF or mutual fund substantially identical to another ETF or mutual fund (see below).
To avoid a wash sale, Symplany will buy the replacement fund if the primary fund has been sold for a loss (in any of the client's household accounts) in the last 30 days.
Common questions
Q: What do you mean by "substantially identical?"
A: Although the rules are clear when it comes to individual stock positions (see pp.56-57 of IRS Publication 550), the IRS hasn't provided a clear definition of "substantially identical" when it comes to mutual funds or ETFs.
We have taken a fairly conservative approach in this regard. To avoid a wash sale, our replacement funds (1) typically track a different index than the primary fund and (2) have less than a 70% overlap in underlying holdings.
Q: Why are replacement funds only ETFs?
A: Mutual funds can be problematic when it comes to short-term trading. Some will lock an investor out of the fund or charge upwards of a 1% fee for buying and selling in a short enough window. Since replacement funds are typically bought and sold relatively quickly, ETFs allow for greater flexibility in this regard.
Q: So what happens after Symplany has purchased a replacement fund? Do I have to hold the replacement fund forever?
A: In a qualified account, Symplany will automatically sell out of the replacement fund as soon as the 30-day wash sale restriction has ended and the primary fund is buyable
If you are tax-loss harvesting in a non-qualified account, Symplany will only sell out of the replacement fund if the wash sale window has passed and the fund is at a loss.