TRADING CORRELATED EQUITIES AND FUNDS (plus LEVERAGED ETNs)
A friend asked: “Should I sell AGNC even when I’m down about $20K on it? Can you only write off $3000 per year in losses of stock investments? Can you carry the loss over several years?”
AGNC is a mortgage REIT which borrows money, some of it short term, to buy mortgages, profiting from the difference between short and long term interest rates, and the difference between individual and business borrowing rates. Such REITs along with almost every other high dividend equity tend to cycle up and down together, with a few exceptions. AGNC is very widely held. You can just about substitute the name of any other high income equity you hold.
MORL is an ETN (exchange traded note, slightly different from an ETF), designed to yield roughly 2x the dividend rate of a basket of high dividend financial stocks, including AGNC. ETNs are very new and some IRS tax issues associated with maturity of the notes, usually in 25 years have not been settled. But the advantage is they don’t accrue compounded losses the way a 2x or 3x leveraged ETF does. How this works, no one knows, or if they do they are not telling.
None of these are growth investments, and all will decline over time. Their purpose is to generate income for
- immediate living expenses
- to pay margin interest, which makes the margin interest also fully deductible
- to pay mortgage interest, which is also deductible
So I advise hold just enough of one or some of them to meet these expenses, and have the rest of your portfolio in something like the S&P 500 via an ETF (e.g. SPY).
Right now all the high yield equities are down. You can see from the chart above, AGNC and MORL are down by about the same amount. They are highly correlated, moving up and down more or less together. This is not guaranteed, but typical.
We’ve discussed the ETN risk. What about AGNC or similar individual company? It might decline forever or even go bankrupt due to management mistakes, like Luminent Mortgage or Novastar Financial. If you haven’t heard of these, you weren’t investing in high yield securities in the early 2000’s. They don’t exist anymore and all shareholder equity was lost. I prefer to take my chances with the IRS rather than management of an individual company.
Because they are correlated, you can’t sell AGNC high and buy MORL low unless you are a reliable market timer. If you are, you know it, and you are not reading this blog.
If you buy MORL and sell whatever else you’ve got on the same day, then your position is basically unchanged. But you may have a tax event. This is what my friend is asking about.
If you exchange them when you have a gain, it feels good, but you pay tax on the gain, which is money you never get back.
If you exchange them when you have a loss, you get a tax deduction, even if what you exchange it for goes back up. Since you may never sell again, it is money in your pocket.
But the question revolves around the fact you can only deduct $3000 of capital losses in any one year, which is archaic, and I want to use a stronger word, like barbaric – like the kind of barbarians that just raid the neighboring village whenever they want some more loot. This number has not changed in 50 years of inflation. (Write your Congressman, by all means.)
However, your tax software should automatically carry over the unused deduction year after year, whittling away at it. My friend’s $20k paper loss will be deducted over 7 years. Quite likely before then she’ll have a gain on something, and it’ll then be deducted all at once.
And remember, it is a paper loss. It is only an actual loss if you sell AGNC (or whatever) and spend the money and do not buy anything else, or buy something else that is in vogue and likely to fall. If you immediately re-invest in a correlated security, you don’t really have a loss. The tax man just has a hard time proving they are equivalent, because they aren’t quite. If you buy the same security or a related security in the same company (like preferred stock or something) then you are subject to the wash sale rule if you repurchase within 30 days. So effectively a reliably correlated but not guaranteed correlated equity is a loophole in the wash sale rule.
Another advantage of the MORL ETN, as opposed to an ETF like KBWD which only yields 8.8% currently (and historically less than that) is that you can hold much less of it to meet the same expenses – exposing yourself to less capital loss as over time these kind of financial stocks often slowly decline. For example:
- For AGNC vs. MORL, you need only 12.9% / 21% = 61% as much MORL to produce the same income.
- For KBWD vs. MORL you need 8.8% / 21% = 42% as much for the same income.
It might also work out to hold MORL in an IRA, without using it to meet expenses. But remember, I am not a licensed investment adviser and I am not responsible for your losses. : )
One more little trick you need to know. If you look up MORL on Yahoo Finance, you will see the dividend and yield is listed as N/A (N/A). This is not very helpful. Click on Historical Prices on the left hand menu, check Dividends Only then click Get Prices. You will see that the dividend varies widely each month. Yahoo can’t make heads or tails of it, thus the N/A. The variation is just because the ETN corresponds to many companies, and some months a bunch of them pay dividends and some months very few of them. If you average the last 3 months, you’ll get a pretty good idea. You can average 12 months, but then who knows whether the component companies have cut dividends during the year.