Substitute Funds for TLH
Substitute Funds for TLH
The entire point of tax-loss harvesting is to capture a tax loss without disrupting your target asset allocation. To achieve this, you must have a substitute—a different fund or ETF that tracks the same market segment or index but from a different issuer, so the IRS does not consider it "substantially identical." Choosing the right substitutes before you need them is crucial; scrambling to find a replacement at harvest time often leads to buying the wrong fund or triggering a wash sale.
Key takeaways
- Substitute funds must track the same asset class or index but be from a different issuer or have a different structure.
- The three main US stock-market proxies are VTI (Vanguard), ITOT (iShares), and SCHB (Schwab); all are acceptable alternates for each other.
- For international developed markets, you can swap between VXUS, IEFA, and IEMG depending on region focus.
- Bond-fund substitutes include BND, AGG, and SCHZ; swapping between them avoids wash sales while maintaining duration and credit quality.
- Verify that the substitute's expense ratio, holdings, and tracking error are similar to the original; a cheaper substitute is not always the right choice if it drifts in performance.
The three-way test for acceptable substitutes
A substitute fund passes if it satisfies all three criteria:
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Tracks the same market segment. If you are harvesting a US total-market fund, your substitute must also cover the US total stock market, not just the S&P 500 or small-cap growth. Substitutes must offer equivalent market exposure, not a narrower slice.
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Comes from a different issuer. Vanguard, iShares (BlackRock), and Schwab are recognized as distinct issuers. You cannot swap between two Vanguard funds that track the same index; that is a wash sale. But you can swap VTI (Vanguard) with ITOT (iShares).
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Is cost-efficient. The substitute's expense ratio should be within 10–15 basis points (0.10–0.15%) of the original. If the original costs 0.03% per year and the substitute costs 0.25%, the extra annual fee may dwarf the tax savings from harvesting.
US stock-market substitutes
The three dominant total-market ETFs in the US are:
- VTI (Vanguard Total Stock Market ETF): 0.03% expense ratio, $250 billion AUM.
- ITOT (iShares Core S&P Total US Stock): 0.03% expense ratio, $50 billion AUM.
- SCHB (Schwab US Broad Market ETF): 0.03% expense ratio, $95 billion AUM.
All three track the entire US stock market (approximately 3,500 stocks) and have identical expense ratios. The differences are negligible; they are substitutable. If you harvest a loss in VTI, buying ITOT or SCHB immediately afterward does not trigger a wash sale.
For S&P 500–specific positions:
- VOO (Vanguard S&P 500 ETF): 0.03% expense ratio.
- IVV (iShares Core S&P 500 ETF): 0.03% expense ratio.
- SPLG (SPDR Portfolio S&P 500 ETF): 0.03% expense ratio.
All three track the same 500 companies and are substitutable.
For small-cap harvesting:
- VB (Vanguard Small-Cap ETF): 0.05% expense ratio.
- IJR (iShares Core S&P Small-Cap ETF): 0.06% expense ratio.
These are also acceptable alternates.
International developed-market substitutes
The International developed markets (Europe, Japan, Canada, Australia, etc.) have fewer options but similar dynamics:
- VXUS (Vanguard Total International Stock Market ETF): 0.08% expense ratio, covers 50+ developed and emerging markets.
- IEFA (iShares Core MSCI EAFE ETF): 0.07% expense ratio, covers developed markets ex-US.
- IEMG (iShares Core MSCI Emerging Markets ETF): 0.08% expense ratio, covers emerging markets.
If you harvest a loss in VXUS, IEFA is a suitable substitute (though it excludes emerging markets, whereas VXUS includes them). The choice depends on whether you want to shift your geographic tilt during the harvest window.
Bond-fund substitutes
Bond funds are trickier because even small differences in duration (interest-rate sensitivity) or credit quality can create meaningfully different performance.
- BND (Vanguard Total Bond Market ETF): 0.03% expense ratio, covers US Treasuries and investment-grade corporates.
- AGG (iShares Core US Aggregate Bond ETF): 0.03% expense ratio, identical mandate to BND.
- SCHZ (Schwab US Aggregate Bond ETF): 0.03% expense ratio, same as BND and AGG.
These three are substitutable; they all track the Bloomberg US Aggregate Bond Index. The differences are cosmetic.
For international bonds:
- BNDX (Vanguard Total International Bond ETF): 0.07% expense ratio.
- IAGG (iShares Core Global Aggregate Bond ETF): 0.07% expense ratio.
Both track global bonds ex-US and are substitutable, though the exact composition differs slightly.
Beware: do not substitute a short-duration bond fund (like a bond ladder or treasury-focused fund) for a total bond market fund. The substitution will fail the "same market segment" test because the risk profile has changed.
Pre-planning your substitutes
The best practice is to decide your substitute pairs before the year begins. Document them in a spreadsheet or digital notes:
| Original Fund | Substitute 1 | Substitute 2 | Why |
|---|---|---|---|
| VTI | ITOT | SCHB | All track US total market, 0.03% ER |
| VOO | IVV | SPLG | All track S&P 500, 0.03% ER |
| BND | AGG | SCHZ | All track US aggregate bond, 0.03% ER |
| VXUS | IEFA | — | Developed markets focus |
This removes decision-making at harvest time. When a position falls below cost basis, you simply execute the pre-planned swap.
Tracking performance after substitution
Once you have harvested into a substitute, monitor its performance relative to the original for the 30-day (or 61-day) window. If the substitute drifts significantly in performance relative to the original, it may indicate a structural difference you missed. For instance, if ITOT consistently underperforms VTI by more than 20–30 basis points per year, there may be a cost or methodology difference worth investigating.
In most cases, the substitutes perform identically because they track the same index. The swap is tax-driven, not performance-driven.
Substitute selection flowchart
Related concepts
Next
Choosing substitutes is just one part of the pre-planning process. Before you start harvesting, you need to design your entire portfolio's substitute pairs and understand how harvesting fits into your broader portfolio construction. We examine this holistic approach next.