Many investors hold a concentrated stock position that represents a large percentage—typically 10% to 20%—of their overall portfolio value. Let’s review the risks of concentrated positions and then survey some of the possible solutions.
Risks of concentration
A concentrated stock position can arise from a compensation package, an investment in an early-stage company that paid off or a long-term investment that has appreciated enough to dominate the portfolio.
Among the many risks to holding concentrated positions, idiosyncratic risk is the largest. We all remember the headlines about stocks like Sears and Enron that lost all or nearly all their value. But the cases don’t have to be that extreme to put an investor’s wealth at risk.
Looking at five-year rolling periods from 2000 through 2021, every stock in the S&P 500 Index experienced a maximum drawdown of at least 20%, and 63% of companies experienced a drawdown of at least 40%. Unfortunately, such drawdowns cannot be predicted, and that can be especially dangerous for an investor with upcoming liquidity needs. Fortunately, this risk can be reduced through diversification.
Solutions to concentration
Even if the risks of concentration and the benefits of diversification are well understood, the investor may still have an emotional tie to the stock. Or they may be concerned about the capital gains that might be triggered when they try to reduce the concentrated position.
Two key goals in reducing concentration are increasing diversification and reducing the tax burden from selling the concentrated position. The good news is that there are many strategies that can help diversify and reduce this risk. Here are four potential solutions that we think advisors ought to know. The best solution for investors may be not one but a combination of these solutions.
1. Direct indexing
Direct indexing can help with both key goals. From a diversification perspective, direct indexing provides access to almost any exposure, which could be as simple as the S&P 500 or Russell 3000 Index. Or a customized index can act as a completion portfolio for a concentrated stock position, placing stock, industry or sector level restrictions on the account to reduce duplicative exposure.
Direct indexing can help to reduce the tax burden in several ways:
- Generating losses is the most basic way to take advantage of directing indexing. These losses can help offset any gains realized when reducing the concentration.
- Building a customized staged diversification plan can help spread the cost of diversification over a number of years or make sure the cost stays within a certain gain budget—allowing for greater control of the tax bill and the degree of diversification. This plan can be modified at any time depending on changes in the market or client needs.
- Using leverage can help increase the losses generated in a direct indexing account and accelerate the diversification. Long/short accounts such as 130/30 allow the client to capture losses in up and down markets.
2. Exchange funds
Instead of selling, a concentrated position can be contributed to an exchange fund and swapped for an ownership share of the fund’s diversified portfolio of equities and qualified assets. This allows for tax-free diversification over the holding period of the exchange fund—typically a minimum of seven years—but the gains are simply deferred, not eliminated.
3. Covered call writing
Investors who want or need to hold their concentrated shares could consider covered call writing. A customized program can seek to enhance total return and lower volatility. This rules-based strategy may also focus on mitigating the number of shares sold and maintaining as much upside potential as possible.
Capturing the volatility risk premium may help dampen volatility while potentially enhancing portfolio return
4. Charitable giving
For an investor looking to combine charitable giving with tax optimization, a donor advised fund or split interest vehicle—like pooled income funds and charitable remainder trusts—can be another option.
- Donor advised funds allow the investor to make a tax-deductible donation through a giving account, thus maintaining control over the timing and recipients of their charitable contributions. Donated securities are limited to no more than 30% of adjusted gross income (AGI).
- Pooled income funds allow investors to receive an immediate partial tax deduction as well as an income stream over their lifetime.
- Charitable remainder trusts are similar, also providing an income stream along with a tax deduction based on the amount designated to charity. They can take on multiple forms depending on investor goals. We have found direct indexing to be a natural fit for managing charitable remainder trusts.
The bottom line
Though by no means exhaustive, this list of potential solutions highlights some key options available to investors with concentrated stock positions. Many can be used in combination with others to meet the unique needs of investment clients. Adding to our existing range, Parametric continues our work to develop innovative new solutions in response to what investors and their advisors need and demand.
Parametric and Morgan Stanley do not provide legal, tax or accounting advice or services. Clients should consult with their own tax or legal advisor prior to entering into any transaction or strategy.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss. Prospective investors should consult with a tax or legal advisor before making any investment decision. Please refer to the Disclosure page on our website for important information about investments and risks.
