MARKET COMMENTARY

Too Much of a Good Thing: Overcoming Concentrated Portfolio Risk

07.28.2021 - Jon Heckscher

Everyone knows the old saying about not putting all of your eggs in one basket. This is especially important for investors, yet concentrated positions are still often found in client portfolios. 

Whether these assets were acquired through an inheritance, a liquidity event, an employer compensation structure or the appreciation of a long-held investment, the result can be too much of a good thing. A high concentration of a single investment within a portfolio—one that may even be an outstanding performer—can become a bigger and bigger investment risk as time goes on. It’s like sitting down at the roulette table in a casino and putting down a good chunk of your net worth on a single number or color. What could go wrong?

Understanding total investment risk

Using a broad definition, total investment risk can be calculated by adding Systematic Risk and Unsystematic Risk. Systematic risk (“market risk”) represents the risk of loss arising from movements in general market prices. Unsystematic risk (“idiosyncratic risk”) represents the risk of price changes due to the unique circumstances of a specific security. 

Unsystematic risks in your portfolio are naturally higher with the fewer investments you have in your portfolio.  As the number of holdings rise, the volatility of return (i.e., risks) falls.  Mathematically, the average volatility of a single stock portfolio is more than double that of a diversified portfolio.

Total Risk = Systematic Risk + Unsystematic Risk

The implications of this conclusion are crucial to expected returns. A high-risk stock (as measured by standard deviation of return) does not necessarily have the greatest expected return. Consider a biotech stock with a drug that is in clinical trials to determine its effectiveness. If it turns out that the drug is effective and safe, stock returns should be high. If, on the other hand, the clinical trials are deemed a failure, the stock will fall. However, if an investor buys a biotech ETF, the sensitivity to trials at a specific company will be mitigated.

Lessons from the S&P 500

History reminds us that high-quality companies can disappear. Whether through competitive innovation (JCPenney, Eastman Kodak and Blockbuster Entertainment), scandal (MCI WorldCom and Enron), acquisition (Tiffany & Co and Mattel) or market duress (Lehman Brothers) it is easy to recall how a once-proud large company’s stock or bond prices were quickly decimated. 

This historical fact is often lost on investors who rely on the S&P 500 Index as a bellwether for assessing portfolio manager performance. Standard & Poor’s actively manages the index, regularly adding and subtracting companies based on both discretion and a set eligibility criteria[1].

Over the past 25 years, nearly half of the companies in the S&P 500 were removed due to acquisition, merger, or significant decline in market capitalization, while 49 companies declared bankruptcy. The S&P 500 is anything but static and these types of market distortions create unsystematic risks for holders of concentrated positions. Managing these positions, therefore, should be a regular part of your investment review process. 

How to reduce the capital gains dilemma

Investors generally hold concentrated positions for psychological and financial reasons. The most common psychological reason is an attachment to the holding because it was a gift from a parent or was part of an estate settlement. The most common financial reason is to defer paying capital gains.

One way to manage capital gains tax liability is to tackle the issue head on. Once an investor understands the actual versus perceived tax liability, the problem is more manageable than first thought. Consider an investor with a $5 million portfolio that contains a $1 million position with a cost basis of $500,000:

  • At a 20% capital gains rate[3] the sale of the position would generate a $100,000 tax bill.
  • The realized net gain would generate an 8% appreciation for the total portfolio and an 80% gain on the individual security.
  • The tax cost would represent a 10% cost relative to the position but only a 2% cost relative to the total portfolio.

In this example, the 2% cost to remove the unsystematic risk may be more manageable. Alternatively, selling half the position would lower the risk and only cost the portfolio 1%. In the end, a 1% to 2% tax liability is more tolerable when the market is up 10+% on the year rather than flat or down.

Unwinding concentrated positions can be difficult

Determining the tax liability for unwinding a concentrated position is easy. The hard part is calculating the future benefits of diversifying a portfolio. This can only be accomplished using return assumptions for both the single security and the overall market. As a result, the ultimate decision to sell or hold needs to come down to other factors such as risk tolerance, total portfolio risk, costs, and time horizon.

  • Investors with higher risk tolerance may be comfortable with more concentrated positions.
  • A portfolio with singularly large or multiple concentrated positions will increase total portfolio risk.
  • Both tax liability and transaction costs must be determined before reducing a position.
  • A long-term time horizon will compound the unsystematic risk over time. Hence, reducing the position sooner is the most prudent decision.
Plan ahead

At Fiduciary Trust, we can help develop a strategy to fit your individual liquidity needs and risk tolerance.  Here are some commonly used solutions:

  1. Tax-Efficient Gifting (Charitable Remainder Trust, Donor Advised Funds, Charitable Gift Annuity, Gifting to Family Members)
    • Instead of gifting cash, consider donating long-term appreciated securities. Capital gains taxes are eliminated when you contribute long-term appreciated assets directly.
    • Fund a Charitable Remainder Trust (“CRT”). A CRT allows an investor to receive a charitable deduction as well as an annual income stream if the client is the beneficiary.
  2. Monetization (Outright Sale, Installment Sale, Variable Prepaid Forward)
    • Set a long-term diversification plan to reduce concentrated positions over several tax years. Setting a “capital gains budget” will allow your advisor to advantageously reduce positions when rebalancing your portfolio throughout the year. In addition, if in any year your income declines, you may find it beneficial to sell a larger portion of your concentrated position.
  3. Hedging
    • Use derivatives (puts, calls and collars) to reduce the risks of a concentrated position. This solution can be complex and costly. Again, Fiduciary Trust can be helpful here.
  4. Tax-Efficient Diversification (Equity Exchange Funds, Tax Loss Harvesting Strategies, Cash Diversification, Net Unrealized Appreciation)
    • Tax loss harvesting strategies help investors balance the capital gains they are willing to realize against an acceptable percentage of tracking error to the desired benchmark exposure.
    • Cash additions to the portfolio (via dividends, interest, or additional funds) organically diversifies concentrated positions.

Although investors can profit from holding large quantities of a specific asset, it is important to recognize the risk and exposure to volatility.  Our investment managers are available to explain the associated risks and to discuss options available to help you reduce risk and preserve your portfolio’s integrity.

We thank Cody Babineaux for his contributions to the preparation of this article

Related Material:



[1] https://www.spglobal.com/spdji/en/documents/methodologies/methodology-sp-us-indices.pdf

[
2] https://en.wikipedia.org/wiki/List_of_S&P_500_companies#Recent_changes_to_the_list_of_S.26P_500_Components

[3] 20% capital gains tax does not include a 3.8% surcharge for individuals earning more than $446,000 or households earning more than $502,000.

 





This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.

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