by: Theodore Schneider, CFA and Anthony Rosetti, CFA

 

Introduction: Understanding Investment Risk and Diversification

“To the moon!” This has been the battle cry for speculative investors in recent years as they watched the vast array of cryptocurrency, meme stocks, and shares of fortune 500 companies continually push higher. However, in the frenzy to capitalize on the overly enthusiast market environment, many investors found themselves taking on increasing risk in one (or a handful) of individual stocks, coins, etc. While the good times were good, it appears that animal spirits in the market have retreated along with many of the gains witnessed in the months following the height of the pandemic. Many investors may have lost sight of maintaining investment discipline and moved away from prudent diversification into concentrated exposures, and with that came a new layer of risk to consider—idiosyncratic risk.  

Constructing an efficient investment portfolio that exhibits optimal risk and return characteristics is an important objective for any individual looking to meet their short-term and long-term financial needs and goals.  During the process of constructing the optimal portfolio, there are several factors and risks that should be taken into consideration.  Outlined below are the different kinds of risks investors should familiarize themselves with when making portfolio allocation decisions.

  • (Systematic) Market risk is defined as the risk of losses in positions arising from movements in market variables like prices and volatility. Systematic risk is not specific to any particular investment, and it affects the markets in its entirety.  This form of risk cannot be eliminated by diversification. 
  • Idiosyncratic or (Unsystematic) Risk refers to risk related to a specific company, industry, or country. Some examples of unsystematic risk would include business risk and financial or credit risk.  Unsystematic risk can be reduced through diversification by owning securities of companies in different industries with low or negative correlations.
  • Interest-rate risk is the risk that changes in interest rates may adversely affect the value of a bond or other fixed income and fixed income-like investments.
  • Inflation risk is the risk that an individual’s purchasing power will decrease due to the increase in the prices of goods and services.
  • Credit risk refers to a bond issuer’s ability to repay its debt as promised.

Diversification is a portfolio management technique that helps limit the risks outlined above by allocating investments across various financial instruments and asset classes.  For example, within the equity portion of the portfolio, an investor should consider allocating between U.S. and International as well as different market capitalizations (i.e., Large Cap vs. Small and Mid-Cap stocks) and styles (growth, core, value).  Within fixed income, investors should consider investing between investment grade and non-investment grade bonds as well as long-term and short-term bonds.  The optimal mix between these asset classes will be dependent on an investor’s risk tolerance, time horizon, current market risks and the goals they wish to achieve.

In this article, we discuss:

  • The current market environment and the importance of diversification as it relates to asset classes; and
  • Concentrated stock positions, the benefits of diversification, and tax efficient strategies that can be implemented to overcome concentration risk.

Is History Repeating Itself? The Current Market Selloff Compared to the DotCom Crash

The risks of holding concentrated stock positions are playing out in real time. After the bull market rally of the last few years, rising inflation, interest rates and the increasing risk of recession has led to a significant drawdown in equity markets in 2022 and a new environment for stocks. While the U.S. equity market, as measured by the S&P 500 Index, is down 20% year-to-date, the drawdown has been more pronounced among stock picker favorites, such as the “FANG” (Facebook, Apple, Netflix and Google) stocks. The NYSE FANG+ Index, which tracks performance of the 10 most highly traded technology companies, is down 30% year-to-date. And when examining those index constituents closer, six of the ten companies (Facebook, Netflix, Nvidia, Tesla, Alibaba and Baidu) have all experienced drawdowns of 50% or more within the last two years.

The current market environment has resulted in severe wealth deterioration for many concentrated investors and has done so in a compressed timeline. The sell-off within growth equities, particularly technology companies, is reminiscent of the DotCom/Tech Bubble Crash in the early 2000s. From April 2000 to September 2002, the technology sector, as measured by the Nasdaq 100 Index, fell 83% over that time frame. To make matters worse, the Nasdaq 100 Index did not fully recover back to its March 2000 highs until November 2014, creating a lost decade for investors concentrated in this area of the market.

In contrast, a diversified investor[1] averaged an annual return of 5.1% over the same time period, which amounts to a cumulative return of 109%. In dollar terms, this would have resulted in a gain of $1.09 million on a $1 million starting portfolio value. Additionally, this was achieved while assuming just one-third of the volatility as the Nasdaq 100 Index.

So why do investors continually hold concentrated positions if the assumed risk is materially higher than owning a diversified portfolio of assets? Below are some of the common rationales we come across. Unfortunately, the decision to hold based on these factors has not historically favored the concentrated investor:

[1] For purposes of this analysis, a diversified investor exhibits the following asset allocation: 60% Global Equity (MSCI All Country World IMI); 40% Fixed Income (Bloomberg US Aggregate Bond Index).

  1. Belief the concentrated position will outperform the broad market.
    We often see investors either develop overconfidence in the concentrated position or fear that if they sell now, they may miss out on future outsized returns. While many are adamant the stock they own will outpace the market, the odds of finding outsized success from stock picking or holding a concentrated stock position is considerably low. According to research done by Aperio, a leading custom indexing and tax-optimization firm, only one-third of stocks in the Russell 3000 Index, a benchmark of the U.S. stock market, outperformed the diversified index over the trailing 35 years, meaning that two-thirds performed worse. Even more detrimental, 37% of companies not only trailed the benchmark but experienced negative performance over that time frame, during which the index gained 11% on an annualized basis. With those odds, a stock picker may be better served heading to the casino and taking their chances on a hand of Blackjack or a spin of the roulette wheel.
  2. Avoid paying taxes.
    Selling a highly appreciated stock position may create angst among investors because of the tax implications. Many investors refrain from selling stock with substantial appreciation because they do not want to accept the haircut that gets taken by capital gains tax. However, while realizing a capital gain and paying the tax is a known loss in value, in many instances selling the stock and paying the tax is the cheaper alternative to doing nothing and letting the position remain at the whim of the market.

    Let’s use the current market environment as an example, where an investor holds a concentrated and highly appreciated position in Netflix. For purposes of the example, the investor owns a $1,000,000 position in Netflix, of which $500,000 is the original cost basis and $500,000 is capital gain. At the onset of the year, the investor had two choices: 1) Sell the shares of Netflix, pay the tax, and reinvest the proceeds into a diversified portfolio, or 2) do nothing and continue to hold the shares. The diagram below highlights the stark difference in ending market value based on the decision to sell or stay:

    * Assumes Capital Gains Tax Rate of 34.55%, which is inclusive of Federal Long-Term Capital Gains Rate (20.0%), Net Investment Income Tax (3.8%), and State Capital Gains Tax (10.75% – New Jersey).

    ** For purposes of this analysis, a diversified investor exhibits the following asset allocation: 60% Global Equity (MSCI All Country World IMI); 40% Fixed Income (Bloomberg US Aggregate Bond Index).

 

Tax Efficient Strategies to Diversify Concentrated or Highly Appreciated Holdings

Although the most straightforward and streamlined approach to diversifying away from concentrated stock is to sell the position and reinvest the proceeds, it may not always be the most appropriate or practical solution. We have detailed two different tax-advantaged strategies below to create portfolio diversification without the need to sell the security upfront.

 Lending & Tax Managed Separately Managed Accounts (SMAs)

Investors who hold concentrated stock positions that want to reduce portfolio risk, while remaining tax efficient, may want to consider margin lending and investing those proceeds in a tax managed separately managed account (SMA).  Borrowing on margin means taking an interest-bearing loan and using the securities you own in your brokerage account as collateral.  The amount of margin available will depend on the type of security, but typically margin loans can be 50-70% of a security’s market value.  For example, if an investor owns $1,000,000 position in Apple stock, they may be able to borrow upwards of $700,000 that can then be used to buy other investments that further diversify the portfolio.  Margin loans can provide many benefits such as readily accessible liquidity, relatively low interest rates, and potential tax advantages as the loan interest may be tax deductible.  Before using margin loans, investors should be aware of the risks as well.  It is important to understand the maintenance requirement when borrowing on margin.  The maintenance requirement is the minimum level of equity that is required by a brokerage firm.  If the equity value falls below the maintenance requirement, investors may be forced to sell securities at depressed levels, potentially locking in losses. The use of margin does not mitigate the risk of loss in the portfolio. In order to protect against a potential margin call, investors should consider purchasing put options on the concentrated security to help offset depreciation in the security’s share price. Additionally, the cost of the interest expense and put hedges should be considered in the overall analysis.

If an investor decides a margin loan is a viable diversification strategy, they may want to consider investing the proceeds in a tax managed SMA.  Tax managed strategies employ a quantitative approach to index investing with a focus on tax loss harvesting.  Tax loss harvesting is the process of selling certain investments within a basket of securities at a loss, while simultaneously replacing them with different investments that exhibit similar characteristics.  This process enables the strategy to generate losses that can be used to offset any capital gains but maintain a close correlation to the selected underlying index, unaffecting an investors desired exposure.  Realized losses in the tax managed portfolio will allow an investor to sell portions of the concentrated stock over time while minimizing the tax burden and reducing the concentration risk.  If the investor was to continue reinvesting the proceeds from the concentrated stock into the tax managed portfolio, they would essentially create a “basis shift” from the concentrated stock to a diversified portfolio.  In turn, the diversified portfolio would leave the investor in a much better position from a risk perspective. 

Charitable Giving

For individuals who are charitably inclined, donations of concentrated stock can be made directly to a charity and or charitable gift fund for simplicity, but a Charitable Remainder Trust may be another effective strategy to help improve diversification and reduce concentration risk, while also accomplishing philanthropic and lifestyle goals.  A Charitable Remainder Trust is an irrevocable “split interest” trust designed to provide financial support to an income beneficiary for a period of time, while the remainder interest is passed on to a designated charitable beneficiary.  There are two types of charitable remainder trusts:

  • Charitable remainder unitrust (CRUT)
  • Charitable remainder annuity trust (CRAT)

A charitable remainder unitrust is designed to distribute a fixed percentage to the income beneficiary based on its year-end balance, whereas a charitable remainder annuity trust distributes a fixed dollar amount to the income beneficiary each year.   

A charitable remainder trust works in the following way.  First, the grantor, the person establishing the trust, contributes assets to fund the trust which is set up to operate during a specific term or measuring life.  Typically, it is best to fund the contribution with highly appreciated assets as sales inside the charitable remainder trust are not subject to capital gains taxes.  Once the trust is established and funded, payments from the trust are disbursed to the income beneficiary, which can be the grantor or another designated individual, as either a fixed percentage or fixed dollar amount.  Lastly, at the end of the term, the remainder assets are distributed to one or more charitable beneficiaries.

Charitable Remainder Trusts (CRT) offer many key benefits.

  • Preserve the value of highly appreciated assets – Assets donated to a charitable remainder trust are exempt from capital gains taxes.  By donating assets in-kind to the CRT, you will preserve the full fair market value of the assets rather than reduce it by large capital gains taxes, allowing more money for the income and charitable beneficiaries.
  • Upfront income tax deduction – With a CRT, you have the potential to take a partial income tax charitable deduction when you fund the trust, which is based on a calculation on the remainder distribution to the charitable beneficiary.
  • Tax exempt – This makes the CRT a good option for asset diversification. You may consider donating low-basis assets to the trust so that when sold, no income tax is generated to you, and you eliminate the capital gains tax on the sale of the asset. However, the named income beneficiary will pay income tax on the income stream received.   With a CRT, the donor must pay tax on the income stream, which is categorized into four tiers: (1) Ordinary income and qualified dividends, (2) capital gains, (3) other tax-exempt income; and (4) return of principal. Only when a higher tier of income is exhausted does the next tier apply.
  • Generates an income stream – Trust income can be paid to you for your lifetime. If you are married, it can be paid for as long as either of you lives.  The income can also be paid to your children for their lifetimes or to any other person or entity you wish, providing the trust meets certain requirements. Just remember, however, that the longer the term of the trust, the smaller the value of the upfront income tax deduction.

Conclusion: Plan with an Advisor

With the rise in equity volatility this year, the detrimental effects of concentrated stock positions have become a widespread reality for many investors and serves as a reminder of the power of diversification. More importantly, the current market environment should act as a trigger to consider how to transition towards a more diversified asset allocation. At Round Table Wealth Management, we encourage all concentrated investors to develop a formal, predetermined plan for their concentrated positions to help take the emotion out of the decision to sell. Working with a professional advisor allows for an objective, unbiased perspective and the creation and execution of a plan that works in coordination with your overarching financial goals and objectives.

Please contact us to learn more or to speak to a wealth advisor to discuss your specific situation.

908-789-7310  |  www.roundtablewealth.com

 

 

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