Unwinding A Highly Concentrated Position in Equities


Do you have a highly concentrated position in a stock, mutual fund or exchange-traded fund (ETF)? Do you have a plan in place to reduce the risk and manage this position in a tax-efficient manner?

In a recent episode of the Science of Economic Freedom, we covered the pros and cons associated with a highly concentrated position, or HCP. And while an HCP can help you build wealth, it can also represent both a threat and a challenge to your financial goals.

In this episode of the Science of Economic Freedom, “Unwinding A Highly Concentrated Position in Equities,” we discuss the tactics and strategies needed to extricate yourself from a highly concentrated equity position so that you can add greater diversity to your holdings while also making sure you don’t sustain a massive tax hit in the process.

Topics covered in this episode include:

  • The reasons why investors are reluctant to sell down an HCP.
  • Why an HCP is good for asset accumulation, but not for asset protection.
  • How to implement “taxable gain harvesting.”
  • When to consider “gifting” shares to a family member.
  • Options strategies for managing HCPs.
  • Using an “exchange fund” to manage an HCP.
  • Key questions to ask before you unwind a highly concentrated position.

Plus, much more…

 

Transcript:

 

Doug:               Do you have a highly concentrated position in a stock, mutual fund, or exchange traded fund? What course of action do you have to reduce the risk and manage this position in a tax efficient way? We close the knowledge gap today on highly concentrated equity positions, on this episode of The Science of Economic Freedom.

Disclaimer:       The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell or hold any specific security. Consult your investment advisor and read any investment perspectives carefully before making any changes to your investment portfolio. This program is sponsored by Mercer Advisors. Mercer Global Advisors Inc is registered with the Securities and Exchange Commission and delivers all investment related services. Mercer Advisors Inc is the parent company of Mercer Global Advisors Inc and is not involved with investment services.

Doug:               Welcome to The Science of Economic Freedom. I’m your host, Doug Fabian. This podcast is all about helping you achieve your financial dreams — we call that economic freedom. This program is about your journey to achieve economic freedom for yourself and your loved ones, today we want to help you identify your next step on that journey. This is episode 30, “Unwinding a Highly Concentrated Position in Equities in a Tax Efficient Manner.”

In episode 29 we discussed broadly how a highly concentrated position can have both positive and negative results on your economic freedom. In this episode we will be clarifying how to manage a highly concentrated position in equities be it a stock, a mutual fund, or an exchange traded fund. Now, before we get into the details on the many ways one can diversify in a tax efficient manner, let’s set some context on the subject.

Now, what is a highly concentrated position? In the portfolio management profession a highly concentrated position is any position of greater than 5% of your portfolio or account. Now, let’s remember the first and second rules of asset management. Rule number one, asset allocation is the single most important decision that you will make, and when you have a highly concentrated position, it can throw of your asset allocation. And the second rule is diversification will lower risk and increase returns over time. A highly concentrated position is anything but diversification.

Now, certainly concentrated positions can build wealth. A single stock like Amazon, Apple, or Google has produced tremendous returns over both the short- and long-term. But a single position that represents a large percentage of your assets is a high risk position. Your portfolio returns will be influenced more by that single stock than any other position you own. A highly concentrated position does not have to be a stock. It can be a mutual fund that you’ve owned for an extended period of time, or an exchange traded fund. Now, these types of investments are more diversified than an individual stock position, but some of the same rules apply.

Now, why doesn’t an individual sell down a highly concentrated position? There are three main reasons. Number one, the investor has an emotional attachment to the position. This can happen whether the position is at a gain or a loss. In the losing position, the investor does not want to take the loss. In a winning position, the investor does not want to take the gain because they feel there are more gains ahead. Emotional attachment to a stock does not need to be rational, and many times it is irrational. Number two, there is a reluctance to pay taxes. The investor does not want to take the gain or the loss. When the highly concentrated position goes well, the consequences of paying taxes seems like a big penalty, and there could be more gains ahead, so why not delay? And the third reason for not selling a highly concentrated position is the knowledge gap. An investor does not know why they should diversify, how to do so in a tax efficient manner, and does not understand the real risk of a highly concentrated position on their overall economic freedom. Now, the purpose of this podcast today is to close this knowledge gap

Something else I want you to be aware of. Here is the hierarchy of making decisions about money. The first decision is to improve your financial situation. Why not always be improving your personal financial situation? What is the best decision for my family? The second reason to make a decision on money is economic. Has the rationale for holding the highly concentrated position changed? Or, are there changes going on in the economy that warrant a change in the highly concentrated position? And then third, the third reason to make changes are for tax purposes. Paying taxes does mean you were a winner. Paying taxes is sometimes necessary in adjusting your portfolio, but paying taxes is in the third position of priority when making decisions about your money.

The last point to make about the highly concentrated position before we get into the discussion of how to diversify in a tax efficient manner is this, you concentrate your assets to accumulate wealth, and you diversify your assets to protect that wealth. And then lastly, your personal timeline does matter here. When discussing how to diversify a highly concentrated position in equities, we are not talking about all or nothing. An equity position can be sold in a controlled manner. Selling specific pieces at one time is not an all-or-nothing decision. Diversification is much like rebalancing, selling down a position to get that position back in line with your overall asset allocation.

Now here are the five ways we help clients at Mercer Advisors diversify their highly concentrated positions. These strategies are for taxable accounts. All the strategies we’re about to discuss require planning. Sometimes the planning is tied to your personal financial plans, other times to your tax plans, and sometimes to your estate plans.

Strategy number one for diversifying a highly concentrated position, taxable gain harvesting. Now, you’ve probably heard of tax loss harvesting. This is when you sell shares of a losing position to offset taxable gains in other positions, or you sell to take the $3,000 annual tax deduction. Taxable gain harvesting is similar whereby you will be selling a predetermined number of shares of a highly appreciated position once you have a tax plan in place. Tax gain harvesting means you’re going to realize a taxable event in the dollar amount of your choosing. Now here’s an example. We have a client in XYZ stock. They have a cost basis in the stock of $10,000. The stock is worth $600,000. We have determined that strategically selling $45,000 per year will keep the family under certain taxable income limits that will avoid them paying Obamacare taxes. We have been implementing this plan in real life for the past four years for this client, and the good news is the stock has continued to appreciate, thereby making up in appreciation what we have sold off for diversification. The plan was developed by a CPA and is reviewed annually, and we are investing that $45,000 in a much different way than the highly concentrated position.

Strategy number two, gifting of shares to family members. Now, not all investors have the desire to gift to family, but some do. When you gift shares you’re removing the position from your estate and passing the position on to another family member. There is no tax benefit to you other than to reduce the size of the position on your balance sheet. The recipient will receive the stock at your cost basis, so when they sell it they will realize a gain but it will be in their tax bracket.

Number three, gifting to charity. This is again a personal decision an investor would need to make, but gifting highly concentrated appreciated shares would give you a tax deduction, and would reduce the size of the position. Again, in this strategy tax planning is key.

Number four, managing a highly concentrated position with professionally implemented options strategies. This can be done to reduce downside risk. This is called hedging. Another options strategy can be deployed to produce income. This is called covered call writing. Options are a sophisticated tool and should only be deployed with an experienced team. We use a manager that specializes in options as a partner when helping clients manage their highly concentrated positions. This is a strategy that requires planning as well as successful execution to reach your long-term goals.

And then strategy number five, and again this is a sophisticated strategy not available to everyone, but you invest your shares of a highly concentrated publicly traded stock in what is called an exchange fund. An exchange fund is an investment strategy that is only available to accredited investors. An accredited investor means you earn more than $200,000 a year annually and you have a net worth outside of your personal residence of more than a million dollars. Now, in addition, the exchange fund does require an investment of shares in the highly concentrated position of at least $500,000. Now here’s how an exchange fund works. You invest your shares in the exchange fund portfolio once your stocks, the stocks that you own in a highly concentrated position, are approved by the fund. Once you are in the fund, you become diversified in many stocks, almost like a mutual fund, and here is no taxable event. Your share value moving forward is now determined by the full portfolio of stocks in the exchange fund. Now, this is a complicated strategy, but it has significant advantages over holding a single position. Now, this strategy can only be implemented with the assistance of an investment advisor.

Now, there you have it. Five strategies to diversify a highly concentrated position in equities. Now the most important point of this discussion are these questions. These are your action steps if you have a highly concentrated position in equities. Where are you on your timeline? Are you still in accumulation mode trying to build up your balance sheet? Or are you in distribution mode, starting to pull money out of your investment accounts? Question number two, what is the right personal decision for your family? Are you taking on too much risk with your highly concentrated position? Question number three, what are the economics of the highly concentrated position? Are they improving, or are they declining? And number four, what are the tax implications of the strategies that I may deploy? This is where you want to talk to your advisor and your CPA. Highly concentrated positions can be a windfall but also a high risk venture depending upon the answers to these questions.

Now I would extend one final comment. If a wealth coaching session would help you to talk through how to handle a highly concentrated position, I want to extend that invitation. Please send me an email to [email protected] This is Doug Fabian. Thanks for joining me today.

Disclaimer:       The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell or hold any specific security. Consult your investment advisor and read any investment perspectives carefully before making any changes to your investment portfolio. This program is sponsored by Mercer Advisors. Mercer Global Advisors Inc is registered with the Securities and Exchange Commission and delivers all investment related services. Mercer Advisors Inc is the parent company of Mercer Global Advisors Inc and is not involved with investment services.

 

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