What do you do with a concentrated stock position?

It turns out you can have too much of a good thing. Custard ice cream comes to mind. So does Netflix stock. The movie-streaming company was one of the early winners in the pandemic, soaring 67% in 2020 and another 11% in 2021.¹ But 2022 has been a different story. Netflix stock fell 76% to a 52-week low in mid-May and has remained in a slump, aggravated by the company's recent announcement of a falling subscriber base.²

For investors with a meaningful percentage of their portfolio represented by Netflix, the stock's earlier gains would have propelled their wealth higher—but the subsequent decline would have had a similarly negative effect. And that is the crux of the problem for an investor with a concentrated position in one or a handful of stocks.

The solution, of course, is to diversify the portfolio. But diversification has a cost for many investors with substantial wealth tied up in one or a concentrated position. There may be emotional ties to the company whose stock they hold. More importantly, if there have been substantial gains in the share price, there may be serious tax implications to divestment.

This is where direct indexing can be a tax-effective and measured way to reduce a concentrated stock position and diversify a portfolio. Let me explain.

What is a concentrated stock position? How much is too much concentration in stocks?

A concentrated stock position is when an investor holds more than 10% of their portfolio in a single name.

While diversification remains a mantra in the investment industry for its ability to reduce volatility and potentially boost returns, the reality is that many investors do have a lot of eggs in only one basket. This happens for many reasons:

• The investor receives part of their compensation package in stock options. Over time, as the stock options vest in a taxable account, the holding can become quite significant and the cost basis low.
• The investor jumped on a particular bandwagon early, and as the stock appreciated in value, it grew to represent a large part of their wealth. Think of some of the early investors in Apple, for example.
• The investor was given shares as a gift by a parent or grandparent, or the shares were held for a long period of time, and their value grew to represent a large percentage of the investor's—or their family's—total wealth. It's worth noting that the stepped-up basis readjusts inherited assets when passed on after death.

Whatever the source, it's a safe bet that you and most other advisors have clients with concentrated stock positions.

Are there risks to holding a concentrated position?

Concentrated stock can be a meaningful way to build wealth, but there are risks when one or a handful of names dominate an investment portfolio. It makes the portfolio vulnerable to any stock-specific news. A significant downturn in the price of that company's shares can have a major effect on the overall wealth and future financial security of the investor and their family.

This is an even more significant problem for investors who obtained their shares through their workplace. They have both their financial and human capital tied up in one company or industry. A major negative event in that company or industry could be devastating.

The case of the Global Financial Crisis of 2008 is illustrative, where many financial institutions worldwide suffered or went out of business altogether. Many employees of these companies lost not only their jobs and pensions, but for those holding their company's stock, the stock's decline likely wiped out a large portion of their savings.

As mentioned earlier, Netflix is only one example of a formerly high-flying stock suffering a sudden reversal in fortune. Enron was the world's greatest energy company, and its stock went to zero. The Eastman Kodak Company stock price is now trading at one-fifth its value of 20 years ago. There are others.

How do you diversify a concentrated stock position?

This can be challenging for many reasons. Often, investors have a sentimental attachment to the stock, whether because they inherited it from a loved one, they have held it for a significant period, or they were employed by the company and identify with its success and, by extension, the increase in the share price.

Divesting a part or all of the holdings is equally challenging while managing the underlying tax costs associated with reallocating the assets. In some cases, the original cost of the shares could be a small fraction of the current price, which would trigger a massive capital gain and a massive tax bill.

One potential solution could be through a direct indexing strategy in a separately managed account. Direct indexing allows the investor to hold a basket of stocks that replicate an index directly. That means the investor can offset the capital gains from selling a concentrated stock position with capital losses generated from other securities in the direct index portfolio. When the transition is done through a program such as Personalized Managed Accounts (PMA) by Russell Investments, the gains can be taken over a determined time period, and the losses can be taken from any of the equities held within the separately managed account. The investor can even hold onto a portion of the shares in the concentrated position, which could help mitigate some of the emotional distress of divestment.

Direct indexing: A versatile tool for reducing concentrated positions

With a direct indexing strategy, investors can determine how much they want to take in capital gains annually until the position is whittled down to a more manageable percentage of the portfolio. Alternatively, the exposure to the concentrated stock position can be pared down by taking gains over a period anywhere from three to five years. And with a PMA strategy, those capital gains will be offset with tax-loss harvesting, keeping any related taxes to a minimum.

Direct indexing is also helpful if the investor has a significant weighting to one sector and wants to pare it down or needs to reduce a holding for any other reason. For example, a top banking executive may be hired away from one financial institution by another. They may have a significant amount of the original bank's stock vested, representing a conflict of interest in their new role at the rival firm. Direct indexing would provide a tax-efficient way of removing that specific holding from their portfolio. Executives at technology firms could be in similar positions, especially with the significant gains most of those shares have seen in recent years. Russell Investments' PMA program provides a well-defined plan for the tax-efficient divestiture of these securities.

The bottom line

Now is a good time to review your client's portfolio and address the potential risks of concentrated stock positions in it. You may even consider preparing a transition analysis, providing your client with different options to move forward comfortably.

¹ Source: Morningstar Direct

² Source: Morningstar Direct

We can help you build around a client's concentrated stock position or transition out of it over time with Personalized Managed Accounts.