By Tim Courtney, Chief Investment Officer
After a prolonged period of strong stock market performance, many investors are finding that their portfolios have become much more concentrated than they intended. This has been most noticeable in U.S. large-cap growth stocks tied to technology and AI, where a small group of names otherwise known as the ‘Magnificent Seven’ has driven a large share of returns.¹ Positions that began as modest investments years ago can now represent a majority of an investor’s overall wealth.
Unlike other risks, such as term, credit, market, and illiquidity, which have historically provided investors with compensation through higher returns, concentration risk provides no expected compensation. So while concentration is an unproductive risk, the challenge is deciding how to address it, especially when those positions sit in taxable accounts. Selling outright can trigger a significant capital gains tax bill, which is why investors often look for alternative solutions to concentration. There are some tools that a concentrated investor might consider.
One option is a Section 351 exchange. This allows investors to exchange several appreciated stocks for shares of a diversified ETF without triggering a taxable event.² The appeal is immediate diversification with no current tax cost. There are limits, though. The largest single exchanged position cannot exceed 25% of the total amount exchanged, and not every stock or situation qualifies.² When it fits, a 351 exchange can be a great solution.
Traditional exchange funds work in a similar spirit but with different trade-offs. These funds are typically structured as partnerships under Section 1031 and allow investors to exchange one or more stocks for an interest in a diversified pool of securities.³ Like 351 exchanges, these transactions are tax-deferred.³ Liquidity is a primary limitation, as investors usually need to remain invested in the partnership for several years.³ Funds may also restrict certain names if too many investors are trying to contribute the same stock at the same time.³
Opportunity zone funds are another potential solution. All or a portion of the gain from a sale of appreciated positions may be deferred for up to five years if reinvested into an opportunity zone fund.⁴ These investments focus on real assets such as real estate and infrastructure rather than public equities.⁴ Because of that, they behave differently from stocks and are generally best used as part of a broader portfolio rather than a full replacement for equity exposure.⁴
As for investors who prefer a more gradual approach, tax-loss harvesting can help reduce concentration over time. This strategy often involves using an appreciated stock as collateral to borrow cash and invest in a diversified but market-neutral portfolio. Tax losses are then “harvested” by selling any position that is in a loss, and the tax losses can be used to offset gains from the gradual sale of the concentrated position.⁵ While this can reduce the immediate tax impact, diversification happens slowly, and exposure to the concentrated position remains during the transition.⁵
Options strategies can also be used alongside these tools. Selling covered calls can generate income from a concentrated position, while buying protective puts can help limit downside risk.⁶ Call option income can help offset taxes as concentrated shares are sold over time, though the income is taxable.⁷
Rarely will a single tool solve concentration risk on its own. In practice, managing this risk often involves combining solutions and, in nearly all cases, should include the straightforward practice of selling a portion of the position each year and paying a level of tax that is reasonable.
If you have questions about how these strategies apply to your situation, please reach out to your Exencial advisor to talk through the options.
Sources
PAST PERFORMANCE IS NOT AN INDICATION OF FUTURE RETURNS. Information and opinions provided herein reflect the views of the author as of the publication date of this article. Such views and opinions are subject to change at any point and without notice. Some of the information provided herein was obtained from third-party sources believed to be reliable but such information is not guaranteed to be accurate. In addition, the links provided within are for convenience only and the provision of the links does not imply any sponsorship, endorsement, or approval of any of the content. We do not guarantee the content or its accuracy and completeness. The content is being provided for informational purposes only, and nothing within is, or is intended to constitute, investment, tax, or legal advice or a recommendation to buy or sell any types of securities or investments. The author has not taken into account the investment objectives, financial situation, or particular needs of any individual investor. Any forward-looking statements or forecasts are based on assumptions only, and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision. Any assumptions and projections displayed are estimates, hypothetical in nature, and meant to serve solely as a guideline. No investment decision should be made based solely on any information provided herein and the author is not responsible for the consequences of any decisions or actions taken as a result of information provided in this book. There is a risk of loss from an investment in securities, including the risk of total loss of principal, which an investor will need to be prepared to bear. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Exencial Wealth Advisors, LLC (“EWA”) is an investment adviser registered with the Securities & Exchange Commission (SEC). However, such registration does not imply a certain level of skill or training and no inference to the contrary should be made. EWA may only transact business in those states in which it is registered, notice filed, or qualifies for an exemption or exclusion from registration or notice filing requirements. Complete information about our services and fees is contained in our Form ADV Part 2A (Disclosure Brochure), a copy of which can be obtained at www.adviserinfo.sec.gov or by calling us at 888-478-1971.