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Concentrated
Portfolios -- Not Worth the Risk
It is quite common to see investors with a substantial portion of their
investment portfolios in a single company or industry. Given that Kobren
Insight Management builds diversified portfolios, it probably won't
surprise many when we say that we believe that the risks of a concentrated
portfolio are not worth the potential returns.
Concentration risk is fairly easy to identify and remedy -- in an emotionless
and tax-free world. The problem with trying to reduce many concentrated positions,
however, is that they have low cost bases and/or many investors have an emotional
attachment to them.
Reducing a concentrated position for many investors may feel like an act
of disloyalty. Oftentimes, the concentrated position is in company stock
where an employee can take pride in the growth of the company or it could
be in another stock that has treated an investor and/or his or her family
well over the years. This is an understandable emotion, but for the financial
health of an investor and the investor's interests, we believe that
the best course of action moving forward is to diversify, reduce the unnecessary
risk, and protect future purchasing power.
Another issue caused by simply reducing a concentrated position usually
involves realizing a significant gain and incurring a taxable event. While
this may still actually remain the best option in some cases, there are several
ways that an investor can reduce concentration risk while attempting to minimize
the tax bite. In this article, we will provide a quick overview of some of
these techniques.
What Constitutes a Concentrated Position?
How large should an individual security position be? At Kobren Insight Management,
our soft guideline is that no one individual stock position should be more
than 10% of an over-all investment portfolio. This can still be a healthy
position though, and we often work to reduce positions even more. For a
frame of reference, the largest stock in the U.S. market is ExxonMobil.
Its current weight is approximately 3% of the total U.S. market.
When it comes to economic sector exposures, we generally attempt to keep
sector weightings between one half to two times their over-all stock market
weight, though we would relax that a bit for sectors with low over-all
market weights (like Media or Utilities) or cap the maximum weight for larger
sectors
(such as Financials or Energy).
When working to reduce concentration risks in client accounts though, our
top consideration at Kobren Insight Management is to get a portfolio to
the appropriate asset allocation as quickly as possible (while being sensitive
to taxes). Setting up the appropriate asset allocation is of critical importance
as asset allocation is in fact the primary driver of a portfolio's
long-term return and risk characteristics. How Did the Concentration Occur?
First, let's review how concentration in a portfolio can occur. Concentrated
positions can be created in many ways. Usually the concentration was intentional,
but sometimes it just sort of happened. Astute investing, of course, can
create concentrated positions. Inheritances can create concentration. Avoiding
realized gains for tax purposes can create significant positions. Stock option
plans and 401(k) matches can also create sizable positions. A long-term investor
who never re-balanced may have developed some significant portfolio imbalances.
Another key ingredient -- and this is a good reason -- is that
the concentrated investment has generally had a pretty good run itself. Sometimes
though, this can create a false sense of security. While indeed some securities
can go on multi-year runs of superior relative performance and successfully
compete for long stretches of time, even the most successful companies can
eventually languish for long periods of time -- if not outright falter
entirely. Just think of the technology stocks from last decade. Many have
fulfilled their economic promise, yet many are still substantially below
their stock price highs -- if they are even still around at all.
A special case of concentration risk is concentrating in an employer's
stock or even in the same industry as one draws his income. In short, this
concentration is even riskier. If significant economic problems in the company
or industry occur, not only is income jeopardized, but the investment portfolio
may also be impaired rather quickly. In a worst case scenario, not only may
a job be lost, but net worth can be significantly reduced if not destroyed.
The Bear Stearns debacle from earlier this year is a fairly recent high profile
example of how important it is to diversify, especially away from an employer's
stock. Many Bear employees lost the bulk of their net worth once the stock
plummeted.
The risk of concentrating in an employer's stock is actually quite
common though. Stock option plans are one way that many investors build large
positions in employer stock. An even more common way for many investors is
that nearly a quarter of all public companies use their stock to match contributions
to 401(k) plans (according to Hewitt Associates). In plans offering company
stock, the average 401(k) participant had 22% of his account in these shares,
with about 16% of the participants having at least half of their account
in company stock. Again, we believe that this is simply inviting too much
risk into a long-term investment plan.
Something about many of the concentrated positions that we see is that remarkably
many of them are not in blue chip, large cap companies. It seems like most
of the time the accumulated position is in a high volatility sector or industry
like technology, biotechnology, or energy service stocks. Needless to say,
volatility is much higher in these types of securities. While this sort of
volatility can create sharper gains, it can also create more dramatic losses
at times as well.
However the concentrated position was accumulated, congratulations to the
investor who was fortunate enough to be in such a situation. Nonetheless,
we believe the appropriate action to take now is to diversify.
Why Diversify?
There are two big reasons to diversify. First, while a concentrated portfolio
is more likely to hit a home run, it is also more likely to strike out.
Avoiding the big mistake, however, is the key. Long-term investment success
is generally more about avoiding the big losses, than it is about hitting
it big with a concentrated position. This is especially so when the time
horizon for a portfolio gets shorter and when there is less time to catch
up and offset past losses either through additional contributions or investment
returns or both.
The second reason is that concentrated portfolios are more volatile. Excess
volatility can be disruptive to long-term investment objectives as it often
creates an emotional response (greed and fear) in many investors, often leading
to undisciplined investor behavior. A diversified portfolio, however, can
often remove a lot of the volatility.
Ned Davis Research has done some pretty interesting work on what drives
individual stock returns. Approximately 20% is due to the over-all market,
roughly 20% is due to the broad economic sector, approximately 30% is due
to the industry within the sector, and the remaining 30% or so is due to
the specific company itself. Needless to say, an investment portfolio dominated
by a single name or two can be quite volatile. Investment theory and practice,
however, shows that diversifying a portfolio can reduce (perhaps even significantly,
if not entirely, depending on the depth of diversification) stock-specific,
industry, and sector-related volatility. In sum, lower portfolio volatility
should provide a smoother ride for investors.
How to Reduce Concentration
There are several possible strategies to deal with a concentrated
portfolio, with the strategies either being financial or charitable in nature.
First, there are financial strategies such as:
- Completion Strategies: In this strategy, a plan is established to reduce
a concentrated position in a disciplined manner and re-invest the proceeds
into assets which are the most uncorrelated to the remaining concentrated
position. The most common example would be to sell a highly appreciated equity
(usually from a portfolio with a heavy allocation to equities) and re-invest
the proceeds into a non-equity exposure such as fixed income.
Reductions in the concentrated position can be set up either on a calendar
basis and spread out over a period ranging from several months to a few
years (the determined time period is heavily influenced by the client's tax
situation) or on market weakness (to take advantage of potentially matching
up tax losses from other positions in the portfolio) or both.
- Hedging Strategies: These are typically option-based strategies where an
investor purchases a put option for protection and pays for this (partially
or in full) by selling a call option. This protected position can then be
borrowed against, where the new funds could be used to invest in securities
that will diversify the portfolio.
A couple ways to do this are through Equity Collars and Variable Prepaid
Forwards (VPF). One difference between these two methods is how much liquidity
can be created from each. Generally speaking, the amount is usually higher
with a VPF if the purpose is to reinvest in the marginable securities.
What these strategies do is basically protect the value of the concentrated
position,
diversify the portfolio to some extent, and if everything is executed properly,
taxes will be deferred on the sale of the stock until the maturity of the
VPF or collar.
- Exchange Funds: An Exchange Fund (sometimes called a Swap Fund)
can allow stockholders of a significant amount of a single stock to diversify
into a larger, more diversified pool of stocks (coming from other investors
doing the same thing) by swapping their stock for a pro rata position in
the larger pool. The goal is to diversify holdings without triggering a taxable
event. The tax is then postponed (due on the difference between the sales
price of the exchange fund and the original cost basis of the contributed
stock).
Public exchange funds hold stocks while private exchange funds own privately-owned
stock (pre-IPO). There are unique features regarding exchange funds, including
the requirement that at least seven years has to elapse before an investor
can sell without realizing a step up in basis and pay taxes. In addition,
public exchange funds are generally not marginable.
There are also charitable strategies:
-
Charitable Remainder Trusts: CRTs offer the benefits of income and estate
tax deductibility, the ability to plan annual cash flow, and ultimately a
gift to a charity. The way a CRT works is that an investor gifts the stock
to a pre-established Trust (a current year income tax deduction for the client),
which in turn sells the stock and re-invests in a diversified portfolio.
The trust will then pay out a taxable, pre-specified amount (could be fixed
or based off percentage of CRT's net assets) each year to a beneficiary.
The beneficiary is typically the donor. At the end of the donor's or
Trust's life, the remaining assets will be gifted to charity (an estate
tax deduction).
- Private Foundations and Donor Advised Funds: Private Foundations and Donor
Advised Funds are another option to gift low cost basis assets. In both cases,
an investor will receive a charitable deduction for the gift to be used to
offset income taxes. There are, however, no other economic benefits. Both
Private Foundations and Donor Advised Funds are tax-exempt entities supporting
qualified charitable organizations.
In Donor Advisor Funds, a donor gifts
to a "host organization" which
is established to accept gifts from multiple donors. The Donor Advised Fund
then sells the gifted security and places the money in a co-mingled pool
of the gifts from multiple donors. The donor then advises the fund to make
charitable gifts out of the pool. Technically, while the Donor Advised Fund
does not have to follow the donor's wishes, it is rare that the trustees
of the fund do not make the gift as long as it goes to a legally organized
public charity. Generally speaking, Donor Advised Funds are more flexible
than Private Foundations, less expensive to establish and maintain, and typically
require less of time commitment for investors who still want to make charitable
gifting a part of their lives.
Private Foundations meanwhile, are often better vehicles for those who
want to devote a significant amount of time to a charitable cause. Private
Foundations
are often family-specific where a donor is frequently trying to put his
or her own personal touch or lasting legacy on a specific charitable venture.
Private foundations offer the advantages of more control over the gifting
process, but the cost (if it is considered such) is the amount of time
in the management of the foundation.
What is the Best Strategy to Use?
What is the best way to reduce concentration risks? The answer, like many
investment solutions, is that it depends on the particular investor. Different
investors have different investment and charitable objectives, risk tolerances,
tax sensitivities and other personal considerations.
Future tax policy is
another consideration. Currently, many people believe that regardless
of the outcome of the next election, most investors are in
for higher taxes. Utilizing tax deferral strategies now may result in deferring
taxes into a future where the tax bite will be even larger. Given this
expectation, the preferred approach for most investors is to consider a completion
strategy
first. If there are compelling reasons why a completion strategy doesn't
meet investor objectives, then the consideration of other strategies makes
sense. Working with an advisor can often help with this process
Regardless
of potential changes in tax policy, our portfolio preferences at Kobren
Insight Management typically default to the simpler solutions.
Whether one wants to refer to Occam's razor ("All other things
being equal, the simplest solution is the best") or even the KISS
Principle ("Keep it simple and short"), there is no reason
to introduce unnecessary complexity. As a result of this philosophy, our
preference is
typically the completion strategy where we work with a client to establish
a disciplined plan to reduce concentration risks in a tax-aware manner
as quickly as possible.
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