Advisors Layer Multiple Tools to Cut Single-Stock Portfolio Risk
While concerns over portfolio concentration risk in today’s market apply to clients across the board, it can be a particularly tricky situation for those who hold most of their wealth in one or two stocks.
In addition, with SpaceX undergoing a mega-IPO earlier this summer, and Anthropic and OpenAI soon to follow, there is a growing group of early investors and employees of those companies who should join that list. The strategies for helping them reduce concentration risk are manifold—ranging from 351 conversions to exchange funds to options overlays and tax-aware long/short strategies—but they have to be carefully chosen to match the client’s specific holdings, tax situation, liquidity needs and timing concerns, according to financial advisors.
Advisors say that clients are often reluctant to address concentration risk when they have come to view the stock as the source of their wealth. This is especially true in a market that hasn’t seen a true downturn in years, and where the stock’s value might continue to rise even as the client is counseled to start divesting some of it.
But the reality is that holding a concentrated stock position for 20 years or longer will often result in a loss or a wash, noted Shang Chou, co-founder and managing partner at Pasadena, Calif.-based RIA Dishmi Capital, which has $250 million in AUM. Chou cites a 2023 research paper by Brooklyn Investment Group, New York University and Yale University, which found that 93% of the time, the median 10-year market-adjusted returns for recent stock winners turned negative. Stocks that have been in the top 20% of performers in the previous five years lost 17.8% of value over the 10-year period.
Dimshi Capital works with a number of high-level executives and early investors in big-name tech firms, including SpaceX. As these companies file for IPOs, the firm’s clients end up with large, concentrated stock positions. Where both Dishmi Capital and another RIA, Chicago-based Arena Private Wealth, which has about $500 million in AUM, start the conversation about potential over-concentration is by helping investors understand they don’t have to go “all or nothing” on the stock that has made them wealthy.
The all-or-nothing decision is “really hard to do,” noted Erik Kratz, chief investment officer at Arena Private Wealth. “So, I try to scale out of these positions over time while mitigating the tax bill.”
Because investors who get most of their wealth from a single stock are so attached to these companies, in conversations, Kratz also tries to focus less on the concentration risk they might be exposing themselves to and more on the growth themes they might be missing by not putting some of their money into other stocks. “It becomes a psychology game,” he said.
At one point, Chou found himself an overconcentrated investor after the biotech start-up his wife worked for went public and was acquired by Gilead Sciences for roughly $11.9 billion. His wife then got a job at another biotech start-up, Allergan Therapeutics, which was later acquired by AbbVie for $63 billion. One of the things Chou remembers vividly from these experiences is how many mistakes he made with their newfound fortune, especially regarding tax considerations.
“Back then, I was not an advisor, and I made every mistake in the book because it’s a very challenging situation where you are navigating idiosyncratic investment risk, you are navigating taxes, and you are also navigating your liquidity needs,” Chou said. “At the time, in 2015 to 2016, there were not a lot of great solutions [for concentration risk], and we ended up incurring more taxes than we probably should have. You fast-forward to today, and there is a slew of really great solutions.”
Chou, who later spent several years working in asset management and helping build portfolio diversification tools, including exchange funds at Cache, cautions that most of these solutions come with trade-offs. For example, exchange funds, which allow investors to put their stock in a communal fund and, down the line, withdraw a basket of different equities, come with seven-year liquidity lock-ups and no way to determine at the outset what that basket will eventually look like. Putting the money into an Opportunity Zone fund is great for maximizing tax benefits, but the promised returns on the investment itself sometimes miss the mark by double digits. Tax-aware long/short strategies have become so popular that both Fidelity and Charles Schwab recently restricted advisors’ access to them on their platforms to reduce balance sheet risk. Fidelity also raised fees on long/short SMAs.
“What we try to emphasize is it’s not ‘one size fits all,’” Chou said. “We need to understand what you are trying to do in terms of liquidity needs, your timeline, your illiquidity tolerance and your tax profile. And then, how do we combine various solutions from the [existing] toolkit to align with that? It’s a combination of these [tools] where value creation starts to happen.”
If a client is tax-sensitive and urgently wants to diversify, an exchange fund, which allows immediate diversification, might be the right solution. For clients who are not time-sensitive, hedging the stock might be a better option. Hedging might be done through the public markets with flex options and SPX box spreads, which allows the advisor to hedge and monetize the stock holding. It can also be done through variable-prepaid forward contracts with banks, in which the bank hedges the concentrated stock and lends the client money.
What Dishmi Capital will then often do is take the cash proceeds from those hedging strategies and invest them in tax-aware long/short strategies. The tax-aware long/short portfolios can help generate some tax losses to defer the gains from the single stock position and diversify the client’s stock holdings, while “hopefully delivering some alpha as well,” Chou said.
Tax-aware long/short strategies are one of Kratz’s preferred diversification tools as well. He brought up a client he worked with recently whose portfolio relied heavily on Apple stock and some healthcare holdings. While Apple is a “great technology name, today it’s more of a consumer staple within technology,” Kratz noted, and the investor had little exposure to current growth themes, such as infrastructure, semiconductors and data centers.
Kratz disposed of the healthcare holdings, then used a tax-aware long/short strategy to exit 50% of the Apple position over several months. He plans to work on mitigating the resulting gains over the rest of the year with the aim of leaving the client with a 0% tax bill and greater exposure to the technology sector.
Chou also mentioned that section 351 exchanges, which allow investors to convert both SMAs and concentrated single-stock positions into ETFs, have become more accessible over the past few years.
“They are now very user-friendly and tech-forward, where you can just contribute a basket working with your custodian bank, and they’ll give you very near-term liquidity in the form of their diversified ETF,” he said.
In fact, 351 exchanges have become so popular as a diversification tool, and a growing list of RIAs has launched their own ETFs to help clients mitigate concentration risk.
To illustrate how Dishmi Capital might combine several strategies to reduce concentration risk while minimizing its clients’ tax bills, Chou cited a client who was an early executive at a technology company that went public several years ago. The stock went from $120 a share when it started trading to roughly $20 per share today.
Dishmi Capital began working with the executive before their liquidity lock-up period ended. It took 20% of the client’s holdings and allocated them to an exchange fund. It worked on the remaining 80% of the holdings over the following three years. Dishmi used European-style flex options, which have the advantage of being exercised only on their exact expiration date, according to Chou, as part of a larger collar strategy. It then used 75% of the proceeds to invest with one of the tax-aware long/short asset managers, relying on a 300% long/200% short beta-one strategy on the Russell 3000.
“When you fast-forward two years down the line, the client will end up with zero single stock, 100% Russell 1000 diversified exposure with these long/short extensions, and ideally some pre-tax alpha,” Chou said.
