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Handling Concentrated Wealth

How can you help clients with concentrated positions reconcile logic with emotions while managing taxes and risk?

August 21, 2008
Sponsored by Rochdale Investment Management

An interview with Charles P. Alberton, CFA, Portfolio Manager, Rochdale Investment Management

The interview was conducted by Christine J. Elbert, Senior Vice President-Marketing Strategy of Rochdale Investment Management.

High-net-worth clients often have a concentration of wealth in one or more stocks. Clients know they should be more diversified, but this can be a challenge when there are emotional issues at play. How do you reconcile logic with emotions while taking taxes into account? We discussed these issues with Rochdale private client portfolio manager Chuck Alberton.

Q: Let's start with what is wrong with having a concentrated position. Most people want to own something they know well, so is that really a problem?

A: We run into many investors with emotional attachments to their investments. They may have seen a stock run up significantly over the years or they become emotionally attached for other reasons.

Regardless of the reason for not wanting to sell, research demonstrates that holding a single stock presents investors with an unfavorable risk/return profile such that there is significant downside risk. If you draw a bell curve for the distribution of returns on a single stock, you will see it is inferior to returns from a diversified portfolio. First, the curve is shifted to the left, so the average compounded return generated by a single stock is going to be about 5.5 percent versus, say, 8.5 percent for the market. Second, the distribution of those returns is very wide, so the return of a single stock tends to be far less predictable than the return of a diversified portfolio. Third, compared to a diversified portfolio, it is far more likely that the single stock will have greater downside than upside. So for the extra risk you are taking on with a single stock, the odds are against you.

Q: What are some of the strategies that people commonly use for dealing with concentrated positions?

A: The three most obvious strategies are to hold the stock, to sell 100 percent of the stock today or to sell the stock in stages over time. In addition to these strategies, various hedging strategies can be used to protect the wealth, manage taxes and diversify the portfolio, as well as charitable giving. We recommend that anyone considering hedging pay very close attention to the tax and legal aspects of each strategy.

Q: What is the most viable solution for an investor who doesn't want to liquidate 100 percent of the portfolio?

A: We generally draw on the third option, to sell the stock in stages over time. But what you do with the proceeds matters. Unlike Rochdale's personalized portfolio process, many separate account managers are not equipped to handle a transition. So even if they can sell the stock over time, they end up just buying the model portfolio proportionately, which may not maximize the risk/return profile. You end up with inadvertent risk exposure. At Rochdale, we use a completion portfolio to minimize risk at each stage of the transition.

Q: Can you elaborate on the concept of a "completion portfolio" and how is that unique?

With a completion portfolio, essentially, you sell the low-basis stock gradually over time and use the proceeds to create a diversified portfolio with low or ideally, negative correlation, to the concentrated position. Rochdale uses a valuation-based diversification strategy, which is a variation of the completion portfolio. The first thing we do is run a crossover analysis to show the client the three alternatives. Option one, assume holding the concentrated portfolio; option two, assume selling the entire portfolio; option three, using staged selling and selling more when the stock appreciates and less when it is depressed.

When we plot these three scenarios, you can see that the hold-all has the highest possible return, but also the lowest median return and the highest loss potential. That is too risky for most clients. If you look at the sell-all today, it has a higher median expected return, lower potential upside and a significantly lower potential loss. This is not a bad choice. However, staged selling has the highest median expected return and if done correctly, this is the best choice. When we implement this, we take valuation into account and adjust the number of shares sold each period. The net effect here is a higher average selling price. It is a dynamic model and we have used it for quite a while with great success.

In addition, we exploit tax-loss harvesting on other positions and we combine outright sales with aggressive covered call-writing, which generates modest income to mitigate the downside risk and may offset the tax bill as well. As I mentioned before, selling the position is only half of the puzzle. Then you need to build the diversified portfolio in a way that will complement the remaining concentrated position.

Q: Let's discuss a common situation: an executive with concentrated holdings from his or her employer. As you are in the San Francisco office, you see many clients with Microsoft, for example. How would you go about identifying the stocks that are the most complementary to Microsoft, meaning they have low correlation or they offset the risk that that position brings to the portfolio?

A: We use proprietary optimization tools to calculate the marginal contribution to utility and prioritize the stocks that balance several competing objectives: maximizing the expected returns, minimizing the risk, minimizing the transaction costs and minimizing the tax consequences.
You mentioned Microsoft. When I ran this analysis for a client a couple of years ago, within the large-cap space, the most diversifying stocks to offset Microsoft were Verizon, Pfizer, Johnson & Johnson, Southern and Tyco. Obviously, this list will change over time with market dynamics and this is just one example. We can customize the optimization in order to go after an expected return or go after an expected risk, to determine which positions to add to the portfolio next.

  • Holding a concentrated position presents investors with an unfavorable risk/return profile, since the potential for a single stock to outperform a diversified portfolio is far smaller than the likelihood that the single stock will under-perform.
  • The three primary strategies for dealing with concentrated positions are: hold the stock, sell 100 percent of the stock immediately or sell the stock in stages over time. Various hedging strategies also can be used to protect the wealth, manage tax consequences and diversify the portfolio.
  • Selling a stock in stages over time, coupled with a valuation-based diversification strategy, may increase the average selling price.
  • Greater diversification is warranted when the stock has above-average volatility, there is longer investment time horizon, the expected return is low and the cost basis is higher.
  • Presenting potential outcomes in an analytical framework can help clients understand the risks of holding the concentrated position and overcome emotional biases.

Q: What factors in general do you take into consideration when strategizing with a client and CPA/advisor?

A: Obviously, taxes matter and they can be the biggest hurdle for nonqualified clients. All else being equal, the diversification strategy is going to be much quicker when taxes are not an issue.

Beyond tax ramifications, there are two major points that we look at here; the first one has to do with the individual investor and the second one has to do with the stock. With the individual, the most important question is the time horizon. In general, the shorter the time horizon, the less the portfolio should be diversified. If there is a step-up in basis coming soon, it might be better to hold the position and protect the downside, so in that case we may build a cashless collar. We also look at the risk tolerance of the individual, as well as the cash flow needs.

In terms of the stock, volatility is very important. When a concentrated stock has significantly more volatility than the benchmark, near complete diversification is recommended, despite the high tax cost. On the other hand, if the stock's total risk is not much higher than average, less diversification is needed because the benefits do not cover the marginal tax costs.

For example, the volatility on a stock like GE, which is a large, established, diversified company, with solid management and a history of earnings, is lower than that of the broad market, so it might require only diversifying about 65 percent of the stock. Whereas a smaller company with a shorter history, an unreliable track record and greater volatility, might require diversifying 96 percent. Traditionally, a high level of diversification is recommended for most securities. The longer you live with an extremely volatile stock, the more bad things can happen.

In addition to volatility, cost basis is very important. Generally, the lower the cost basis, the less the portfolio needs to be diversified. If the cost basis equals the market value, the solution is mostly to diversify immediately.

We also look at liquidity, as well as the outlook for the stock, which is very important.

Q: So how is an executive with a concentrated position different from an elderly widow with a concentrated position and probably also low cost basis?

A: A 75-year-old client with substantial assets outside his or her concentrated stock would approach the situation much differently than an investor who is 45 and whose concentrated position makes up most of their wealth. For the 45-year-old with the long time horizon, we would use Rochdale's intelligent, staged diversification strategy. Depending on the volatility of the stock, the expected return on the stock and the cost basis, as well as the state tax rate, we would expect the average client to recoup the tax cost of selling and have a superior net after-tax return in about five to 10 years.

For the 75-year-old client whose heirs may receive a step-up in basis, in that situation, the tax burden probably outweighs the short-term benefits of diversifying. The recommendation here would be to collar the volatile stock and then with a more stable position, we would write covered calls and generate income. In writing those calls, we would probably focus 15 percent to 20 percent out of the money. So there is something you can do to protect downside risk, even in those cases.

Q: How do you handle the emotional side of investing? You can give a convincing argument full of statistics about why it's bad from a risk perspective, but how do you get clients to buy into the concept?

A: That is one of the true challenges here. We have found that displaying these various outcomes in an analytical framework, using the crossover analysis and the Monte Carlo analysis and showing the downside potential can help people overcome their biases.

Q: What is the role of the CPA or advisor in this process?

A: The key to a successful transition is ongoing communication with the client and CPA/advisor. Setting the proper expectations at the beginning and getting the client to sign on to diversifying a specific number of shares over a specific amount of time is very important. As we execute the strategy, the CPA/advisor can help keep us abreast of changes in the client's overall financial picture. Since our model is dynamic, we can adapt to theses changes.

On our side, we are actively managing the portfolio risk and the tax consequences by harvesting losses, monitoring the covered calls and the market volatility. We have many team members working together to execute the sales and the options transactions at the optimal time. We do quite a bit of work to help limit the downside exposure. Most of these clients have built their wealth on these concentrated positions and it is our job to help them maintain it.

Charles P. Alberton, CFA, is a Portfolio Manager in the San Francisco office of Rochdale Investment Management, a private client money manager specializing in personalized portfolio management for high net worth individuals and families. For more information or for a confidential analysis of a client’s portfolio, please call Patrick J. Vignone, CPA, at 800-245-9888 or e-mail info@rochdale.com.

All opinions constitute Rochdale's opinion and are subject to change without notice. Rochdale Investment Management LLC, its affiliated companies or their respective shareholders, directors, officers and/or employees may have long or short positions in the securities discussed herein.

This publication is for informational purposes only and is not intended to be a solicitation, offering or recommendation by Rochdale or its affiliates of any product, transaction or service, including securities transactions and investment management or advisory services. The opinions expressed in this publication should not be considered investment, tax, legal or other advice and should not be relied on in making any investment or other decision.

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