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Many years ago, I had a tennis partner who consistently defeated me. He was always gracious about it, making me feel like he had to work hard to win, but the scoreboard didn’t lie. During our breaks, our conversations often drifted to finance and investing.
He was older than me and nearing retirement. Over the course of a long, successful career, it turned out that a substantial portion of his wealth had become tied up in company stock. He had systematically acquired these shares over the decades through various corporate compensation programs, including restricted stock units (RSUs), employee stock purchase plans (ESPPs), and stock options. Because his company had performed so well over the previous two decades, he was seemingly in a phenomenal position for retirement.
Then, circumstances changed.
Over the following year, the stock plummeted by roughly 70 percent. I could tell he was devastated and a little embarrassed by how quickly things had turned. I tried to reassure him as best I could, but because I wasn’t his formal financial advisor, I wasn’t really in a position to give him specific strategy or advice.
That single year completely altered his whole outlook on retirement and legacy planning. In the years that followed, the stock price did recover a bit, but it lagged dramatically behind the broader market indexes. His situation was a textbook example of what I call the risk/reward paradox: Concentration often builds wealth, but diversification preserves it.
Why Investors Hold On Too Long
There are a few very common psychological and practical hurdles that routinely prevent people from diversifying a concentrated position, even when they know they probably should:
- Emotional Attachment: Loyal, long-term employees often feel a deep bond with their company. Subconsciously, they might feel like selling their company stock is an act of disloyalty or a vote of no confidence. Others just enjoy having skin in the game.
- The Comfort Trap: Comfort level plays a massive role. If a stock has performed beautifully for 10 or 20 years while you’ve owned it, inertia convinces you that it will continue to perform well forever.
- Fear of the Tax Hit: This is the most significant practical reason I see. For stock held in a standard taxable brokerage account (rather than a tax-deferred wrapper like a traditional IRA or 401k), selling triggers immediate capital gains taxes. The fear of handing over a large percentage of their hard-earned wealth to the IRS keeps many investors paralyzed.
While there is no clear, hard-and-fast rule on this in the financial planning world, if a single stock or asset exceeds 20 percent of your total investable assets, you have crossed into dangerous territory. It may fall in the camp of being “a good problem to have,” but it is a problem nevertheless—and one you may want to deal with sooner rather than later.
Fortunately, there are several tools and strategies available to address this. In this piece, I want to explore one of the most effective modern tools for the job: the Separately Managed Account (SMA).
How Do SMAs Differ from Standard Investment Accounts?
A Separately Managed Account (SMA) is an investment vehicle where you, as an investor, directly own the underlying “securities” in the account. While “securities” is a broad financial term, most often in this context, it refers to individual stocks from hundreds of different companies.
To understand an SMA, it helps to contrast it with how most modern investment portfolios are built: using mutual funds or exchange-traded funds (ETFs).
When you buy a standard mutual fund or ETF, you are pooling your money with many other investors. The fund managers use that massive pool of money to buy hundreds, if not thousands, of different individual stocks. As a result, your investment statement might only show a handful of different “ticker” symbols representing those funds, even though you technically have exposure to a vast number of positions.
The fundamental, structural difference between an SMA and these pooled investment funds comes down to tax flexibility: An SMA can pass through capital losses from the sales of individual securities directly to you.
The Power of Tax-Loss Harvesting
But wait. You invest to grow your money, right? Why would a sophisticated investment strategy focus so heavily on capturing capital losses?
The simplest answer is that capital losses are a natural part of what you are already experiencing as an investor under the hood, but you just aren’t seeing them on your statements.
Suppose an ETF you own is comprised of 1,000 individual stocks. The fund has a “good” year and its overall price is up 10 percent. Under the surface, it’s virtually impossible that all 1,000 stocks had positive returns. It’s far more likely that there’s a wide distribution of returns. Perhaps only 500 of those stocks had positive returns, while the other 500 actually lost money. Because a handful of those positive-return stocks had massive, outsized gains, the collective average ended up at a positive 10 percent.
If you own a standard fund like the ETF described above, you cannot use those internal 500 losing stocks to lower your tax bill. The fund absorbs them internally.
An SMA holding those same 1,000 stocks, however, can—and probably will—generate valuable capital losses for you. Throughout the year, the SMA manager can systematically sell off a portion of those 500 down positions, thus generating realized capital losses. They then immediately redeploy the cash from those sales into different, highly similar stocks to maintain the characteristics of the investment strategy you are seeking.
How SMAs Systematically Dismantle Concentrated Risk
Now, how does this ability to harvest losses tie back to improving your specific concentration risk?
When you transition into an SMA, you aren’t starting with a clean slate of 1,000 perfectly diversified stock positions. Instead, you are approaching the manager with one very large, highly appreciated stock position—such as the stock of the company you work for.
A well-constructed SMA acts as a systematic unwinding tool using a step-by-step process:
- Establish a Capital Gains Budget: First, you work with your financial advisor and accountant to determine your tax tolerance for the year. For example, you might decide you don’t want to exceed $30,000 in net capital gains for the current tax year.
- The Initial Trim: The SMA manager starts the year by immediately selling enough shares of your concentrated stock to hit that $30,000 capital gain budget ceiling. The proceeds from that sale are immediately diversified into the broader market strategy.
- The Virtuous Tax Cycle: This is where the real magic happens over the rest of the year. As the manager monitors the newly diversified portion of your portfolio, they will harvest capital losses from the positions that inevitably fluctuate downward.
- Accelerated Diversification: Because those newly generated losses drag your net capital gains down below your $30,000 budget, it opens up a tax cushion. The SMA manager can now immediately sell additional shares of your concentrated stock position to bring you back up to your budget line.
It works almost like a virtuous cycle. There is always a tradeoff between realizing capital gains (and the immediate pain of paying higher taxes) and achieving higher expected returns through a diversified portfolio. A well-constructed SMA allows you to manage those tradeoffs with a systematic approach, reducing overall portfolio volatility and improving what’s likely your ultimate goal: after-tax investment returns.
What Are Some Other Benefits and Costs of SMAs?
You may have heard about a concept called “direct indexing,” which has been around in the financial industry for quite a long time. Direct indexing is just one possible investment strategy that can be deployed within an SMA framework.
There are many SMAs in the marketplace, but for transparency about how I run my firm, I use the SMA platform from Dimensional Fund Advisors (DFA). Some of the core benefits of an institutional platform like DFA include highly efficient portfolio design, continuous daily portfolio monitoring, and flexible implementation.
Furthermore, a great SMA manager is looking at advanced, granular tax-management strategies that the average investor might not consciously consider:
- Lot Relief Mechanisms: Ensuring that the exact right “tax lots” of your concentrated stock (specifically the shares with the highest cost basis) are systematically targeted for sale first to minimize the initial tax impact.
- Dividend Optimization: Maximizing the portion of your dividend income that is treated as “qualified,” which subjects those payouts to lower tax rates rather than standard ordinary income rates.
- Gifting Opportunities: Seamlessly identifying specific high-basis or low-basis shares for charitable gifting or family wealth transfers around corporate actions.
- Exclusion of Structural Inefficiencies: Filtering out complex tax drags like Real Estate Investment Trusts (REITs) or Passive Foreign Investment Companies (PFICs) when they don’t align with your tax profile.
The Trade-offs and Costs
As with anything in finance, these substantial benefits do come with costs and restrictions that must be weighed carefully:
- Management Fees: Institutional SMAs carry an additional layer of expenses. For example, the DFA SMA starts at 29 basis points (an annual fee of 0.29%).
- Account Restrictions: You will likely face administrative restrictions, such as being required to use a specific institutional custodian or maintaining a substantial minimum amount of investable assets to open the account.
- Tax Document Complexity: You must keep in mind that your annual 1099 tax form will typically be much larger. Because the account is trading individual stocks rather than a single ETF, your tax documents will display significantly more positions and trading activity.
A Brief Review of Alternative Strategies
An SMA is a highly effective, modern solution, but it is certainly not the only way to address the concentrated stock problem. Every investor has different priorities when it comes to liquidity, costs, and complexity. Let’s do a brief run-through of the other core options investors have at their disposal.
- Systematic Selling
This is probably the simplest diversification strategy. Let’s say we’re dealing with a concentrated stock called XYZ. One way to attack this is to simply map out a plan to spread the sale of XYZ over several consecutive tax years. By spreading the capital gains out, you can accomplish a few specific planning goals:
- It minimizes the tax hit in any single calendar year, making the tax bill more manageable from a cash flow perspective.
- It allows you to stay within a lower federal capital gains tax bracket. The federal tax system is tiered, meaning you could pay a long-term capital gains rate anywhere from 15% to 20% (plus the 3.8% Net Investment Income Tax, totaling up to 23.8%).
- If you are fully retired and don’t have significant earned income, careful tax planning might even allow you to fill up the 0% capital gains tax bracket.
- Hold Until Death
The tax problem that prevents people from dealing with concentrated stock risk could also just disappear on its own—eventually. That’s because current federal tax laws allow for what is called a “step-up in basis” at death.
In other words, any embedded capital gains you have built up during your life are legally erased upon your passing. It’s a strange way to put it, but for some older investors, the absolute best “tax strategy” is actually to hold the stock until they pass away, allowing their heirs to inherit the shares at current market value.
The major downside, however, is that this strategy carries the absolute highest concentration risk. If the stock takes a deep, permanent hit during your lifetime—just like my tennis partner experienced—and it severely impacts the quality of your retirement lifestyle, the tax savings won’t matter.
- Charitable Giving
For some investors, a concentrated stock position is so large that it doesn’t directly impact their day-to-day lifestyle. If you can afford to give a portion of the stock away, you can effectively chip away at the risk.
Without getting bogged down in the tax rules, you can give shares of highly appreciated stock directly to a qualified charity. You get the benefit of taking a tax deduction for the full, fair market value of the shares given, and you never have to sell the shares or trigger a tax bill to begin with. The charity can then sell the shares without paying a single penny of capital gains tax, utilizing 100% of the proceeds for their mission.
For larger amounts of stock, you can look into structures like Donor-Advised Funds (DAFs) or Charitable Remainder Trusts (CRTs) to manage the mechanics.
Notably, shares can also be gifted to family members, like adult children or grandchildren. If the recipients are in a much lower tax bracket than you, you don’t avoid the capital gains tax entirely, but you enjoy massive tax savings at the family unit level.
- Advanced Wall Street Solutions
If the strategies above sound complex, we are still only scratching the surface of what the financial industry has engineered. Scan enough financial headlines, and you will see options such as:
- Exchange Funds: Swapping your concentrated shares into a private diversified partnership with other investors without triggering a taxable event.
- Long/Short SMAs: Using short positions to hedge out the specific sector risk of your concentrated stock, allowing you to wind down the position faster than a standard “long-only” SMA.
- Equity Collars: Simultaneously buying a protective put option and selling a covered call option to lock your stock into a strict, tight price range.
All these strategies have intriguing benefits, but they require immense due diligence. They frequently pose significant challenges, including structural illiquidity, extremely high-cost structures, and risks associated with leverage and debt.
The Bottom Line
In the end, no matter which approach you take to reduce your concentrated stock risk, the most critical step is simply to have a formalized plan. By removing raw emotion from the stock-selling process and implementing a systematic framework, you can successfully protect the wealth you worked so hard to build.
If you have comments or questions on this piece, please drop me a line at: [email protected]
