A multiphase transition plan may help investors diversify while managing the tax impact.
Investors worried about highly appreciated stock positions and the related capital gains exposure may avoid transitioning concentrated portfolios to more diversified tax-managed solutions. In our view, a multiphase transition may enable them to strike a balance between how fast concentration risk is diversified and the size of their annual tax bill.
Here’s the conundrum with highly appreciated securities: A high-flying stock may feel like a lottery winner, but the prize could vanish if the company falls on hard times, which makes reducing concentration a sound idea. But if the stock’s price is far above its cost basis, selling in one fell swoop could bring a sizable tax bill. Behavioral biases are in play, too; it can be hard to convince investors to diversify away from a successful position and take a painful tax hit—even if reducing risk is the goal.
From Concentration to a Multiphase Transition Plan
A multiphase transition offers an alternative by gradually diversifying concentrated positions, while managing taxes and reducing concentration risk over time.
Before any transition, it’s critical to evaluate what investors own in their portfolios today—especially how much profit is built into portfolio holdings, how concentrated the portfolio is in a few stocks and its tracking error versus the desired market benchmark.
Evaluating the transition over several different timelines, it’s possible to estimate and compare how much taxable gain an investor would need to realize each year depending on the length of the transition. This annual “gain budget” acts like a spending limit for taxes. It sets the amount of gain that can be realized each year as concentrated positions are gradually sold down and the portfolio moves closer to the targeted mix.
The objective with a multiphase transition is to reduce overconcentration in individual stocks without triggering a bigger tax bill than a client wants. Investors who are very tax-sensitive may own stocks that have built up big gains over the years. They could hold inherited positions or concentrated securities from compensation plans. The tax implications matter, but so does the risk of waiting to diversify.
Balanced Direct Indexing Adds Another Dimension
A coordinated solution like balanced direct indexing in a separately managed account (SMA) may help during a multiphase transition by managing taxes through tax-loss harvesting and by keeping exposures aware of the benchmark. It pairs an equity direct indexing approach with municipal bonds in a single, coordinated account.
The annual budget for capital gains applies to the total portfolio, not just the equity allocation. Losses harvested from selling stocks or munis may help offset realized gains as the transition reduces portfolio concentration. Any muni losses realized may offset equivalent equity gains, speeding the transition. If munis must be sold at gains to rebalance duration or maintain the target allocation, harvested equity losses might help offset them.
This holistic approach doesn’t manage stocks and bonds as separate tax silos—it coordinates across the two sleeves with one capital gain budget and a long-term allocation plan.
Transitioning Portfolios at the Client’s Own Pace
How fast should a portfolio transition happen? That comes down to a client’s choice of trade-off between reducing risk in relation to the benchmark and the annual tax burden.
An immediate transition may reduce tracking error fast but could produce more realized gains up front. A longer transition period may ease the annual tax burden but take longer to reduce tracking error. With a multiphase transition, the trade-off of each timeline should be visible: how much diversification can I achieve now, how much will that cost me in taxes and how will the portfolio evolve?
In our view, transitions shouldn’t be “set it and forget it” but managed year round to align with diversification plans. Using the annual budget early in each transition year may reduce tracking error as much as possible, and loss harvesting across the portfolio can help out. Progress reports check in on the plan, and capital gain budgets can evolve as clients’ tax circumstances change. Once the portfolio reaches its target tracking error, any further harvested losses can be used beyond the portfolio if needed.
A Multiphase Approach Expands the Transition Tool Kit
As we see it, a multiphase transition to an SMA and balanced direct indexing add more choices to the available portfolio transition options, which also include exchange funds, 351 exchange-traded funds (ETFs) and planning structures like charitable remainder trusts.
The choice depends on an investor’s specific situation. A multiphase transition could make sense if an exchange fund or 351 ETF isn’t suitable—perhaps because they lack the capacity to hold the stock or stocks a client wants to diversify. Other investors might be better able to tolerate the risk of pre-tax underperformance, or they could consider the concentration risk to be minor. For some clients, the destination itself—such as a balanced direct indexing strategy—might be preferable versus, say, an active equity strategy in an exchange fund or 351 ETF.
A Holistic Planning Conversation with Investors
We think multiphase transitions can help financial advisors change the client conversation. Instead of asking, “Are you willing to sell and pay the tax bill in April?” an advisor can ask, “How much gain are you comfortable realizing each year to reduce your risk?” That tees up a holistic planning discussion.
Which investors might consider a multiphase transition versus other tools in the kit? In our view, they include people who own stocks with low cost bases or substantial embedded gains, and those looking to diversify without a rapid tax shock. Investors could live in high tax brackets, be executives with company stock, hold inherited positions or be long-term investors whose winners have become too big a share of their portfolios. Other investors may want to transition immediately, notably those who are less tolerant of the risk that a concentrated portfolio underperforms on a pre-tax basis during the transition.
As we see it, a well-designed multiphase transition offers tangible progress toward diversifying concentration risk while managing tax impact. Coordinating the transition across equity direct indexing, municipal bonds, tax-loss harvesting, thoughtful rebalancing and an annual gain budget puts multiple tools to work in moving clients from where they are today to where they want to be tomorrow.