Many of our clients hold a significant portion of their net worth in company stock and options. Although they are passionate believers in their company, many are all too aware of the risk associated with concentrating their net worth in a single company. Memories of the demise of such companies as Enron and Bear Stearns are still fresh, and clients realize that events beyond their control could cause them to lose their nest egg and career at the same time.
In many cases, clients’ stock positions are held at a significant unrealized capital gain, and they feel “locked in” emotionally and financially by the tax implications of selling.
One method to “unlock” concentrated positions is through active tax indexing -- selling losing positions in your taxable investment portfolio and using those capital losses to offset gains from selling the concentrated position. This technique helps reduce the tax impact of selling a portion of the concentrated holding and facilitates the creation of a more diversified portfolio.
The active tax indexing strategy is typically financed with a combination of cash and proceeds from the sale of a portion of the concentrated holding. The resultant portfolio of individual equities (or ETFs in certain cases) is designed to track a benchmark index.
The strategy takes advantage of the natural movement of stock prices, identifying losses among portfolio holdings and selling those positions to capture the loss. As stocks are sold, replacement securities are purchased so as to maintain the portfolio’s risk positioning relative to the benchmark.
For example, it’s common to replace securities of similar companies for one another, such as Coke for Pepsi, Exxon for Chevron or Bank of America for Wells Fargo. Risk models help to identify less obvious substitutions, but these intuitive examples show the risk management approach inherent in the strategy.
Realized losses generated by the strategy are intended to be used to offset gains realized from sales of the concentrated stock position, thereby easing the tax pain. This harvesting technique can reduce taxes and improve after-tax returns (that is, create “tax alpha”) while gradually diversifying away from the concentrated position.
Taxes are often a “silent killer,” eroding investor returns while getting insufficient attention other than in the days leading up to year-end or April 15. The good news for investors is that they can take steps to manage their tax bill.
The good news for clients and their advisors, is that an active tax indexing strategy is easy to implement, low cost and transparent.
Daniel S. Kern, CFA, is president and chief investment officer at Advisor Partners in Walnut Creek, Calif., where he is responsible for establishing and driving the overall company strategy.