Case Study: Diversification Benefits of Tax-Managed Equity

Tax-managed equity provides several major benefits to investors who are looking to diversify away from concentrated equity holdings.

Investors often hold equity portfolios that are highly concentrated, sometimes in just one or two companies and other times in as many as 10 or 20. Often, this is because they’ve inherited low-basis stock, received executive compensation in the form of stock or made an early investment in a highly successful company.  

A handful of well-selected equity investments can be a great way to establish wealth, but for those who have already made their money, a diversified portfolio is a better way to maintain it. A diversified portfolio contains a broad array of assets that respond differently to various market environments, reducing the overall portfolio fluctuation. It also untethers an investor’s success from that of a single company, eliminating the chance that idiosyncratic business failures result in a portfolio failure.

Despite being a better fit for wealthy investors, there are often significant hurdles to diversifying away from what has succeeded in the past. Among the more powerful deterrents are capital gains taxes, emotional attachment and fear of regret.

Background

Recently, our tax-managed equity (TME) team worked with a wealth manager to transition a $3 million client portfolio comprising nine stocks into a well-diversified TME portfolio targeting the S&P 1500 index portfolio. In this case, the main concern was minimizing the realization of the $1.3 million of unrealized gains embedded in the portfolio. The wealth manager recommended this route for several reasons: the client was getting closer to retirement and couldn’t bear the risk associated with a concentrated bet, the transition needed to be done as tax-efficiently as possible and a structured approach would prevent emotion from derailing the plan.

Process and Solution

TME uses a customized process that combines passive stock selection and active tax management. TME portfolios are customized to the specific circumstances of individual clients, reflecting the tradeoff between risk and taxes for each client. The result is a customized, individual approach that minimizes deviations from index returns resulting from capital gains and income taxes.

In this case, TME moved from a concentrated portfolio of nine stocks to a 650-stock diversified portfolio over the course of 33 months. In doing so, approximately $600,000 in gains were realized, less than half of the total embedded gains at the beginning of the process.

In this analysis, we compare the actual TME process (“TME Actual”) to two hypothetical scenarios that are less efficient. The first scenario is what we term “TME Schedule,” a process that trades the same number of shares on the same dates as our TME team but doesn’t consider the most attractive tax lots – the varying purchase price of shares that constitute an allocation to a stock position. The second scenario is what we call “Pro Rata,” a process that trades an equal percentage of each position at each rebalance date.

A simplified way to think about these scenarios is that TME Schedule does not consider tax lot level information; Pro Rata considers neither tax lot level information nor security level information; and TME Actual considers both. The difference is drastic, with TME Schedule and Pro Rata incurring approximately $1.2 million and $1.5 million in gains, respectively, more than double TME Actual in the pursuit of the same goal. See Exhibit 1 below.

Exhibit 1: Gains Incurred by Rebalance Date and Total

Under the TME Actual, the case portfolio value grew 29.06% during the time period, while TME Schedule and Pro Rata grew 17.26% and 18.38%, respectively. If we apply these growth rates to a portfolio with a starting value of $10 million, we can see that TME generated value of over $1 million, relative to the two alternative diversification scenarios. See Exhibits 2 and 3.


Exhibit 2: Portfolio Growth Under Each Scenario

Exhibit 3: Summary of Results

Long-Term Advantages

At BNY Mellon Wealth Management, managing taxes is a key component of Active Wealth, the framework we use to help investors achieve long-term financial success. TME, an important strategy in reducing tax liability, provides several major benefits to investors who are looking to diversify away from concentrated equity holdings, whether they have one stock that dominates their allocation or 20.

The most obvious and easily quantifiable benefit is the reduction in incurred gains and concomitant increase in after-tax returns through conscious management of positions at both the security and tax lot level. Evaluating your plan on a regular basis with your wealth manager can help ensure that your portfolio is making the most out of tax efficiency.

While this study looks specifically at managing a concentrated portfolio, TME is also an effective strategy for other scenarios. The transition process can be utilized to tax-efficiently address reallocation of existing portfolios (i.e., not concentrated per se, but moving from “active” management or another manager), as well as transitioning to a new target benchmark (e.g., large cap to all cap portfolio allocation).

Beyond minimizing taxes in each scenario, a TME-driven diversification or transition plan reduces portfolio risk, increases the odds of goal achievement and eliminates the emotional decision-making that often undermines an otherwise well-thought-out financial plan. Removing the emotion from investing through a consistent, repeatable process can help grow and maintain wealth more efficiently over time.

Conclusion

Concentrated portfolios come in all shapes and sizes, from single-stock portfolios that reflect the success and failure of one company to portfolios with 20-plus names that may appear diversified but expose investors to a high degree of tracking error relative to their chosen benchmark. No matter the form of concentration, tax-managed equity presents a viable avenue to reducing portfolio risk while minimizing the cost of such a transition. The result is a more diversified portfolio that manages both risk and tax sensitivity in line with a client’s specific situation.

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