Concentrated stock position? Direct indexing can help.
June 5, 2023
June 5, 2023
Can you ever have too much of a good thing? Yes, if you're talking about a client with a concentrated stock position in their portfolio. Diversifying that concentration to reduce risk is a clear priority, but how can you do that in a tax-efficient way? Direct indexing is one effective solution.
When a client holds 10% to 20% or more of their portfolio in a single stock, their portfolio is vulnerable to single-stock events. If the company in question goes out of business or its stock declines in value, there goes a significant chunk of your client's wealth.
Concentrated positions can develop in several ways:
Diversification mitigates risk in these situations but may also have a cost for your clients. Selling that position outright, particularly if the stock has appreciated significantly, could saddle your client with a large capital gains tax bill.
Direct indexing strategies like Vanguard Personalized Indexing (VPI) let you customize portfolios to fit each client's existing holdings and tax needs—helping you diversify concentrated positions in a tax-effective way.
As a reminder, a direct indexing portfolio is a separately managed account (SMA) where the investor owns individual stocks that represent a chosen benchmark index. Because the investor directly owns each stock in their direct indexing portfolio, they gain extra opportunities for tax efficiency that may not be possible with ETFs and mutual funds.
The diagram below illustrates how you can use direct indexing to diversify a concentrated position in a tax-efficient way.
Start the process by selling a portion of the low-cost-basis portfolio to fund a direct index SMA. (The client may incur a one-time tax cost.) Direct indexing software will regularly harvest tax losses from this SMA. Vanguard Personalized Indexing scans the portfolio for tax-loss harvesting opportunities every day.
Over time, your client's portfolio will likely accumulate enough tax losses to offset capital gains from the sale of another piece of the original portfolio. You can then further fund the direct indexing portfolio. In this way, your client could potentially experience no overall tax cost in the newly established SMA as they gradually diversify the concentrated position into a fully transitioned direct index.
There are other ways besides direct indexing to diversify a concentrated position of course, including equity derivative structures, exchange funds, and equity collars. But direct indexing is a tax-efficient solution that allows you to customize portfolios for your clients in additional ways.
Direct indexing also lets you build a target portfolio around your client's legacy positions. For example, you might have a client who works in technology and receives compensation in company stock. With direct indexing, you can underweight exposure in the portfolio to their company stock specifically, or the entire tech sector.
Vanguard Personalized Indexing allows you to enter a client's account details and generate a transition analysis that lets you see different scenarios. You can evaluate the potential tax cost of each scenario and choose the option that works best for your client. Transitioning concentrated positions over time helps minimize the tax obligation while enabling the portfolio to achieve your desired investment exposures.
This example does not represent any particular investment and the rate is not guaranteed. For illustrative purposes only.
Another way direct indexing lets you tailor portfolios to specific situations is when a client is preparing to sell their business. Clients in this situation are often preparing for retirement and focused on getting the best sale price possible. However, another important consideration might be maximizing how much they can keep from the sale after taxes—that's where direct indexing can help.
If your client has a direct indexing portfolio, the tax-loss harvesting feature can capture tax losses for a few years before the business sale. These losses can help offset future capital gains generated by the sale.
In addition to the ability to customize your clients' portfolios around their existing holdings, Vanguard Personalized Indexing also gives you the flexibility to:
Offering appropriate clients the tax-efficient, customized investing experience they expect could help differentiate your practice. Discover how Vanguard Personalized indexing could be an extra edge for your practice that helps you retain and attract high-net-worth clients.
Request a demo today to discover how Vanguard Personalized Indexing can help deliver additional value to you and your clients.
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