Concentrated stock position? Direct indexing can help.

Key takeaways

• Vanguard Personalized Indexing can help you diversify concentrated positions.
• Thanks to the tax-loss harvesting feature of direct indexing, you can minimize tax costs as you gradually diversify the concentrated position into a direct index.
• If a client is preparing to sell a business, a direct index can also help offset capital gains from the sale—so clients can keep more of the purchase price.

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.

What is a concentrated position?

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:

• Stock options people get as part of their compensation. As the shares vest over time, the position can represent significant value with a low-cost basis.
• Early investments in companies that delivered outstanding performance, such as Apple or Google.
• Gifted shares of stock (not inherited shares, whose cost basis resets when shares change hands), or shares that are held for a long period of time and have seen significant appreciation.
• Significant weighting to one sector. For example, a banking executive with a significant holding of vested shares of the bank's stock could be hired away to another financial institution. The original stock holding represents a conflict of interest at the new job and needs to be removed from the portfolio.

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.

Make tax-efficient transitions

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.

Build around existing positions

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.

Sample VPI transition analysis

This example does not represent any particular investment and the rate is not guaranteed. For illustrative purposes only.

Offset taxes

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.

Tax-efficient customization

In addition to the ability to customize your clients' portfolios around their existing holdings, Vanguard Personalized Indexing also gives you the flexibility to:

• Align clients' portfolios with their preferences and values.
• Apply factor tilts.
• Offer clients the potential for improved after-tax alpha.

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.

Find your edge with Vanguard Personalized Indexing

Request a demo today to discover how Vanguard Personalized Indexing can help deliver additional value to you and your clients.

Notes

• Vanguard Personalized Indexing Management, LLC (“Vanguard Personalized Indexing Management”), formerly Just Invest, LLC, an SEC-registered investment advisor, is an independently operated wholly-owned subsidiary of The Vanguard Group, Inc. (“Vanguard”). Vanguard Personalized Indexing is an asset management technology that has been developed and is offered solely by Vanguard Personalized Indexing Management.
• For more information on Vanguard Personalized Indexing Management and Vanguard Personalized Indexing, and to access Vanguard Personalized Indexing Management’s Form CRS and Form ADV Part 2A disclosure brochure, please visit the Vanguard Personalized Indexing topic page. 
• All investing is subject to risk, including possible loss of principal. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.
• Tax-loss harvesting involves certain risks, including, among others, the risk that the new investment could have higher costs than the original investment and could introduce portfolio tracking error into your accounts. There may also be unintended tax implications.  Prospective investors should consult with their tax or legal advisor prior to engaging in any tax-loss harvesting strategy.  Neither Vanguard Personalized Indexing Management nor Vanguard provide tax or legal advice.
• The information contained herein does not constitute tax advice and cannot be used by any person to avoid tax penalties that may be imposed under the Internal Revenue Code. Each person should consult an independent tax advisor about their individual situation before investing in any security.
• Factor investing is subject to investment style risk, which is the chance that returns from the types of stocks selected will trail returns from U.S. stock markets. Factor investing is subject to the risk that poor security selection will cause underperformance relative to benchmarks or funds with a similar investment objective.