A tax-managed exit strategy into a diversified SMA may reduce investment risk and the tax bill at the same time

In Brief:

  • Concentrated stock positions bring significant investment risk to a portfolio, including a very low probability of outperforming the broader market over the long term.
  • Selling out of concentrated positions may trigger large tax liabilities due to unrealized gains.
  • Tax-managed exit strategies may help investors reduce investment risk and their tax liability at the same time.

Investors may own or inherit concentrated stock positions for many reasons—stock rewards from an employer earned over a career or early investment in a single company. Left untouched, these positions can become outsized over decades and present a dilemma for investors: single stock positions have rarely outperformed the broader market over the long term, yet exiting can trigger significant tax liabilities from unrealized gains.

Thankfully, investors have an alternative to this binary choice. Using a tax-managed exit strategy from the concentrated position to invest in a diversified portfolio may reduce investment risk and the tax liability at the same time.

Concentrated stock positions rarely outperform over time

Staying in a concentrated stock position over time can create unwanted risk in an investment portfolio because the position is exposed to the idiosyncratic risk of the underlying company. The odds that this risk can lead to a highly unfavorable outcome are significantly greater than the potential that the idiosyncratic risk helps the portfolio over the long term.

In an analysis of the Russell 3000 Index going back to 1980, more than 40% of all companies that were ever in the Russell 3000 Index experienced a catastrophic stock price loss, defined as a 70% decline in price from peak levels that is not recovered.

The average concentrated stock position also hasn't done better than a diversified index. Around 66% of stocks underperformed the Russell 3000 Index and 42% experienced negative absolute returns. Only 10% of stocks proved to be "megawinners," with a cumulative price return greater than 500% vs. the Russell 3000 Index. The risk of a concentrated position to a portfolio’s return over time is hard to ignore.

Tax-managed exits may reduce investment risk and the tax bill

J.P. Morgan's Tax-Smart separately managed account (SMA) transition capabilities provide a solution to reduce investment risk by moving into a diversified strategy in a way that can also reduce the tax liability owed. While it's unlikely that taxes will be avoided completely, the taxes saved in this process can also add value through reinvestment. The amount of time to transition out of the position can also be shortened, further reducing the portfolio’s exposure to the risks of a concentrated position.

Our intelligent tax technology powers this process. The technology scans a client’s holdings in a Tax-Smart SMA on an ongoing basis, looking for opportunities to harvest losses that can be used to offset gains from selling the concentrated position.

Case study: Comparing three scenarios for tax-managed exits

We explore three different exit scenarios and their potential for reducing investment risk and capital gains taxes using the following assumptions:

  • A single stock position worth $10 million with no cost basis
  • Maximum federal long-term capital gains tax rate of 23.8% (20% rate for individuals with long-term capital gains over $518,900 and the 3.8% net investment income tax for individuals with modified adjusted gross income over $200,000) 
  • Resulting tax liability associated with this position is $2.38 million
  • Stock price stays constant

Scenario 1: Steady divestment with no Tax-Smart SMA

Realize $1 million in gains from the stock each year, allowing the investor to eliminate the position in 10 years.

The total tax bill of $2.38 million would be spread out to $238,000 per year, which may be more tolerable to the investor.

Scenario 2: Steady divestment with proceeds invested in a Tax-Smart SMA

Transfer the position into a Tax-Smart SMA and realize $1 million in gains from the stock each year, using the proceeds to diversify the account around the concentrated position and look for tax-loss harvesting opportunities on an ongoing basis. As losses are harvested within the Tax-Smart SMA, they can be netted against gains from selling down additional increments of the concentrated position.

For example, in year 1, $1 million would be invested in a collection of individual securities and $9 million would remain in the concentrated stock position. The Tax-Smart SMA may harvest losses of roughly $100,000, or about 10% of the non-concentrated stock assets. By the end of the year, these losses would allow an extra $100,000 of the concentrated stock position to be sold without incurring an additional tax bill.

In year 2, $2 million would be invested around the concentrated position, across which losses could be harvested, with about $7.9 million remaining in the concentrated stock vs. $8 million in scenario 1. This pattern continues each year and results in the concentrated stock being fully sold off in nine years rather than ten.

The total tax bill would be $2.11 million, $273,000 less than in scenario 1.

Scenario 3: Steady divestment with proceeds invested in a Tax-Smart SMA that is funded with additional cash

Transfer the position into a Tax-Smart SMA and add $5 million in cash in year 1 to the Tax-Smart SMA to increase the asset base for harvesting losses (in scenario 2, only $1 million is available for tax-loss harvesting in year 1).

Realize $1 million in gains from the concentrated position each year and invest the proceeds from the sale to diversify the account around the concentrated position. Continue to look for tax-loss harvesting opportunities on an ongoing basis, which can be used to offset additional sales of the stock; as a result, the position could be fully sold off in eight years.

The total tax bill would be $1.90 million, $476,000 less than in scenario 1.

*Scenarios are shown for illustrative purposes and should not be interpreted as a recommendation to buy or sell.

Tax-Smart SMAs have many benefits

In addition to the potential to reduce portfolio risk and tax bills, transitioning with a diversified Tax-Smart SMA offers additional benefits:

  • Outsource the work associated with diversifying a concentrated position. Our technology optimizes for the most efficient buys into a diversified strategy.
  • Customize the SMAs to exclude the concentrated stock’s peers and industry from the new strategy to avoid additional exposure.
  • Get real-time updates on the status of a transition or make updates to the transition plan using our on-demand portal.

J.P. Morgan’s Tax-Smart SMAs take an active approach to tax management, easing the process for advisors so they have more time for their clients. Our on-demand transition capabilities provide solutions for concentrated stock positions; however, multiple stock positions and ETFs (and mutual funds on certain platforms) can all be used to fund a Tax-Smart SMA. With a customizable approach, advisors are empowered to solve the tax problems most important to their high net worth clients.