Overconcentrated stock positions can be highly risky for a portfolio. If one stock makes up 10% or more of a portfolio, that portfolio is vulnerable to that one company’s moves. And if that company goes out of business or its stock declines in value, the portfolio’s overall value could plummet.
There are many ways a portfolio can develop overly concentrated positions. An investor may have received stock options as part of their compensation, for example. Or they could have made early investments in companies that wound up outperforming. Or maybe they’re a senior executive at a firm with a significant holding of vested shares of the company’s stock.
Whatever the reason, it’s important to diversify the portfolio to mitigate overconcentration risk. But here’s the rub: if one were to sell that position outright, the investor could be hit with a huge capital gains tax bill.
So, the solution? According to Vanguard, this could be an ideal scenario for direct indexing.
See more: “Be Your Own Portfolio Manager With Direct Indexing”
Diversifying Positions in a Tax-Effective Way
A direct indexing portfolio is a separately managed account where the investor owns individual stocks that represent a chosen index. But unlike a mutual fund or an ETF, the investor directly owns each stock. This gives them extra opportunities for tax efficiency.
Direct indexing lets advisors customize portfolios to fit clients’ existing holdings and tax needs. It also helps diversify concentrated positions in a tax-effective way. The diagram below shows how direct indexing can diversify a concentrated position in a tax-efficient way.
Source: Vanguard
Vanguard Personalized Indexing can help diversify concentrated positions. And as the investor’s concentrated position is gradually diversified, VPI’s tax-loss harvesting feature can minimize tax costs.
Vanguard CEO Tim Buckley said at Exchange 2023 that the company will “be investing heavily” in direct indexing. More information about VPI can be found online.
For more news, information, and analysis, visit the Direct Indexing Channel.