Given the strong performance of equity markets over the past few decades, many investors have accumulated concentration in one or a few stocks, and advisors are often seeking ways to help investors diversify from concentrated exposure in a tax-efficient way. Sirion Skulpone, CFA, Global Head of Client Portfolio Management for Quantitative Equity Solutions at Goldman Sachs Asset Management, talks through the risks of being concentrated in individual stocks, several tax-managed investment solutions for concentrated stock, and use cases for unlocking concentrated stock. Addressing how to diversify while being thoughtful about tax consequences is a critical challenge to solve.
Question: Given how strong markets have performed and how narrow leadership has been in the past couple of years, stock concentration is emerging as a big concern for many. How often is concentration an issue today?
Sirion Skulpone: Stock concentration is an issue we see very often with clients, and this has resulted from market dynamics. US stocks are up 200% in the last 10 years, and within that the Magnificent 7 are up over 2000% on average. According to research firm Cerulli, almost half of billionaire wealth is concentrated in tech and financials. But it’s not only billionaires. We definitely see many clients with concentration in these names, whether they were employed at these companies, inherited stock, or simply bought and held the stocks from years ago.
Question: From a portfolio perspective, if you look at an S&P 500 Growth portfolio, it currently has almost 50% allocated to top five stocks. By contrast, S&P 500 Value has 12% in top five. Different styles currently pose different concentration risk. Is this primarily a concern for growth investors?
Skulpone: While the trajectory for growth stocks in recent years has led to more concentration in growth-oriented positions for investors holding the broader market, we still see clients who have concentrated stock in, say, utilities or other value-oriented companies because they’ve accumulated a large amount of wealth from employer stock over the years, or perhaps they’ve founded and sold a company. Therefore, it’s common for us to meet with investors who have concentration in an energy, utility, or retail company stock. Overall market dynamics have created a great deal of wealth in specific sectors like technology and financials over the last decade or two, but the broader market has still seen significant appreciation and we help investors diversify concentration risk across all sectors.
Question: We always say diversification is a ballast of good investing, but concentration can work well in some cases. How do you know when concentration is working for you or against you?
Skulpone: That’s an interesting thought. We have done a lot of research and analysis on the risks of concentrated stock versus the broad market, and we find that, yes, if you happen to be holding the right name, concentration can work in your favor, the Magnificent 7 are a good example of that. The challenge is you may not be holding the right name, and even if you are, you’re likely better off diversifying while you’re ahead.
We’ve done some analysis looking at the Russell 3000 from 1992 to 2023, looking at lifetime returns of individual stocks and the corresponding time period returns for the index. What we found was that if you’re holding an individual stock versus the broad market, it’s essentially a coin toss whether the stock produces a positive or negative return over its lifetime – said differently, half the time you’re likely to earn a positive return while half the time you actually end up losing money. Contrast that to the market, which over corresponding periods produced a positive return roughly 90% of the time. That means that on a relative basis, historically the broad market may outperform holding an individual stocks approximately 70% of the time.
Our analysis also shows that individual stocks carry significantly more drawdown risk, which can be damaging to long-term wealth potential. Our analysis found that in roughly the last 3 decades, 72% of Russell 3000 stocks* experienced a 50% or greater drawdown, and more than half of those stocks never recovered to their pre-drawdown level. That’s because the math is not in your favor: if you lose 50%, you need to earn 100% just to get back to even. The market, on the other hand, has experienced some massive drawdowns—the financial crisis, for example, saw the market plunge 56%, and during the tech bubble, the market was down 47%. But the key point to keep in mind is that the market has recovered 100% of the time, hence why it’s important not to have not all your eggs in one basket.
Given many of our investors hold the Magnificent 7, we are commonly asked why they should diversify out of their winning stocks. We’ve done analysis that shows that winning stocks tend to lack persistence in outperforming the market, and investors are likely going to be better off in the long run if they lock in their outperformance and diversify before their winners start to lose.
* The stock universe includes Russell 3000 index members from 1992 through 2023.
Question: We know that a lot of investors are holding onto big winners right now, and big concentration. What should they do right now? Should they hold onto those winners or sell high?
Skulpone: That is going to have to be a decision each client makes with their financial advisor. There are so many things to consider for a client’s individual situation: risk tolerance, tax tolerance, liquidity needs, estate planning considerations, selling restrictions, even emotional attachment to the stock. As I mentioned, in general, we’ve found that historically it’s better to sell high to diversify, cash in those winnings. Additionally, these winning names have generally had high volatility, diversification can help smooth the ride. However, it doesn’t have to be all or nothing, all at once. Diversification plans can be customized around individual client needs.
Question: As an advisor, where do you begin the process of identifying spots of concentration and tackling it while considering tax impact?
Skulpone: There are many different definitions of concentration, and no set rule. This is a broad generalization, but we generally believe if your investible wealth is 30% or greater in any one specific stock, some investors may consider that to be fairly concentrated. Another measure of stock concentration could be if any one stock in a client’s portfolio is significantly greater than the benchmark weight of a broad market index. Some investors may be more comfortable with concentration than others. This is why determining wealth concentration tolerance is an important step towards proposing solutions.
Question: How is Goldman Sachs Asset Management helping clients navigate stock concentration? What’s unique about how Goldman Sachs Asset Management can help solve for this?
Skulpone: We have decades of expertise in two key pillars of concentrated stock diversification: direct indexing and exchange funds.
Direct indexing can be a helpful solution because of the ability to customize around wealth concentration. With direct indexing, the investor owns their own separately managed account in which they own the underlying securities directly. By owning the securities directly, we are able to manage their portfolio at a tax lot level. This means we can tax loss harvest, fund portfolios with existing securities, and recommend securities to gift, all customized to each client’s specific holdings.
When you own a direct indexing portfolio within a separately managed account, you have the flexibility to screen specific stocks out of your portfolio entirely, which is helpful for, say, an executive of a large-cap company who wants to screen out their employer’s stock to avoid further concentration, or even screen out the entire sector their employer stock belongs to. When purchasing an ETF, investors don’t have that flexibility, and therefore may be doubling down on exposure on that company or sector.
The ability to customize a direct indexing account also means the investor may be able to choose from different diversification timelines and tax budgets, depending on their goals. Tax loss harvesting within a direct indexing account may also help accelerate diversification, realizing losses to offset gains from selling concentrated stock.
Exchange funds are a solution for qualified purchasers only. They are pooled vehicles in which investors contribute individual stock holdings in exchange for shares of the fund, and in return receive much broader exposure to the equity market. The key benefit of doing so is this can be done with no immediate tax liability. Also, after 7 years of holding the fund, the client can choose to remain in the fund, or they may receive back a diversified basket of stocks, which can be held outright or contributed to a direct indexing portfolio.
When funding accounts with existing securities, direct indexing and exchange funds can be used simultaneously to improve outcomes in many scenarios. We can provide advisors with details on exactly which tax lots to contribute to the exchange fund or to a direct indexing portfolio to strike the right balance of risk and tax for a client’s portfolio.
It’s important to remember that many investors have very complex financial scenarios. Whether that means estate planning considerations, selling restrictions, or a mix of existing investments, the interplay of their complexities should be carefully considered. One of our key differentiators is the insight we have into how High Net Worth investors can maximize the potential benefits of these solutions, and we can create custom analytics to help them understand and decide what makes sense for them. Our goal is to partner with advisors to build customized solutions for clients that cater to their unique circumstances.
Question: Bottomline is, investors have options with which to tackle stock concentration. What would you say are the key takeaways for an advisor here?
Skulpone: I’d say there are three takeaways. The first is that equity markets have created enormous wealth, but investors with concentrated stock positions may be subject to significantly more risk than those invested in the broadly diversified market.
The second is that investors may benefit from solutions designed to reduce concentrated stock risk in a tax efficient manner by customizing solutions to their unique scenarios.
The third is that this is a huge advisor opportunity. Based on Cerulli data, it’s estimated that about $9 trillion is sitting in individual stocks in brokerage accounts that are unmanaged by a financial advisor. With that much unmanaged wealth, there are likely a lot of investors who are looking for guidance on how to approach tax efficient diversification. Therefore, advisors have an opportunity to capture ‘money in motion’, as investors move assets from brokerage to advisory relationships, looking for professional management as they seek tax efficient diversification. We see this as potentially a big opportunity for advisors to win more business.
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Risk Considerations
Equity investments are subject to market risk, which means that the value of the securities in which it invests may go up or down in response to the prospects of individual companies, particular sectors and/or general economic conditions. Different investment styles (e.g., “growth” and “value”) tend to shift in and out of favor, and, at times, the strategy may underperform other strategies that invest in similar asset classes. The market capitalization of a company may also involve greater risks (e.g. “small” or “mid” cap companies) than those associated with larger, more established companies and may be subject to more abrupt or erratic price movements, in addition to lower liquidity.
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