Academic work by leading market researchers like Nobel Laureates Eugene Fama and Harry Markowitz leads IFA's wealth advisors to warn investors that portfolios holding concentrated positions in a few big stocks are a risky way to manage their finances. 

For one, holding a large stock position can skew overall portfolio performance in terms of trying to monitor and benchmark returns over different periods. This acts to cloud an evidence-based portfolio allocation and diversification strategies, all of which are aimed at maximizing expected returns according to each investor's risk capacity. 

IFA Taxes, which is a division of Index Fund Advisors, was created to assist clients in need of tax planning, tax return preparation as well as financial planning. IFA desired to create synergies for its clients by offering investment, accounting and financial planning services. This means we help clients make sure they've got tax-efficient portfolios that align with their financial planning needs. We also are often brought into conversations by IFA's wealth advisors concerning a variety of different financial planning issues in order to present tax-savvy recommendations. These discussions can include any type of issue, from household budgeting and how best to save for college to getting a leg up on retirement planning and potential health care needs. 

Taxpayers invested in globally diversified and passively managed portfolos of index funds typically are looking for ways to limit their capital gains tax exposure. If a major reason why a client has maintained concentrated positions of individual stocks is to limit their capital gains tax exposure, we recommend a conversation with an IFA wealth advisor. "You can ask your wealth advisor to run a special report to identify opportunities to sell highly appreciated positions and liquidate positions at a loss to offset the tax losses of any gains.

Taking Taxes into Account

This type of an analysis is referred to by IFA's wealth advisors as a portfolio "Gains/Loss Report." Such a written breakdown is used to check a fund or security's capital gains and capital losses status. 

In these cases, IFA's wealth advisors examine a client's total portfolio and look for opportunities to use capital losses to offset any capital gains. Should an investor decide to sell only part of the position, our portfolio management team would sell those shares that generate the least amount of taxes.

A method that might be helpful in this regard for large and concentrated positions which we've determined are best unwound over time is tax-loss harvesting. This is a standard service offered to all of our clients. TLH, as it's commonly called, works like this:

• When a fund declines significantly in value, IFA's portfolio managers can sell it. For tax purposes, such a transaction locks in capital losses. This drop in value can be used to then offset capital gains, and potentially, reduce ordinary income. 
• Any realized losses that aren't utilized in the current tax-year can be carried forward for as many years as necessary until completely used up. As a result, a market downturn provides investors with an opportunity to examine their specific tax situations and determine if they've got additional capital gains that can be offset by losses harvested for tax purposes.

Given this tax-offset value of realized capital losses, investors need to consider a disciplined and consistent TLH strategy after stock or bond positions have experienced a large enough decline. (For an explanation of how IFA applies such a strategy, you can read "Tax-Loss Harvesting: Taking Advantage of Opportunities.")

As more investors gravitate to index investing, it's not uncommon for IFA's wealth advisors to be asked about the wisdom of holding concentrated stock positions in an otherwise globally diversified and passively managed portfolio of index funds.

In general, such questions run along the following lines: 

"I hold a large stock position in the company that used to be my employer. Would it be possible for IFA to help me unwind that position so that I can invest the proceeds into a more diversified and risk-appropriate portfolio?"

In the past, we've helped many clients liquidate large stock positions which resulted from changes in situations related to employment, inheritance or simply longer-term investment goals. (See: "The Hidden Costs of Holding Concentrated Stock Positions.")

Of course, the primary reason to consider liquidation is the diversification benefit of the lower risk of many stocks versus one stock, as illustrated in the chart below. Notice how much greater exposure to risk investors are being asked to accept — even if they might be able to achieve similar gains — by concentrating their bets on one stock instead of a globally diversified and passively managed portfolio of index funds. 

When unwinding a large stock position, there are several important factors that we take into consideration. Below are three overarching issues we address in trying to efficiently and effectively execute on such a strategy.

Timing and Brokerage Trading Rules

Are there any restrictions such as blackout dates on trading the stock? Our wealth advisors would consult with you, and if needed, we'd help you research such a potential issue.

We'd also consult with you to determine over how long of a period you'd like to liquidate the stock. Even if you want to liquidate as quickly as possible, it might not be prudent to complete such a sell in a single day, or even a couple of days. A lot will depend on how liquid a stock might be at any given time.

Another consideration is understanding different brokerage trading fees involved in such a process. For example, an asset custodian that IFA uses might allow for 60 days — or some other specific period — of free trades on new accounts. That could lead to cost-saving opportunities in terms of actually carrying out such a transaction.

These types of execution decisions, however, are weighed by our portfolio management team against other possible technical ramifications, including any possible tax impacts relating to short- and long-term capital gains. 

At IFA, we like to point out to investors that all of the custodians we work with maintain institutional-caliber trading desks. Such professional staffers stand ready to assist us in executing a large sell that might require special techniques, including coming to a determination of volume-weighted average pricing, which helps our clients to get a better idea of the full impact of such a transaction.

Is a Donor Advised Fund Right for You?

If you're philanthropic-minded, it might make sense to donate your highly concentrated and highly appreciated assets. For such clients, we might look at unwinding concentrated positions by donating stocks that've appreciated in value to a charity. Such an act of charitable giving can be done either directly or through a Donor Advised Fund (DAF).

DAFs are set up as separate charities and are often run by arms of major brokerages such as Schwab and Fidelity. The costs and minimum account sizes required by a DAF are likely to be far lower in general than establishing and maintaining a private foundation. It's also probably going to require much less in terms of paperwork, legal fees and related complexities necessary to setting up and maintaining a foundation. 

After transfering cash or securities into the fund, donors become eligible for a tax deduction and won't be required to pay capital gains on those appreciated assets. At the same time, such philanthropists are typically allowed to pick the time and amount of their donations, as long as such gifts are made to an IRS-certified 501(c)(3) charity. 

An advantage of investing through a DAF is that donors can diversify highly appreciated and concentrated positions without tax ramifications. This can help donors to maximize expected returns in the DAF and leave more assets to give to the charities of their choice. Donors can also choose a DAF that lets them work closely with their IFA wealth advisors to make sure such a fund's investment choices are consistent and complementary to the philanthropic portion of their holistic financial planning process. 

One of the ways DAFs are most frequently used is as an estate planning tool. DAFs are particuarly well-suited to open avenues for an estate to continue its philanthropic activities and create opportunities for heirs to participate in distributing assets to charities. (For more details about specific DAF sponsors we're referred clients to in the past — including differences in how each fund operates and the fees typically charged — you can read "Is a Donor Advised Fund Right for You?")  

In summary, if a large part of a client's wealth is held in a single stock, we recommend that he or she diversify in a sensible and cost-conscious manner. Having an investment fiduciary in your corner can be beneficial to you in terms of finding the most effective and tax-savvy way to accomplish such long-term investing goals.

If you would like to consult with an IFA wealth advisor about your specific situation, please feel free to call (888) 643-3133. To contact Lisa Rimke, Director of Tax and a Certified Public Accountant (CPA), you can reach her by phone at: (888) 302-0765. She can also be contacted directly at: [email protected].

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This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product or service. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. Performance may contain both live and back-tested data. Data is provided for illustrative purposes only, it does not represent actual performance of any client portfolio or account and it should not be interpreted as an indication of such performance. IFA Index Portfolios are recommended based on time horizon and risk tolerance. For more information about Index Fund Advisors, Inc, please review our brochure at https://www.adviserinfo.sec.gov/ or visit www.ifa.com. This is intended to be informational in nature and should not be construed as tax advice. IFA Taxes is a division of Index Fund Advisors, Inc.

Certified Public Accountant (CPA) is a license to provide accounting services to the public awarded by states upon passing their respective course work requirements and the Uniform Certified Public Accounting Examination.