Considerations for Diversifying a Concentrated Position

Many individuals or families become wealthy through ownership in a business or single asset. Over time this results in a concentrated position, which arises when a single asset makes up a significant portion of a private client’s overall net worth.

Having a concentrated position exposes an investor to significant specific risk (also known as unsystematic risk). This business or property specific risk flies in the face of modern portfolio theory and the benefits of diversification which the CFA L3 curriculum stresses so much. 

As a result, Study Session 6 spends a considerable amount of time discussing both why and how to diversify a concentrated position. This blog post outlines some of the basic considerations for how to fold diversification into the broader client management process. 

Goal-Based Planning in the Concentrated Position Decision-Making Process

It’s worth highlighting a strategy for incorporating psychological considerations into the asset allocation process. Basically we do this by using goal-based planning and separating assets into three buckets:

  • A personal risk bucket
  • A market risk bucket
  • An aspirational risk bucket

Just like with Goal Based Investing, the aspirational bucket contains the highest risk positions, i.e. this is where the concentrated position would be placed. Framing an individual’s assets in this way can be a productive way to start the conversation about whether they should begin to diversify a concentrated position. For example we can separate the owner’s lifetime spending needs into primary capital and bucket the rest as surplus capital.

Asset Location and Wealth Transfers

When selling or monetizing an asset, the asset location, or type of account an asset is held in, can have significant tax implications.

Asset location determines the method of taxation that will apply. Location in a tax-deferred account would defer all taxes to a future date. In a taxable account, interest, dividends, and capital gains may be subject to different tax rates (or deferral possibilities in the case of when to realize capital gains).

Wealth transfers involve estate planning and gifting to dispose of excess wealth. The specific strategies used depend on the tax laws of the country and the owner’s situation but there are some general considerations and principles that can apply more universally.

Key considerations include:

  • If there are no unrealized gains, there are generally no financial limitations on disposing of the concentrated position. That means that advisors can have the greatest impact by working with clients before significant unrealized gains occur because they can employ aggressive strategies like direct gifts to individuals or trusts.
  • Donating assets with unrealized gains to charity is generally tax-free even if there are gains.
  • An estate tax freeze is a strategy to transfer future appreciation and tax liability to a future generation. This strategy usually involves a partnership or corporate structure. A gift tax would be due on the value of the asset when the transfer is made; however, the asset (including any future appreciation in value) will be exempt from future estate and gift taxes in the giver’s estate. Any tax owed is “frozen,” meaning paid or fixed near an initial value. The most common structure employed here is the creation of preferred shares with voting rights and common shares with no voting rights. The preferred shares are retained by the older generation while the common shares are gifted.

It also worth noting that another strategy can be to transfer the assets to a family owned limited partnership. The valuation of this partnership is generally lower than the assets within it due to two factors: a discount for lack of control and a discount for lack of marketability. By reducing the value of any appreciated assets in this structure a family can typically achieve a 10 – 40% reduction in overall valuation.

The Five Steps to Deciding to Diversify a Concentrated Wealth Position

Ultimately diversifying a concentrated position follows a five step process:

  1. Identify and establish objectives and constraints
  2. Map the tools and strategies that can be used to achieve the objectives in #1
  3. Compare the tax advantages and disadvantages of each strategy
  4. Compare the non-tax advantages and disadvantages of each strategy
  5. Formulate, document, and execute the strategy