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While most RIA firms employ funds and models when building client portfolios, a handful of wealth management and investment advisory firms utilize single-stock allocations. A distinct investment process, rigorous research and analysis, and prudent risk management serve as necessary inputs to the maintenance of equity portfolios. On the output side, the ability to consider client preferences, efficiently diversify, and effectively manage taxes are benefits worth discussing.
Considering client preferences
At Blue Chip Partners, while our in-house investment department manages specific equity models that are composed of 25-40 companies, shares of many of these firms have a performance profile that is similar to peers within the same industry. For example, if an individual has an emotional attachment to shares of a company in the beverages industry, we will utilize their preferred holding in the space as a replacement for the company that is held within our internal models. If a client seeks exposure to a company that our investment department does not recommend, our advisors educate the client as to why we hold an adverse view. But ultimately, the decision rests with them. The fact that we already run equity allocations composed of individual stocks allows us to better integrate emotional holdings without disrupting our ability to properly diversify and without causing unnecessary overlap.
Diversification
Given our internal investment department navigates and has full knowledge of our clients exposure, it is easier to diversify an equity allocation using individual stocks relative to employing externally managed products. Building a portfolio of 25-40 companies with targeted exposure across sectors and industries allows us to take advantage of areas exposed to secular trends and avoid those we view as poised for disruption. Further, ownership of individual stocks presents a more seamless opportunity to manage position sizes, as with mutual funds or ETFs our clients may receive outsized allocations to a single company in a manner that is outside of our control. In short, we can build portfolios that are diversified across business exposures, sectors, and styles all while maintaining the ability to be nimbler.
Diversification problems can arise if an individual position has run, thus potentially displaying large embedded taxable gains, which can lead to unnecessarily large exposures to a single company. Additionally, if robust analysis is not completed before allocations are determined, overlap (or overconcentration to a specific industry or style) can arise. For example, before including both an automobile manufacturer and a semiconductor producer in a portfolio, it is important to understand if the semiconductor producer is highly levered to the automotive industry.
Tax planning and potential tax consequences
There is no “one size fits all” solution to stocks that hold large embedded taxable gains, but those positions generally should be worked down to maintain proper diversification within an equity allocation. We typically work to sell down an outsized position in small pieces, pairing the recognition of gains with losses where available. In certain circumstances, we may forego ownership of other companies within a sector if a client holds an individual stock at size to avoid overconcentration of exposure to a specific area. In others, we may recognize small gains over a number of years, slowly working down the position. There is a reason that we try to be more proactive in managing position sizes, not letting securities run meaningfully relative to others within a client’s portfolio – if not addressed early, it is not likely to become any easier as time progresses.
Read the full article here by Daniel Dusina, Advisor Perspectives
