Tax Aware
A 3-for-1 Solution for Concentrated Stock
April 9, 2024
Topics - Tax Aware Alternative Investing Factor/Style Investing
Becoming rich from holding a single stock is rare. 1 1 Close Stein et al (2000), Miller (2002), Boyle et al. (2004), and Bessembinder (2018). Staying rich that way is even rarer. 2 2 Close For example, Bessembinder (2018) shows that, during the 1926–2016 period, for all the 25,967 common stocks in the Center for Research in Securities Prices (CRSP) database, by far the most frequent one-decade buy-and-hold return is -100%. (Granted, Bessembinder rounds to the nearest 5% — but even a -97.5% cumulative return probably feels just as catastrophic as the full -100%.)
A big reason for this is that individual stocks tend to be very volatile, and volatility can erode compounded returns. 3 3 Close This can be a big problem for buy-and-hold investors (such as holders of concentrated stock), less-so for strategies with regular rebalancing. For example, a stock that goes up 10% one year and down 10% the next loses a bit of money round-trip (-1%); but a stock that goes up 50% one year and down 50% the next loses much more (-25%). This so-called “volatility drag” 4 4 Close Sometimes called “variance drain” or even “volatility tax.” goes a long way toward explaining why even good companies can end up as a detriment to long-term wealth.
In theory, diversification is the simplest way to reduce the volatility drag because diversified portfolios have meaningfully less volatility than a single stock. However, in practice, diversification of concentrated stock is quite hard to achieve.
We probably all know investors with a large fraction of their wealth concentrated in a single stock. Their objections to diversifying some of that concentration risk may range from the behavioral (“why would I sell the company that made me rich”) to the statutory (“I’m an insider of the company and am restricted in what I can do”). Another common objection is taxes: Selling highly appreciated stock entails a significant tax burden. And more important, after the stock is diversified, how should the proceeds be invested such that the resulting portfolio is not only diversified but also profitable?
Long/short tax-aware factor strategies may be of particular interest here. 5 5 Close Another we’ve written about is the use of Variable Prepaid Forwards, where we also find a potential role for long/short factor strategies. As we’ve shown elsewhere, long/short strategies designed to generate pre-tax returns can also realize meaningful net capital losses if executed with an eye toward tax efficiency. This helpful “byproduct” of the investment process can provide the means to offset gains resulting from a transition from a concentrated stock to a diversified portfolio.
From an investment perspective, we think of this as a 3-for-1:
- The ability to de-risk concentrated stock into a diversified portfolio,
- the addition of active pre-tax returns (i.e., returns in excess of a passive index), and
- potential ongoing tax benefits after the transition is complete
…all facilitated by a highly tax-efficient transition.
This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. Diversification does not eliminate the risk of experiencing investment losses.
This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.
The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.