Separately Managed Accounts Diversify concentrated stock positions tax efficiently

A concentrated stock position often results from years of equity compensation, participation in a successful initial public offering (IPO), or ownership in a growing business. These situations can create a planning dilemma: Sell the stock to diversify and pay the capital gains tax — or live with the risk of a highly concentrated portfolio.

A tax-managed long/short equity separately managed account (SMA) offers a potential solution. Rather than forcing an immediate sale of the concentrated position, SMAs can help clients diversify gradually while using tax-loss harvesting to offset gains and reduce the transition’s tax impact.

Why manage single-stock risk

In addition to wanting to avoid taxes on unrealized capital gains, clients who own one stock representing a large portion of their wealth may be hesitant to sell. Maybe they’re confident in the company, have an emotional attachment, or want to retain some potential upside.

But a stock that helped create wealth can eventually become one of a portfolio’s largest sources of risk. Over the prior 10-year period, 71% of US stocks underperformed the S&P 500 Index.¹ The median US stock also experienced 38% annualized volatility, compared with 14% for the index.²

For clients owning a stock with a low cost basis, the challenge often isn’t recognizing the risk but finding a tax-efficient way to reduce it. Selling enough shares to create a diversified portfolio may trigger a substantial capital gains tax liability. That can leave them feeling trapped between portfolio risk and tax consequences.

How a long/short SMA works

A long/short SMA seeks to diversify a concentrated position by combining traditional long stock investments with a limited amount of short selling while maintaining broad market exposure.

Suppose a client owns $1 million in highly appreciated company stock with a zero cost basis. Selling the entire position at once would realize a substantial capital gain. Instead, they could place the stock in a long/short SMA designed to transition the position gradually.

In a 130/30 structure, the original $1 million position initially remains in the portfolio. The strategy borrows on margin to add approximately $300,000 of long positions, broadening the client’s stock exposure. The strategy also establishes approximately $300,000 of short positions. The result is a 130% long exposure and a 30% short exposure, or approximately 100% net stock exposure.

This approach broadens the opportunity to harvest losses across all market environments. In a rising market, some short positions may produce losses as the prices of the shorted securities increase. In a falling market, some long positions may produce losses as their prices decline.

The SMA investment manager can use any losses to offset gains from selling a portion of the concentrated stock position and use the proceeds to diversify the portfolio. The manager can repeat this process until the portfolio reaches the desired level of diversification. 

There are tradeoffs to this approach. Short selling and margin borrowing introduce additional risks and costs, and the tax results depend on market performance, implementation, tax rules, and the client’s circumstances.

Other tools financial professionals can consider

A long/short SMA isn’t the only tool for managing concentrated stock, and each alternative has different distinct liquidity, cost, risk, and tax considerations. Exchange funds, a type of private fund, may eliminate single-stock exposure immediately by pooling contributed shares into a diversified portfolio, but they generally involve a multi-year lockup, limited liquidity, and K-1 reporting. Options overlays can manage risk or potentially generate income while deferring gains, though the degree of risk reduction depends on the overlay design.

A long/short SMA takes a different path. The position diversifies gradually according to the client’s personalized schedule, and tax-loss harvesting opportunities may continue after the transition is complete. Reporting is provided on Form 1099, which may be more familiar and operationally straightforward for clients than K-1 reporting.

Invesco Enhanced Tax-Optimized Large Cap Equity SMA

Drawing on our more than 30 years of experience managing SMAs, the Invesco Enhanced Tax-Optimized Large Cap Equity SMA is designed to help investors transition concentrated stock positions into diversified large-cap equity portfolios while managing taxes along the way. The strategy targets the S&P 500 Index, typically holds approximately 300–400 securities, and accepts funding through cash or securities.