Taxes in Focus: The BEAT Q3’26

Transcript

Chris, you know, I think most people broadly understand that concentration is an exposure that has grown so large that it now represents a disproportionate share of an investor’s net worth. The concentration conversation is particularly timely right now.

We’re seeing a substantial increase in IPO activity. We just had SpaceX a few weeks ago, and around the corner could be names like Anthropic, OpenAI, Kraken, Discord, Databricks, and Stripe. So, we’re seeing this incredible wealth creation among founders and executives. So, for advisors, the concentration conversation has become one of the most important planning dynamics for affluent clients.

But concentration doesn’t always come from an IPO, it can come from many places. It could be employer stock plans, incentive compensation programs, long-term ownership of a winning stock, a sizable inheritance, or simply a tendency to hold on to familiar investments.

Behavioral finance, we call this the endowment effect, the tendency to place a higher value on something because you simply own it already, it’s familiar to you.

So, regardless of how concentration is built, it often reflects success, and we have to reward that success or celebrate that success. The challenge lies in that that same position that helped build substantial wealth can eventually become one of the greatest risks to preserving it.

So, we move to the next slide. When discussing concentration, it’s important to separate admiration for what a stock has accomplished versus an objective assessment of future risk.

On the left-hand chart, we show that an individual stock has historically shown much more volatility than a diversified benchmark. The median stock in the Russell 3000 experienced annualized volatility of roughly fifty-seven percent, compared to approximately fifteen percent for a broad market index.

But volatility only tells part of the story. If we move to the right-hand side, common assumption is that stocks that have outperformed in the past are likely to outperform in the future.

And historical data tells a very different story. Most stocks underperform cap-weighted markets over longer time horizons. Prior winners often have an even greater tendency to underperform.

For example, the light blue lines here are names that were in the top quintile within the prior five years, and you’ll see they have a larger propensity for underperformance.

So that’s what makes concentration so challenging. Investors become concentrated because a stock has done exceptionally well, and that success creates confidence in future success. And this leads us to a really important topic when we discuss concentrated stock within a client’s portfolio.

The goal isn’t necessarily to eliminate the position from their portfolio. The goal is to objectively evaluate whether maintaining that level of concentration will make sense for our future financial planning objectives.

So, let’s move to the next slide. There’s another dimension to concentration that we should consider. The traditional view of diversification was to own a diversified broad market index.

However, today’s market capitalization weighted benchmarks have become increasingly concentrated themselves. On the left-hand side, this is illustrating the top 10 largest companies within the S&P 500 and the outsized exposure they now represent. On the right-hand side, it’s showing the technology and communication services sectors, and that they’re now approaching nearly half of the benchmark.

Now, this on its own isn’t necessarily a problem. As Andrew was discussing, these companies in sectors have produced tremendous value. What it can create is an unintended blind spot.

Let’s consider an investor who owns a concentrated tech stock. They may believe they’re diversifying by allocating to a broad market index. In reality, they might be investing in similar risk characteristics.

What appears to be diversification may still represent significant exposure to a single sector, theme, or the drivers of return across their portfolio. That means that concentration conversations need to look beyond individual positions and evaluate exposure across the entire balance sheet at the household level.

So, let’s jump to our next slide. Frequently, one of the biggest obstacles for investors is taxes. Appreciated positions often carry substantial embedded gains, and clients might understand the risk, but hesitate to take action because of tax.

This is an example of a California client with a ten-million-dollar position, a one-million-dollar cost basis. If they were to sell that position, they could face a tax bill in excess of three million dollars to go pursue the objective of diversification.

A reinvestment of the after-tax proceeds would require a subsequent return of fifty percent just to break even and get them back to the ten million dollar starting point.

So, this creates a false choice: continue to hold the stock and accept the risk or sell everything and incur a large tax bill. This kind of hold versus sell mindset leads investors right back to the default option, which is to do nothing.

This is why we created the HOPES framework. Rather than a single solution mentality, it introduces a combination of solutions to align with varying planning objectives. That could be things like risk reduction, tax management, liquidity, estate planning, charitable giving.

Diversification works best as a process, not a moment in time transaction or transition.

So, moving to our last slide here. So, HOPES organizes this mindset into five categories. Holds: The reason that this is here is it really is intended to stress that this is not all-or-nothing decision-making.

You may want to maintain a targeted exposure just at a more prudent sizing. Options and derivatives can be used to modify risk, manage downside exposure, and in some cases, monetize the position.

Our planned giving bucket can reduce concentration, support charitable goals, and provide an itemized deduction against adjusted gross income.

When we move to the exchanges, these are diversification-oriented solutions for accredited investors and qualified purchasers. They allow an investor to immediately diversify while deferring the tax liability, and this can be through tools such as a traditional exchange fund, a diversified exchange fund, or something like a tax-managed long/short fund.

And then last, moving to strategic selling. This incorporates techniques such as a tax-aware liquidation schedule, and also tax loss harvesting.

And I want to take a minute on that one just because of how important it is. When we’re talking about selling stock, we’re really having a conversation about asset allocation. How are you going to take advantage and take your reinvestable proceeds after a liquidation transaction and put them back to work within that designed asset allocation?

As we are designing that, there’s an opportunity to incorporate systematic and opportunistic tax loss harvesting, and that could be through tools like direct indexing or long/short separately managed accounts. The tax assets that are created through these tax loss harvesting strategies, they speed up the rate at which you can take chips off the table from your concentrated position, and they can defray the tax cost of that sell schedule.

So, the important takeaway of this framework is that a single strategy is rarely the answer. There is value in a combined toolkit, and that different tools will solve for different financial planning objectives. The best outcomes are often the result of several strategies working in tandem.

So, to wrap up, concentration continues to be driven by IPO activity, equity compensation packages, and growth in individual market leaders, and the opportunity here is to move beyond the question, “Should I sell?” And more so focus on the question, “What’s the most tax-efficient path towards aligning with my long-term financial goals?”

HOPES provides the framework for that conversation.

That’s great, Brian. Thank you for our very helpful perspective and practical guidance for our taxable clients. Finally, you recently took on a new role as head of the Wealth Education Center. Can you please share a bit more about what that is and, and how clients can use this new educational platform?

Yeah. Absolutely. I’m incredibly excited about this new initiative. The idea behind the Wealth Education Center was to build a forum that helps advisors drive durable growth and move upmarket in the clients they serve through investment education, practice management insights, and market intelligence.

And so, there are four pillars of this new Wealth Education Center. The first pillar I’m not going to spend too much time on, because we are in it right now. The BEAT brings timely market intelligence across bonds, equities, alternatives, and taxes, in both a report and a quarterly webinar.

The second pillar is our Tax Forward Investing Center. This is a learning management system that delivers long format courses, short videos, white papers, blog posts, thought leadership, as well as centralizes all of our investment tax calculators into one place. You’ll have access to these resources by visiting taxforwardinvesting.com.

The third pillar is the Alternative Investing Center. It’s a very, very similar format to the tax center. It’s a learning management platform where you’ll find long format courses, short videos, white papers, thought leadership, all of the same types of content, but really focused on alternatives in private markets. So, courses on things like private equity and venture capital, real estate and infrastructure, net leasing, private credit, direct lending, hedge funds, anywhere that you might want to go deeper, but you can choose the format in which you best digest information.

If you want to watch a video or if you want to read a white paper, or if you’d rather just a short format, give me the quick and dirty, you know, six-minute video to really understand what this is, and you can access that center by going to investinginalts.com.

The last pillar of the Wealth Education Center is the Advisor Institute. That was actually founded in 2008, and the content from the Advisor Institute focuses on strategies and insights to help advisors attract new clients and deepen client conversations and connections.

So, with that, we can conclude our quarterly update. Thank you so much to our speakers who joined us today to share perspective, but most importantly, thank you to everyone that joined us.

Please be sure to register for the Beat, join our future updates, and check out the additional resources that I just mentioned across the broader wealth education platform.