For years, our firm has built equity strategies that fit squarely into traditional style boxes, like “U.S. large-cap growth” or “small-cap value.” But when our clients tell us what keeps them up at night, they don’t speak in terms of style boxes; they ask for things like income, protection against a market correction or (of particular relevance to this publication) a way to offset the risks of a large, concentrated stock position they hold.
Today, we are focused on developing strategies that specifically address our clients’ stated needs. Working in close collaboration, our equity research team and private client portfolio managers have opened a new frontier in portfolio building, enabling us to offer truly customized portfolios that fit our clients’ specific circumstances.
As addressed elsewhere in this publication, we appreciate the many reasons that a client may want to maintain exposure to a large, concentrated stock position. Tax considerations may outweigh the risk of the position losing market value, and other factors may also come into play in the decision to hold the position. But to the extent that the client can deploy other funds—either from liquidating a portion of the concentrated position or from freeing up assets elsewhere—we can use those funds to construct a portfolio that can act as an anchor to windward that offsets the risk embedded in a client’s concentrated stock.
We recently had a situation where a client came to us with nearly his entire liquid net worth invested in one stock (the result of selling his business to a public financial services company). Let’s call the stock "XYZ." After consulting with the client, we decided to sell the XYZ shares over multiple tax years, but only if we could maintain the level of income currently generated in dividends from XYZ (the client relied on this income). So, our task was to build a portfolio of equities that matched or exceeded the XYZ dividend (approximately 3%) and whose performance was relatively insensitive to the specific attributes that drive the performance of XYZ. As a financial services company, those factors include interest rate sensitivity and financial-sector exposure.
Typically, we begin building a client-driven portfolio by targeting a specific metric or set of performance attributes. That was the case here: We were aiming for a specific minimum level of yield, plus a low level of sensitivity to the risks embedded in XYZ. By supplementing our research team’s fundamental stock-picking efforts with analytical tools to guide portfolio construction, we were able to target those specific income and risk reduction outcomes.
To begin, we analyzed XYZ stock’s performance over time in detail vs. that of a broad-market stock index to see how closely the stock tracked the index. We also tested its sensitivity to various economic and financial considerations (to identify what are commonly referred to as “macro risks”). Has the stock tended to move up or down in tandem with the financial sector? Has its performance been heavily influenced by changes in interest rates? Through our analysis, we found that the performance of XYZ stock was in fact strongly linked to both of these factors.
Armed with this knowledge, we then set about building a portfolio with reduced exposure to the primary macro risks we found in XYZ stock. The aim was to truly diversify the client’s risk—for example, if the financial sector suffers a major setback next year, we would expect XYZ stock to suffer, so we would want a portfolio that we believe could hold up relatively well in that scenario.
In terms of stock selection, we have a very strong head start: The body of research created by our global research platform (our equity research team performs deep due diligence on hundreds of stocks each year and meets with hundreds of management teams) gives us an ample universe of stocks that our team favors based on fundamentals and valuation. From this set of names, we can build a portfolio based on both our fundamental judgment (i.e., our highest-conviction stock ideas), alongside data that help us see how the addition of any name or the sizing of any position may influence the attributes of the overall portfolio.
What did all of this analysis eventually produce? After several iterations, we recommended a portfolio of 35 stocks—each of which were strongly recommended by our research analysts— that offered a yield of approximately 3%, volatility on par with the broader stock market and a low exposure to the macro risks embedded in XYZ stock. We determined that if the client sold 35% of his XYZ stock to fund this new portfolio, the resulting combined allocation (to be clear, 65% XYZ stock and 35% in this newly created portfolio) would cut nearly in half the client’s exposure to financial-sector and interest rate risk vs. the status quo of simply holding onto the initial position.
This exercise delivered a strong result for our client and also opened the door for a new solution that we can now offer other clients. Building an “offset” portfolio like this will not be the right answer for every client with a concentrated position, but we now have an additional solution to offer to clients in these situations.
The example shown is for illustrative purposes only. The investment team will customize portfolios to meet the guidelines, requirements, and risk tolerance of the client.
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.
The views expressed are those of the author and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be and should not be relied upon as investment advice and are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance and you may not get back the amount invested. The information provided in this material is not intended to be and should not be considered to be a recommendation or suggestion to engage in or refrain from a particular course of action or to make or hold a particular investment or pursue a particular investment strategy, including whether or not to buy, sell, or hold any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients, is for informational purposes only, and is not individually tailored for or directed to any particular client or prospective client.