Stephan Maritz, a portfolio manager at Woodland Securities, has outlined a strategy for investors to manage concentration risk in their portfolios. One approach is to gradually reduce a concentrated holding and diversify the portfolio. This strategy is particularly relevant for investors who have held the same shares for many years and face substantial capital gains. Maritz uses the example of a R10m portfolio with 69% invested in Richemont, a holding with an original cost of R1.75m and an unrealized capital gain of over R5.1m.
The challenge for investors is deciding how quickly to reduce their concentrated position. Selling the entire holding at once may reduce concentration risk immediately but can also crystallize a large capital gain in a single tax year. Using the example of the R10m portfolio, Maritz illustrates that selling R4.9m worth of Richemont shares immediately would realize a capital gain of about R3.66m, resulting in an estimated tax liability of around R650,000 for an individual investor subject to the highest marginal tax rate.
Alternatively, spreading the sales over three years can help manage tax liability. In this scenario, the investor would sell about R1.64m worth of Richemont shares each year, reducing the position from 69% to 53% after the first year, 36% after the second, and ultimately 20% after the third. This approach would allow the investor to utilize the annual capital gains exclusion three times, resulting in an estimated tax liability of around R632,000 over the three years.
Maritz emphasizes that gradual diversification is not primarily about reducing capital gains tax but about flexibility. By spreading disposals and tax payments over several years, investors can avoid making the entire diversification decision at a single share price and adjust their sales as circumstances change. As each portion of Richemont is sold, the portfolio becomes progressively less dependent on a single share.
However, there is a trade-off between immediate risk reduction and flexibility. Reducing the Richemont holding from 69% to 20% immediately removes a substantial portion of concentration risk, while a three-year strategy leaves the investor exposed to that risk for longer. The pace of diversification should reflect the size of the holding and unrealized gain, the investor's broader financial position, and their willingness to remain exposed to a single share.
Market conditions can also influence the timing of individual disposals, provided they do not become an excuse to postpone the decision indefinitely. Tax should influence the pace of diversification but not determine whether diversification occurs. Maritz concludes that gradual diversification is ultimately about finding a sensible pace for reducing concentration risk, rather than allowing tax considerations to dictate the decision.
The key to successful gradual diversification is finding the right timeframe for reducing concentration risk. This timeframe may vary depending on individual circumstances, and Maritz suggests that it could be 12 months, three years, or even five years. By adopting a gradual diversification strategy, investors can manage concentration risk, minimize tax implications, and achieve a more balanced portfolio.
Key points
- Gradual diversification can help manage concentration risk and tax liability.
- The pace of diversification should reflect individual circumstances, including the size of the holding and unrealized gain.
- Tax should influence the pace of diversification but not determine whether diversification occurs.
