August 09, 2023

Taming an Unintentional Portfolio

For simplicity, folks like me who write about financial markets and planning present a fairly crisp version of the world. Equity strategies are concentrated enough to diversify risk and are split across regions. Bonds play a meaningful role absorbing shock and there’s a small allocation to cash. Maybe there are alts in there. In practice, particularly in private client portfolios, this gleaming version of the world does not always line up with reality. Private clients had a life before they came to us, and the evidence of that life can result in an “unintended portfolio,” which has so many moving parts with so many accounts and managers, that it’s impossible for clients to understand the risks being taken – not to mention, being confusing and stressful!

I spoke with Patti Shannon, Principal & Portfolio Manager – Private Clients, and she presented this hypothetical:

"The unintentional portfolio comes from accumulating investments over decades. Often when we are transferring in a new private client portfolio, it is coming from several different sources. Clients are tired of all the paperwork and want to consolidate. For example, they started an account with a retail broker in the early days when Cousin Bob started an oilfield service company (investing in family). The broker later marketed several other IPOs to them which they funded with new money and today (after some failures and some successes) is a fairly high-risk portfolio (betting on fliers). Next, they were frustrated with the performance of their managed account so after reading some articles about the potential benefits of ETF investing they opened a self-directed, non-registered account that holds several ETFs (following trends). Then, the company they work for had a service provider change for the RRSP account. All of her friends decided to go to a bank-owned manager with their RRSPs and so she followed along (administrative). Her husband’s step-brother has an insurance business and sells mutual funds as well so they gave him a bit of business as they wanted to help him out (supporting family employment). Now it’s getting closer to retirement and the paperwork is driving them crazy. They don’t know how much exposure they have to equities overall and no idea how much exposure to financials, tech, US equities, etc, from a big picture, consolidated point of view.”

There are still other ways the picture can become muddied over time.

For example, we work with many founder-entrepreneur clients who, when they take their company public or merge it for stock with a public company, suddenly have maybe 80% of their equity portfolio in one stock. When the lock-ups on trading that stock come off, they can also be tempted to hold onto it a bit longer and resist diversifying.

Clients can also have an emotional attachment to a certain holding due to employee loyalty (any holders of Nortel share certificates out there?) or if, say, their father gifted shares of Coca Cola to them and told them to never sell… but those shares now represent half their portfolio.

Another consideration is tax. A stock bought 20 years ago – say, Royal Bank – can arrive to us with a huge, embedded capital gain in it because investment managers can be loath to crystallize taxable gains in stocks they have long-term confidence in. That’s a challenge we inherit and manage as part of our own process (more on that below).

Do any or several of these situations sound familiar? An unintended portfolio can sneak up on you and potentially bite you if you’re not careful. So how can you manage for it?

Taking control of an unintended portfolio

Start with a fresh-sheet mentality. Once you and your investment manager decide to clean things up, it helps to go in with a bit of a no-holds-barred attitude. Remember: this isn’t the portfolio you’d build with fresh cash, so the effort will prove worthwhile when it’s consolidated, clean, and being managed effectively with a clear strategy in mind.

Let others, and your capital, do the work. If you earned your wealth through entrepreneurial pursuits, reframe your idea of wealth management to include more traditional – but effective long term – strategies. Diversifying your risk into a balanced portfolio of public and possibly private markets can help secure your retirement in a deliberate, measured way – and starting early can help smooth your transition into retirement by helping you acclimatize. If investing in or running an operating business is still in your blood, consider carving out an allocation for each of venture capital and diversified portfolios, giving you the best of both worlds.

Once a client arrives at Leith Wheeler, we spend time getting to know their unique circumstances and then set to work to help transition the holdings into a simple, easy-to-understand and manage collection of investments.

Amalgamate all the constituent elements into one picture. The first step in getting an unintended portfolio under control is taking stock of the risks and return opportunities of the legacy portfolio. For new clients of Leith Wheeler, we start with an inventory of all holdings to understand the exposures a client may have to certain geographies, sectors, capitalization levels, and so on. This gives us a starting point for transitioning the portfolio to one that’s optimized to reach the client’s long-term investment goals without carrying excess risk.

Clear out the high risk/low reward holdings. As part of that process, we look closely at any holding that sits outside our model portfolios*. Any stocks that raise alarm bells (broken business models, or even evidence of fraud, for example) we flag for immediate sale, but beyond that we look at a staged process for aligning the consolidated portfolio with our models.

Identify untouchables. Next we discuss with clients which off-model stocks are off limits. If shares in Cousin Bob’s company can’t be touched, we would ringfence that holding into a separate account so that the risks and returns of the ‘core’ portfolio can be managed and assessed on its own merits. Stocks with special trade constraints (for example, shares not permitted to trade for a period after a merger) can also be dealt with here.

Create a plan to hit long-term investment goals. This is the point where the haze of the unintended portfolio begins to lift, as a long-term plan takes shape. We establish one portfolio with an allocation to equities, bonds, and possibly other assets, the mix of which is monitored and managed. Allocations within individual account structures (taxable, non-taxable etc.) are also determined on a tax-effective basis.

Transition to model.

When tax is not an issue: We establish a structured sell-down plan that reduces or eliminates the position based on the passage of time or hitting certain market thresholds.

When tax is an issue: We first assess the downside of just selling remaining holdings to buy model holdings. Which stocks would trigger big capital gains (tax bills), and which are minor or might even provide offsetting tax losses? If there are significant unrealized gains, we might follow a few paths:

• Engage you and your tax advisor on the trade-off of realizing gains today (devil you know) versus in a future tax environment (devil you don’t). While deferral is desirable if you’re in a high-earning stage of your life, the tax liability doesn’t go away (and risks rising)
• Assess the costs embedded in any incoming pooled products, as outsized fee burdens may erode capital more than the tax hit
• Explore the benefit of donating a portion of the position to meet the client’s charitable goals without attracting tax on the sale
• Permit minor differences versus model weights to persist for tax reasons, but manage overall portfolio risk by matching sector weights. For example, maintain a 7% weight in Royal Bank (0.5% above model) but hold 0.5% less of other Big 5 bank holdings, so the overall Financials exposure is the same as model

In no time, the chaos of an unintended portfolio can be tamed to one that has a risk and return profile that can be easily understood, and managed for the betterment of your long term financial (and mental) health. It just requires the initial decision to set forth on that path!

*A model portfolio is the mix of stocks and their weights that our portfolio management team manages. All the elements in a given model add up to 100%. For example, we held ~6.5% in Royal Bank and 1.0% in Sleep Country Canada in the Canadian model as of June 30, 2023.