Modernize your approach to high net worth portfolios

Key takeaways

1. Innovative strategies and investment vehicles may present new ways for advisors to seek after-tax returns for high net worth clients.
2. Help reduce your client’s tax bill with direct indexing SMA strategies.
3. Manage risk tax-efficiently with option overlay strategies.
4. Seek higher returns with private market interval funds.

Industry innovations make it easy to maximize after-tax returns for high net worth clients

Maximizing after-tax returns is a key goal for high net worth clients, and advisors have new tools at their disposal given recent innovations in the financial industry. Building direct indexing, option overlay and private investment strategies into client portfolios help reduce taxes, manage risk and with a goal to reach for higher returns.

Help reduce your client’s tax bill

Taxes are one of the biggest pain points for clients with substantial investments in taxable accounts. Federal taxes can be as high as 40.8% for short-term gains and 23.8% for long-term gains. Some U.S. states such as California and New York impose capital gain add-ons which can push an investor’s short-term tax rate above 50%.

At these rates, the expected impact of taxes may easily deter an unadvised investor from implementing portfolio adjustments that would have been beneficial for their long-term outcomes. This creates an opportunity for you as an advisor to add value for high-net-worth clients as higher tax rates mean your portfolios decisions may have a greater impact on your client’s tax bill.

While tax-loss harvesting is not a new practice, there are now more efficient ways to do it. Instead of rushing to sell underperforming investments toward year end, high-performing advisors are using direct indexing strategies in separately managed accounts (SMAs) to harvest tax losses throughout the year without having to adjust their strategic asset allocations. Additionally, the tax losses generated by direct indexing SMAs can be used to offset gains reported on Schedule D, including gains on the sale of a business or non-primary home.

Manage risk tax-efficiently

Another recent innovation is the use of option overlay SMAs to help reduce risk without selling any holdings and thus not triggering taxable events.

Option overlay SMAs provide varying levels of risk management on individual holdings or on equity portfolios and can be customized based on clients’ goals. These strategies can be effective in different scenarios, including 1) rebalancing portfolio risk when a client’s risk tolerance changes, and 2) reducing single-stock risk when a client holds a concentrated position.

1. Rebalance portfolio risk

Let’s say you need to dial down risk for a client who holds an equity-heavy portfolio. Trimming the equity allocation would result in the realization of capital gains, which could mean significant tax costs for a high net worth individual. Instead of selling down the client’s equity holdings, you can implement an option overlay strategy to limit stock market risk and effectively adjust the overall risk profile of the client’s portfolio.

2. Limit concentrated stock risk

Many wealthy investors hold concentrated stock positions. They may have accumulated the stock as a senior executive for the company where they built their career and personal wealth, or they may have inherited a multi-generational stock position. Either way, these concentrated positions can drive significant portfolio risk.

While there are many individual stocks that have outperformed markets over time – sometimes in a very big way – most stocks do not. And, in fact, many underperform significantly. According to Aperio Research and MSCI, the top decile stocks in the Russell 3000 Index produced significant excess returns over a 36-year period, but performance drops off meaningfully below that top decile – and 70% of stocks underperformed the index.

A concentrated stock position rarely wins
Average excess returns on stocks in the Russell 3000 Index by decile, 12/31/86-4/30/24

Despite the glaring risk in holding a concentrated stock position, many high-net-worth investors are reluctant to reduce their position either because they have an emotional attachment to the company, or because they are deterred by the tax implications of selling a low-cost-basis holding while subject to very high tax rates. And in some cases, both reasons apply.

If a client feels strongly about maintaining a concentrated stock position, you can manage the individual security risk with option overlays without necessarily needing to sell the stock. If a client agrees to liquidating their concentrated stock position, either partially or entirely, there are ways that you can ease the pain of taxes. If you plan to gradually reduce the position, option overlay strategies may generate tax benefits that can soften the blow of realizing gains on the shares you sell while limiting the single-stock risk associated with the shares you still hold. If you earn money on the options, those proceeds may help offset the tax cost of realizing gains on the underlying security. If you lose money on the options, you can net those losses against the realized gains.

You can also help offset the tax cost of selling the concentrated stock by taking advantage of tax-loss harvesting strategies in other parts of your portfolio. If you have cash on hand to invest, putting it to work in a direct indexing SMA could generate losses that help offset the gains realized as you liquidate the concentrated stock, which may make it easier to reduce the position more quickly.

Lastly, don’t forget about charitable giving. If your client chooses to donate shares of the concentrated stock to a qualified charity, the fair market value will be deducted from the donor’s taxable income and neither the donor nor charity will be taxed on the capital gain.

Seek higher returns

Private market investments have long been a staple in institutional portfolios. They offer investors the potential to earn above-market returns in exchange for liquidity constraints. Both private equity and private credit have outperformed their public counterparts over the past 8 years.

Private markets have outperformed public markets
Annualized returns from 9/30/15-12/31/23

Until recently, access to private market investments has been limited to qualified institutional buyers. However, the introduction of private market interval funds opens the door to accredited investors and presents fewer logistical challenges – with generally lower investment minimums, quarterly liquidity, and easier tax reporting via Form 1099 vs. K-1.

If you’d previously written off private market exposures, it’s worth revisiting for your high-net-worth portfolios where suitable for the client.

Build innovative portfolios for your high-net-worth clients

As the financial industry evolves, exciting innovations may continue to present new ways to build portfolios for better after-tax returns. Direct indexing SMAs, option overlay strategies, and private market exposures may all play significant roles in driving better portfolio outcomes.

BlackRock can help you construct well-diversified portfolios for your high net worth and ultra-high-net-worth clients. Contact your BlackRock representative for more information or explore our online investment tools and resources.

Explore the Advisor Outlook – BlackRock’s monthly market outlook for financial advisors – for more details on our latest market and portfolio insights.

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