Diversifying Concentrated Portfolios with Custom SMAs: A Guide

General information, not personalised tax, legal or investment advice.

Introduction

Affluent investors often face a hidden risk: a significant portion of their wealth concentrated in a single stock, sector, or employer equity. Whether from a business exit, inheritance, restricted stock units (RSUs), or decades of holding a winning position, this concentration exposes portfolios to volatility that's easy to underestimate. Research analyzing 6,500 U.S. stocks from 1985 to 2024 found the median maximum drawdown was 85% — with an average recovery period of 2.5 years.

Selling immediately seems obvious, but embedded capital gains can make full liquidation financially painful — especially when decades of appreciation translate to six- or seven-figure tax bills. Custom separately managed accounts (SMAs) offer a more surgical path forward, letting investors diversify gradually while managing tax impact through techniques unavailable in mutual funds or ETFs.

What follows is a practical breakdown of the risks, the mechanics, and the decisions that determine whether a transition plan actually works.

Key takeaways

• Concentrated portfolios — when one stock or sector represents more than 10–20% of total holdings — dramatically amplify downside risk versus diversified portfolios
• Custom SMAs enable gradual, tax-efficient diversification through direct ownership, tax-loss harvesting, and strategic lot selection
• Best results come from pairing a clear Investment Policy Statement with a disciplined transition plan built around cost basis, timeline, and tax bracket
• This strategy suits investors with larger positions (typically $250,000+) needing precision standard funds cannot offer
• Outcomes vary based on transition pace, tax lot management, target allocation design, and ongoing monitoring discipline

Understanding Concentrated Portfolios and Their Hidden Risks

A concentrated portfolio exists when a single stock or sector represents a disproportionate share of total investable assets. Most advisors treat a position as concentrated once it exceeds 10–20% of total holdings, with concern rising sharply above 30–40%.

Common scenarios that create concentration:

• Employer stock grants and RSU vesting schedules
• A single high-growth stock held for decades
• Inherited shares with stepped-up basis
• Business sale proceeds reinvested into one holding
• Executive compensation programs tied to company performance

Risks Beyond General Market Exposure

Concentrated positions introduce specific risks that diversified portfolios avoid:

Single-stock volatility: Individual stocks exhibit dramatically higher volatility than broad indices. Stocks in the Russell 1000 Index averaged 37% volatility since 2014, compared to just 15% for the index itself.

Catastrophic loss risk: Nearly half of Russell 1000 constituents suffered a 50%+ decline at some point over the past decade. More severely, 40% of Russell 3000 stocks suffered permanent 70%+ declines from peak value.

Lifetime underperformance: The median stock's lifetime excess return versus the Russell 3000 Index was -54%, and two-thirds of all stocks underperformed the index.

The correlation trap: Investors often believe they're diversified across multiple accounts but hold the same company or sector in each, creating hidden concentration risk.

Why Investors Delay Action

Three factors typically delay diversification:

• A stock that built their wealth carries real emotional weight — selling feels like abandoning something that worked
• No clear replacement plan makes the transition feel riskier than staying put
• Capital gains taxes on highly appreciated positions can reach 20–37% of the gain when federal and state rates combine

That delay is itself a risk decision. Custom SMAs are specifically designed to address it by spreading the transition across multiple years and applying tax-management techniques unavailable in mutual funds or ETFs.

How to Diversify a Concentrated Portfolio Using a Custom SMA

A custom separately managed account (SMA) is a professionally managed portfolio where the investor directly owns individual securities, not fund shares. This structure gives advisors full control over which securities are bought or sold and when, enabling precise tax management and customization that pooled vehicles cannot replicate. The five-step process below shows exactly how that control gets applied — from assessing your concentration risk to maintaining the portfolio long after the transition is complete.

Step 1: Assess the Concentration and Establish an Investment Policy Statement

Review the full portfolio to map concentration:

• Identify specific holdings creating concentration
• Document cost basis per tax lot
• Calculate estimated embedded gain
• Assess current tax bracket and income sources
• Determine investment timeline and income needs

Establish a written Investment Policy Statement (IPS) defining:

• Target allocation across asset classes, sectors, and geographies
• Risk tolerance parameters and expected volatility range
• Income requirements and withdrawal timeline
• Tax constraints and acceptable annual gain realization
• Any position restrictions (no sector overlap with concentrated position, ESG screens)

At Sentinel Asset Management, every client portfolio is guided by an IPS and stress-tested against historical bear markets, recessions, and inflationary periods before a single trade is made. The IPS becomes the decision framework that keeps the transition disciplined — defining in advance what gains are acceptable to realize each year, which positions are off-limits, and when rebalancing is required.

Step 2: Evaluate the Tax Situation Before Any Trades

Map each tax lot of the concentrated position:

• Identify lots with highest embedded gains (long-term vs. short-term treatment)
• Model tax liability under different transition speeds
• Compare immediate full sale versus multi-year gradual approach
• Calculate effective tax rate including federal, state, and Net Investment Income Tax (3.8% for high earners)

Determine offsetting opportunities:

• Identify positions with unrealized losses that could be harvested
• Calculate how much loss harvesting could reduce net tax impact
• Assess whether timing aligns with other large income events (business sale, bonus, retirement)

With a clear picture of the tax exposure, the next step is building the portfolio that replaces it.

Step 3: Set Up the Custom SMA and Design the Target Portfolio

Work with an advisor to construct the SMA's target allocation:

• Choose asset classes, sectors, and geographies to replace concentration
• Ensure new holdings are genuinely uncorrelated with the original position
• Avoid replacing a tech stock with a tech-heavy index fund
• Consider international equities, fixed income, and alternative asset classes

Confirm practical requirements:

• Minimum investment thresholds: Custom SMA minimums vary by provider. Fidelity's direct indexing starts at $5,000, Schwab Personalized Indexing requires $100,000, while Vanguard and Parametric Custom Core typically require $250,000
• Custodian setup and account titling
• Advisory fee structure and ongoing management costs

Step 4: Execute the Transition Gradually Using Tax-Management Techniques

Begin transitioning in stages:

• Sell portions of the concentrated position across multiple tax years
• Spread capital gains to avoid bracket spikes
• Reinvest proceeds into diversifying holdings per target allocation
• Monitor cumulative gain realization against annual budget

Employ tax-management techniques:

• Use Highest-In, First-Out (HIFO) accounting to sell lots with the highest cost basis first, minimizing realized gains at each transaction
• Pair concentrated position sales with loss harvesting from other holdings — systematic tax-loss harvesting can generate 0.47% to 2.00% in annual after-tax excess returns
• Donate long-term appreciated, low-basis shares directly to a charity or donor-advised fund — this eliminates capital gains tax on the contributed shares entirely while generating an income tax deduction

Step 5: Monitor, Rebalance, and Adjust Over Time

Once the transition is underway, ongoing discipline prevents the portfolio from quietly drifting back toward concentration.

Establish a rebalancing schedule:

• Define drift tolerance (e.g., rebalance when any position moves 5% from target weight)
• Prevent the portfolio from re-concentrating in high-performing positions
• Coordinate rebalancing with tax-loss harvesting opportunities
• Continue harvesting losses to offset future concentrated position sales

Revisit the IPS regularly:

• Review annually or after significant life events
• Adjust for retirement, inheritance, divorce, or major income changes
• Ensure the SMA's strategy reflects current situation and goals
• Update target allocation as risk tolerance or income needs change

Key Variables That Determine Your Diversification Outcome

Two investors with identical concentrated positions can achieve dramatically different outcomes using the same SMA structure. The following variables have outsized effects on tax efficiency, timing, and final portfolio quality.

Pace of Transition

A faster transition reduces market risk on the concentrated position but triggers more capital gains in a shorter window. A slower pace preserves tax deferral but leaves you exposed longer to single-stock risk.

A faster transition reduces market risk on the concentrated position but triggers more capital gains in a shorter window. A slower pace preserves tax deferral but leaves you exposed longer to single-stock risk.

The right pace depends on your tax bracket, remaining income sources, and proximity to retirement. A high earner in peak earning years may prefer a 5–7 year transition to stay in the 15% long-term capital gains bracket. An investor entering retirement with lower income might accelerate to 3–4 years when rates are temporarily lower. The right pace emerges from your full financial picture, not a fixed formula.

Tax Lot Selection and Harvesting Precision

The ability to select specific tax lots for sale is one of the primary advantages of an SMA over a fund. It directly controls how much gain is realized in any given year and whether short-term or long-term rates apply.

Pairing lot-specific selling with opportunistic loss harvesting from other positions can reduce net tax drag across the full transition period. Vanguard research shows tax-loss harvesting generates 0.47% to 1.27% in annual tax alpha, with higher benefits for investors in top brackets — a gap that compounds over a 5–7 year transition.

Target Allocation Design and Sector Overlap

If the replacement portfolio contains significant overlap with the concentrated position — such as using a tech-heavy index fund to diversify out of a single tech stock — the diversification benefit is diluted even if the number of holdings increases.

Build the target portfolio around positions genuinely uncorrelated with the original. If you're selling a large-cap U.S. growth stock, consider:

• Emerging markets equities
• Value-oriented domestic equities
• Real estate investment trusts (REITs)
• Intermediate-term bonds

Simply buying the S&P 500 as a replacement often preserves far more sector concentration than it eliminates.

Market Conditions During the Transition Period

A bear market during transition can reduce the tax burden — lower prices mean lower gains — but introduces the psychological risk of pausing or abandoning the strategy at the worst time. A bull market does the opposite: tax costs rise, but so does the temptation to hold rather than sell.

A pre-committed transition schedule defined in the Investment Policy Statement typically produces better long-term results than a reactive one. It removes emotion from the timing of sales. Investors who pause during downturns often miss the recovery and restart only after prices rebound, increasing both risk exposure and eventual tax costs.

Common Mistakes When Diversifying with Custom SMAs

Skipping the IPS or Treating It as a Formality

Investors who enter an SMA without a clear, written policy for transition pace, tax constraints, and target allocation often make ad hoc decisions that undermine the strategy. They either sell too slowly—leaving excessive concentration risk—or too quickly, triggering an avoidable tax event. The IPS is not paperwork; it is the decision framework that governs every trade and keeps emotion out of execution.

Choosing a Target Portfolio with High Correlation to the Original Position

This is the most common structural error. Selecting broadly diversified-seeming funds or ETFs that still carry heavy exposure to the same sector or company as the concentrated holding defeats the purpose of the SMA's customization advantage. If you're diversifying out of a mega-cap tech stock, replacing it with a growth index fund that allocates 30% to the same sector provides minimal actual diversification.

Ignoring the Wash Sale Rule When Pairing Loss Harvesting with Reinvestment

When you sell a depreciated security to harvest a loss and immediately buy back a substantially identical security within 30 days, the IRS disallows the loss under 26 U.S. Code § 1091. In an SMA context, this requires careful coordination between the securities being sold and the replacement holdings.

Custom SMAs navigate this by purchasing correlated but not substantially identical proxy securities during the 30-day window. This preserves market exposure while keeping the harvested loss intact — but it requires precise security selection and timing that an advisor manages on your behalf.

Alternatives to Custom SMAs for Concentrated Positions

Custom SMAs are powerful but not universally appropriate. The right fit depends on portfolio size, timeline, tax situation, and complexity. The three most common alternatives each solve a different version of the problem.

Exchange Funds

Exchange funds work best for investors with very large concentrated positions (often $1 million+) who want immediate diversification without triggering a taxable sale. The fund pools contributed stock across multiple investors' positions, delivering built-in diversification at the cost of control and liquidity.

Trade-offs to weigh:

• Requires a 7-year lock-up to satisfy IRS requirements
• No choice over which holdings you receive in return
• Requires Qualified Purchaser status ($5 million in investments) or Accredited Investor status
• Annual fees run 0.85%–0.95%, with upfront fees up to 1.5%
• Must invest at least 20% in qualifying illiquid assets (typically real estate) to satisfy IRS requirements

Charitable Strategies (Donor-Advised Funds, CRTs)

This approach suits investors with genuine philanthropic goals who hold highly appreciated stock. Donating shares directly to a donor-advised fund (DAF) or charitable remainder trust (CRT) avoids capital gains tax on the contributed shares entirely, while generating a charitable deduction.

That said, the structure comes with real constraints:

• Contributions of appreciated capital gain property are limited to 30% of Adjusted Gross Income for DAFs
• CRTs require the charitable remainder's present value to equal at least 10% of the initial contribution
• A CRT provides income but ultimately transfers assets to charity — a poor fit if leaving wealth to heirs is a priority
• Assets cannot be reclaimed once contributed

Covered Call Strategies or Collars

Collars work for investors who want to reduce downside risk on a concentrated position without selling. Buying a put and selling a call caps both losses and gains — useful as a bridge while planning a longer-term exit, but not a permanent solution.

Key limitations:

• The CBOE S&P 500 95-110 Collar Index returned just 3.2% annualized from 1986–2014, versus 7.3% for the S&P 500
• Requires active management and continuous rolling of positions to maintain protection
• Reduces volatility but leaves the underlying concentration intact
• Most effective as a temporary hold while a permanent diversification plan is put in place

Frequently Asked Questions

What is considered a "concentrated" portfolio?

While definitions vary, most financial advisors consider a position concentrated when a single stock or sector accounts for more than 10–20% of total investable assets. The concern grows significantly as that percentage rises above 30–40%, where single-stock risk begins to dominate portfolio outcomes.

How is a custom SMA different from a mutual fund or ETF for managing a concentrated position?

Unlike a fund, a custom SMA gives the investor direct ownership of individual securities, so the advisor controls exactly which tax lots are sold, when, and in what quantities. Mutual funds must distribute at least 98% of realized gains annually—creating tax liabilities even for investors who never sold a share—a problem SMAs avoid entirely.

What is the minimum investment typically required for a custom SMA?

Minimums vary by manager and custodian. Direct indexing options now start as low as $5,000 at providers like Fidelity, while traditional custom SMAs typically require $100,000 to $250,000. Below certain thresholds, direct indexing or ETF-based approaches may offer comparable benefits at lower entry points.

Can I diversify a concentrated position without triggering a large tax bill?

Taxes rarely disappear entirely, but a custom SMA's tools—multi-year staged selling, tax-lot selection, and loss harvesting—can meaningfully reduce and defer the impact compared to an outright sale. The goal is spreading gains across multiple years to stay within favorable tax brackets while steadily reducing concentration risk.

How long does it typically take to fully diversify a concentrated position using an SMA?

The timeline depends on the size of the embedded gain, your tax bracket, and how aggressive the transition plan is. Multi-year transitions of 3–7 years are common for large, highly appreciated positions; faster timelines become viable when cost basis is higher or when investors move into lower-income years—such as early retirement.

What happens to my concentrated position if the stock drops significantly during the transition?

A market decline reduces the capital gains tax owed on remaining shares—lower price, lower gain—which can actually accelerate the transition. A well-designed IPS builds in contingency rules from the start, so you can increase selling when tax costs drop without letting market emotions override the plan.