Be Wary Of Concentrated Portfolios

[If] the customer nevertheless insists on concentrating his portfolio in a few aggressive growth stocks, abandoning diversification, the investment advisor, after informing the customer of the risks of concentration, should obtain the customer’s express acknowledgement of the admonitions and his authorization to pursue this strategy. In essence, the customer would be expressly authorizing the investment advisor to give advice that, by objective standards, might amount to malpractice. Thus, brokers need to appreciate that concentration is viewed as a risky strategy. Much like the use of margin, brokers must carefully discuss the risks of that strategy with their clients in advance.

Second, what percentage constitutes over-concentration? The answer appears to depend upon the investment objectives of the customer. In one disciplinary decision, for example, the National Business Conduct Committee of the NASD (NBCC) found that the investments were unsuitable and also found “concentrations too high given the investors’ age, financial condition, sophistication and investment objectives”. Courts and regulators have found over-concentration in cases ranging from a high of 100% concentration to a low of 50% concentration of account (except for the court decision discussed below). That said, one NBCC decision found 25% concentration to be acceptable, but “at the high end of the acceptable range”, given the investor’s financial situation, needs and objectives. In the decision finding over-concentration with 50% concentration, the NASD NBCC focused upon the fact that the investor, a widow, needed a secure stream of income. The NBCC disciplined the broker, finding that he did not satisfy this objective by placing 50% of the assets in illiquid investments that offered an uncertain rate of return.

Third, how is the percentage calculated? Most courts and regulators calculate the percentage by measuring the challenged investment as against the total market value of the account. However, a recent decision from the 9th Circuit Court of Appeals (covering California, for example) affirmed an order by the SEC sustaining a NASD disciplinary decision. There the appeals court opined that measuring the challenged investment against the investor’s net worth, and not as against the account market value, was “more relevant”. The court upheld the SEC’s and NASD’s view that investing 25% of the investor’s net worth constituted over-concentration.

Finally, an ERISA plan requires careful analysis. For example, by statute the diversification requirement does not apply to holding qualified employer securities in an eligible individual account plan. Hence, 100% concentration may be permissible. On the other hand, courts have identified several factors that must be considered in determining the degree of concentration that would violate ERISA’s diversification requirement. These factors include the purposes of the plan, financial conditions, distribution as to geographical location and distribution as to industry, as well as dates of maturity. Thus, one court concluded that investments of 15% in zero coupon bonds (with a different maturity date) and 70% in government bonds (with a single maturity date) were not diversified because they exposed the plan to liquidity risk.