AQR's latest: direct indexing "largely ineffective" at culling single-stock risk
Completion portfolios are an incomplete solution
We find little empirical evidence that the completion portfolio approach helps hedge the risk of concentrated stock positions.
AQR’s latest paper, Are Completion Portfolios Effective for Managing Concentrated Stock Risk? considers whether direct indexing (or the broader strategy called a “completion portfolio”) is any good.
Most people don’t know what a “completion portfolio” is, but I see this strategy for de-risking single-stock concentration in product pitches regularly. It goes like this…
Investor has a concentrated position (e.g. 40% of their net worth is invested in a single, publicly-traded stock with low cost basis)
Investor would like to reduce risk, but wishes to do so without realizing net capital gains
A vendor pitches the investor on selling, say, 20% of their concentrated position, realizing capital gains, and investing the proceeds in a diversified strategy, oftentimes direct indexing or something similar
Over time, the direct indexing portfolio harvests losses, and they usually harvest an equal amount of gains from the concentrated position
The proceeds are reinvested in the completion/direct indexing portfolio
Thus, over time, the completion portfolio becomes 100% of the investor’s assets, and diversification is achieved
But…
AQR says direct indexing is “largely ineffective” at reducing expected and realized risk because:
Completion portfolios hedge common, not stock-specific risk
"losses realized by direct-indexing strategies are typically small," meaning unwinding (under the assumptions in the image below) leaves investors exposed
They are also "highly variable depending on the market environment"
Worse… “To add insult to injury, as a stock’s volatility increases - and therefore the need for de-risking becomes more urgent - the stock-specific risk becomes a larger contributor to the stock’s total risk.”
They compare completion portfolios to tax-aware long/short strategies, which tend to reduce concentrated positions quicker than direct indexing and, therefore, also reduce overall portfolio risk faster.
There are other ways to de-risk (see meme below), but in this paper, AQR shows that tax-aware long/short strategies generally do a better job than a completion portfolio.
I heard 7 of these earlier this week…
