Investment Strategies - Concentrated Stock Portfolio Strategies

Concentrated stock positions may or may not be a significant risk factor, depending upon what percentage the stock is of the investor's total portfolio. Strategies to address the risk of excess concentration involve monetization and hedging, namely the reduction in the amount of stock held in a manner designed to achieve simultaneous diversification and a manageable tax liability, all the while attempting to minimize any reduction in the portfolio's value. Planners need to be mindful of any restrictions on a sale due to securities law. What follows are some of the more common approaches to the risk management of concentrated portfolios.

  1. Immediate Sale - the portfolio is sold, freeing the client from considerable potential downside risk and enabling him or her to reinvest proceeds immediately. The investor loses equally quickly the benefits of any sizable appreciation and will probably face a significant tax liability if the basis of the stock was low.
  2. Separate Account Workout (tax managed index separate account) - here, the separate account manager looks to reduce the concentrated position through gradual sales, carefully orchestrated to benefit from timing and the minimization of tax impact. The goal is to diversify assets consistent with the client's specific goals. A tax managed index separate account is a typical strategy of this type. The strategy provides moderate liquidity as proceeds become available through gradual exit, enabling diversification and tax liability management.
  3. Equity Collar - this approach utilizes options to facilitate a gradual exit while preserving value. A client may not wish to sell until his stock options are vested or may not be able to sell until SEC restrictions are satisfied. The collar, a type of options strategy known as a straddle, involves the simultaneous sale of a call option and purchase of a put. This two-part transaction brackets the value of the portfolio. The put price is the floor and the call price the ceiling. Planners should consult experienced tax counsel as such strategies may engender unwanted tax liabilities if not structured with a proper view toward current tax law.
  4. Prepaid Variable Forward - a forward contact is, in essence, a futures contract that is custom tailored to a client's unique circumstances, here, the monetization of a large position in a single stock. This approach affords the investor a similar risk management outcome, bracketing the stock's potential for appreciation and decline. The client agrees to sell a quantity of stock at a future date within a specified price range. In economic terms, it is similar in operation to an equity collar.
  5. Exchange Fund - an investor contributes shares of low basis stock to a fund with other investors holding similar basis stock in other companies. In exchange, the investor receives shares in the fund which holds a diversified basket of stocks. This approach enables the investor to postpone recognition of a gain, so long as the investor holds onto the share basket for seven years. 20% of the exchange fund's shares must be invested in relatively illiquid shares. At the conclusion of the seven (7) year term, the client receives a pro-rata share of the more diversified portfolio, yet with the original basis of the shares in the concentrated portfolio. The target portfolio may not afford the investor the best trade-off in terms of diversification and risk/reward.
  6. Borrow on margin - the investor borrows money to purchase a diversified portfolio of shares while still holding the concentrated portfolio. This approach affords the investor only partial diversification as the original stock position is retained, offering substantial potential for both appreciation and price decline. Margin involves balance maintenance requirements.
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