“With the longest bull market in our nation’s history, now is the time to protect the larger portion of your wealth.”
If you have a highly appreciated, concentrated stock position, you have likely invested in, or inherited, one or two stocks that have done exceptionally well. Alternately, your career success has allowed you to amass a considerable exposure to shares in the company you work for.
With the current bull market having officially become the longest in our nation’s history, now may be a very good time to shift your focus toward protecting those few assets that account for an oversized portion of your wealth. But first you have to protect yourself against risk.
Following are two compelling strategies you can employ to help mitigate the excessive risk associated with holding a concentrated stock position.
STRATEGY 1: DIVERSIFY THROUGH
AN EXCHANGE FUND
Not to be confused with ETFs, exchange funds (or “swap funds”) are investment pools specifically designed to help diversify your highly appreciated, concentrated stock position without your having to sell shares, which would trigger capital gains taxes. Each investor in an exchange fund contributes his or her shares of a concentrated stock position in “exchange” for an interest in the fund, which is benchmarked to a specific index.
In this way, you, as an investor, gain exposure to a diversified pool of stocks while retaining the original cost basis of the stock you contributed (allowing the larger, pretax amount to continue compounding). After seven years from the subscription date, you receive a diversified basket of stocks with sector representation similar to the fund’s target benchmark.
Not that you have to sit around passively for seven years. Instead, during those initial years of subscription, you can claw back your shares, but only at the lesser value of your contributed stock or the value of your interest in the fund. (Typically, a one-year lockup is required and a 1 percent redemption fee applies for the first three years.) Also, should you happen to die before the seven-year commitment is up, your heirs will receive the step up in basis and be allowed to redeem out of the fund.
To participate, investors must be “qualified purchasers” (meaning they have $5 million or more of investable assets) and must contribute a minimum of $500,000 in securities. Further, dividends from contributed stock are retained as part of the fund’s operating cash flow. These dividends then pay down the loans on the 20 percent of the exchange fund portfolio that must be in qualifying assets (real estate) for the fund to qualify as nontaxable.
STRATEGY 2: PROTECT THE DOWNSIDE/ GENERATE INCOME WITH AN OPTIONS COLLAR STRATEGY
If the prospect of a seven-year lockup or the loss of regular dividend income is a nonstarter, you may want to consider an options collar. This strategy allows you to hold on to a concentrated stock position—and continue receiving any dividends it provides—while limiting your downside risk and generating additional income from selling options.
By simultaneously establishing put and call options on your shares, you can ensure that the stock will retain a value between a minimum and maximum price for the period the options cover. And, because options collars typically aren’t set too far into the future, they can be closed out and renewed based on any price movement of the underlying stock.
If you employ this second approach, make sure your advisor uses cost-effective options experts who can generate enough premium on the options to more than cover all management fees and transaction costs, and thus provide you with a net return. At SEIA, we’re even able to provide clients with a no-call-away provision that ensures they will never be forced to sell their original low-basis shares regardless of how the stock price performs.
Keep in mind that these are just two among several potential strategies to diversify or mitigate the risk of a concentrated stock holding, and they should be considered within the context of your overall wealth-planning strategy.
Your financial advisor can help identify which solution is best for your circumstances and long-term goals, but don’t procrastinate. The time to act is now, because the bull market won’t last forever.