After an 11-year bull market and 2020's liquidity fueled recovery, family offices, corporate executives, and wealthy investors face a situation where they may own outsized concentrated single-stock positions with a low-cost basis and high unrealized gains. This creates a conundrum. Should the investor reduce portfolio risk exposure and incur a tax liability? Or, should they avoid paying taxes today and take their chances that capital gains tax rates don't rise, and the concentrated stock price won't fall.
The good news is that investors have options.
A completion strategy manages the single position's risk exposure by gradually selling small portions of the holding and reinvesting the money to purchase a more diversified portfolio. Unlike an exchange fund (mentioned below), the investor remains in control of the assets and can complete the desired diversification within a specified time frame.
Example: Suppose you own $5 million worth of ABC Corp. stock, and you want to reduce your exposure to this stock, but you have a $2 million unrealized gain after a decade-long bull market. Instead of selling the position, realizing the gain, and paying tax, you could choose to sell 20% of the position each year over the next five years and reinvest the proceeds into a well-diversified, risk-managed portfolio. Over time, the investor achieves a fully diversified portfolio aligned with their objectives and reduces the concentration risk created by ABC Corp's stock.
An exchange fund pools an investor's concentrated position in ABC Corp. stock with 20-25 investors in a similar conundrum with concentrated positions in different discrete equity holdings. The concentrated shares go into a private placement "partnership," and each investor receives a pro-rata share of the exchange fund. Now the owner of ABC Corp. stock owns a pro-rata share of a diversified fund with 20-25 other stocks. The stock position is still subject to market gyrations, but the exchange funds allow the deferral of taxes and diversification.
An equity collar involves the purchase of a long-dated put option on the concentrated stock holding combined with the sale of a long-dated call option. The collar leaves room for potential gains and losses. The put option gives the owner the right to sell their stock position at a given price in the future, providing downside protection. The sale of the call option provides premium income.
With a variable prepaid forward, the owner agrees to sell the stock at a future date in exchange for a cash advance at the present rate. The benefits are immediate liquidity, deferral of capital gains, and flexibility.
For family offices, corporate executives, and wealthy investors, the biggest hurdle to diversifying low-cost stock is paying tax on the capital gains. However, if those stocks take a hit, they can have an outsized impact on portfolio performance, increasing the investor's risk of missing their investment objectives.
While RiskBridge Advisors believes that we are in the early stage of a new economic cycle, there is no assurance the stocks that led the last bull market will propel the next bull market. After years of outsized, liquidity fueled gains, we believe investors may have the wrong quantity and type of risks in their portfolio. This is especially true if they hold large, concentrated positions in single securities. All is not lost, however. Investors are in control. To learn more or request a portfolio review, please contact RiskBridge Advisors.
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DISCLOSURE: Past performance is no guarantee of future results. Investment involves risk.
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This material is distributed solely for informational purposes only and is not a solicitation or an offer to buy any security or instrument or participate in any trading strategy. All material presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed, and RiskBridge makes no representation as to its accuracy or completeness. Securities highlighted or discussed in this communication are mentioned for illustrative purposes only and are not necessarily recommended for investment. Any opinions, recommendations, and assumptions included in this presentation are based upon current market conditions, reflect our judgment as of the date of this material, and are subject to change. All investments involve risk, including the loss of principal. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy. Risk Report and this information are not intended to provide investment, tax, or legal advice.