Strategies For Handling Concentrated Stock Positions
The very asset responsible for helping to create wealth in your portfolio may eventually become one of the biggest risks to your financial peace of mind.
Some investors have amassed personal wealth through equity-based compensation, the inheritance of a sizeable single stock position, or from receiving stock in a publicly traded company as part of the sale of a closely held business.
These situations could result in too high of a concentration of assets in a single investment, typically in the form of common stock. Ironically the very asset responsible for helping to create wealth might eventually become one of the biggest risks to an investor’s financial peace of mind. At Mariner Wealth Advisors, we offer assistance in managing this risk and can help coordinate the effort as part of a comprehensive personal wealth management plan.
Some investors might find themselves with a large position in a single stock. Some may even develop an emotional attachment to a stock, driven by a sense of loyalty, bullish sentiments regarding the company’s future, concerns of being a corporate insider, or simply for practical tax reasons. Sometimes, the investor simply adheres to an, “if it isn’t broken, don’t fix it” philosophy. Unfortunately, circumstances might change, and good things don’t always last forever.
Outsized or concentrated positions in a single stock might expose an investor to excessive (and potentially uncompensated) risks. As one example, a blue-chip stock could lose its allure abruptly, resulting in a steep price decline. Alternately, for example, a company could experience cyclical swings in profitability, which might cause its stock price to materially deviate from the broader market. And the broad equity market historically has had its own ups and downs.
It’s a good idea to consider diversifying your portfolio across asset classes. Regardless of the history associated with a concentrated stock position, its existence potentially produces unnecessary risks, particularly over time as your objectives and needs evolve.
For these reasons it is recommended that you evaluate stock concentration before circumstances demand it. Working with an advisor is designed to help you see the larger picture so you can develop a coordinated plan to diversify your portfolio to help protect your net worth.
At Mariner Wealth Advisors, we provide experience and advice on various strategies or options available to help you divest and diversify, including:
Incrementally Selling Shares
A sale of stock is might be the most appropriate and simplest means of reducing a concentrated stock position. Tax considerations, potential market impact, reinvestment of proceeds and timing of sales, however, are all elements for you to consider within the context of a coordinated personal wealth management plan.
If your shares are subject to Rule 144 (or are otherwise subject to restrictions) additional considerations might be appropriate. For example, filing for a 10b5-1 plan to demonstrate your selling decisions in advance, while specifying a formula to control the trading of the shares over a specific period of time, might be appropriate. Alternatively, you and your advisor may want to discuss the use of a blind trust. A blind trust may be managed by a discretionary trustee who can determine how much will be sold, at what price and when. A trustee can also consider incorporating various hedging strategies.
Net Unrealized Appreciation (NUA)
An NUA strategy allows investors to pull low basis, highly appreciated stock out of the corporate retirement account and pay ordinary income tax on the basis only. Because the stock is removed from the qualified account, the net unrealized appreciation, or the difference between the basis and the current price, is taxed when it is sold at a long-term capital gain.
Utilizing Options to Hedge the Position
You also might consider using singular or multiple combinations of options to help guard against a significant drop in stock value. For example, purchasing a put option is similar to buying insurance against the risk of loss (below a certain level) in your stock. A protective put option provides an investor the right (but not the obligation) to sell all or a portion of his or her shares at a predetermined price. Similar to insurance, if the price of the stock goes up, the value of the option could expire worthless. For this reason, purchasing puts should only be considered as part of a comprehensive plan. At Mariner Wealth Advisors, we have internal staff with experience in providing analysis on the relative opportunities and risks of this strategy.
In addition to purchasing puts, selling call options (attached to the underlying stock position) can provide income (and some level of price protection) against a decline in share value. Selling call options limits participation in future price appreciation, so it should be considered as part of a larger, systematic strategy.
In addition to standalone puts or calls, you may also want to consider option combinations. For example, a cashless collar combines the two previous strategies of buying protective puts while also selling calls. Based on market pricing and parameters, premiums received from selling the call options may partially or fully offset the cost of buying the put option (and thus the “cashless” reference).
The components of a cashless collar are as follows:
- Purchasing a put gives the investor the right (but not the obligation) to sell stock at a predetermined price.
- Simultaneously, the investor may sell a call, providing another investor the right to purchase the stock at a predetermined price.
- The premium earned on the call may be used to offset the cost of the put.
- The taxability of this option contribution differs, based on the underlying components and their tenure, and must be analyzed as part of the larger strategy in advance.
- Hedging incentive stock options before or shortly after exercise creates a separate and special set of considerations, since hedging during the first year after exercise might be a disqualifying disposition and trigger ordinary income taxes.
- In addition to general taxability, special tax rules might apply, as some transactions could be considered a “constructive sale.” Consider seeking the advice of a tax professional before beginning an options-based disposition strategy.
- Mariner Wealth Advisors retains internal tax professionals, along with dedicated options specialists to assist in designing a customized plan.
Gifts of Stock
Outright gifts of concentrated stock might be a part of a larger plan but should be considered within the context of an investor’s estate and estate taxes.
Gifts are subject to annual limitations (as to taxability). Our wealth advisors coordinate with our in-house estate and tax professionals, who are available to help analyze your estate or estate tax considerations in advance.
Donate Shares to a Trust
By donating highly appreciated stock to a charitable remainder trust (CRT), you might be eligible to receive a tax deduction at the time of the contribution. The trust’s future payout rate may be managed in a manner conducive to income objectives or tax planning, as appropriate.
Gifts to the trust would be treated as irrevocable donations that could subsequently be sold to diversify or to create income. In most circumstances these sales would not trigger immediate capital gains tax at the time of sale.
In addition to these more common tools, there are several methods to manage concentrated positions, although they often involve additional risks, costs and complexity. These include:
Borrow to Diversify
If an investor is precluded from selling shares (either by choice or by legal mandate), the concentrated position might be available as collateral for a margin loan. Proceeds from the loan might be used to improve portfolio diversification, through the purchase of complementary options or securities.
Trading securities in a margin account involves significant risk, however, so consider working with your wealth advisor to thoroughly research and discuss this option in advance.
A pairs trading strategy involves holding both long and short positions in similar securities. A security held short is one that has been sold without first owning the security. By combining the concentrated stock position (as the long position) with a similar security held short, price movements in one might be effectively offset with opposite movements in the other.
Pairs trading is intended to offset the systematic (or broad) risks inherent in a stock, as it relies on the two stocks reacting similarly to common influences. Holding these offsetting positions does not hedge all price risk, however, including the risks specific to a single stock (also known as idiosyncratic risk), versus the general risks associated with an industry or market.
In addition, short selling introduces multiple levels of complexity. Given the potential hedging imperfections, and for reasons associated with legal, tax and regulatory complexity, pairs trading requires significant advance analysis.
Exchanging Shares via an Exchange Fund
One final option available for consideration involves the exchange of a concentrated stock position for shares in an exchange fund. An exchange fund is a private placement limited partnership vehicle that pools the shares contributed by each limited partner. From this collection of concentrated positions, the fund manager seeks to employ various versions of the strategies above to create a portfolio that exhibits greater diversification (and therefore less risk) than any single contributed position. Each shareholder who contributed shares is given a pro-rated claim on the pool assets. Immediate liquidity is either not allowed or severely limited, but by pooling multiple positions and managing around them, the goal is to create greater safety, while potentially minimizing negative tax impacts.
Exchange funds have several characteristics that might make them less attractive. In addition to a lack of liquidity, exchange funds typically provide no (or very little) current income. Exchange funds also typically have high fees, which might reduce the overall value of the fund over time. Contributing investors typically have little to no control over the management (or contents) of the fund and rely almost exclusively on the fund manager for the fund outcomes.
Because exchange funds are private placements, some investors may not meet the SEC’s minimum qualifications as a partner. In addition, many exchange funds have significant minimum balance requirements. Exchange fund performance is not guaranteed, and the tax laws and regulatory requirements surrounding exchange funds are subject to change.
Consequently, and as with several of these strategies, you should only consider an exchange fund after a thorough review and analysis with your wealth advisor and within the context of a broader personal planning strategy.
Concentrated stock positions can represent a fortunate outcome for some investors. Concentrated positions introduce significant potential risks, however, that you should carefully consider.
Mariner Wealth Advisors offers the professional resources necessary to fully analyze your situation. We will work to develop a strategy that considers your objectives and time horizon, how your securities are titled and any restrictions that apply, while simultaneously considering your investment objectives, including charitable aspirations, as well as applicable fees, costs, complexity and potential tax impact.
For additional information about managing your concentrated stock position, please contact your wealth advisor.
This article is limited to the dissemination of general information pertaining to Mariner Wealth Advisors’ investment advisory services and general economic market conditions. The views expressed are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. As such, the information contained herein is not intended to be personal legal, investment or tax advice or a solicitation to buy or sell any security or engage in a particular investment strategy. Nothing herein should be relied upon as such, and there is no guarantee that any claims made will come to pass. Any opinions and forecasts contained herein are based on information and sources of information deemed to be reliable, but Mariner Wealth Advisors does not warrant the accuracy of the information that this opinion and forecast is based upon. You should note that the materials are provided “as is” without any express or implied warranties. Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. Past performance does not guarantee future results. Consult your financial professional before making any investment decision.
Options trading involves a significant degree of risk and the risk of loss in trading options can be substantial. Clients and prospective clients should carefully consider whether such trading is suitable for them in light of their financial condition and individual risk tolerances. The high degree of leverage that is often obtainable in options trading can work against investors, as well as for them. More information on the risks of buying and selling options contracts can be found on the CBOE’s website at www.cboe.com.
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