Managing Concentrated Stock Positions: Strategies for Savvy Investors
As an investor with a concentrated stock position, you may find yourself in what some call an “enviable dilemma.” While holding a significant amount of a single stock can lead to substantial wealth, it also comes with increased risk and potential tax implications. In this post, we’ll explore three powerful strategies to help you in managing a concentrated stock position effectively: exchange funds, covered calls, and equity access programs.
The Risks of Concentrated Stocks
Diversification is a fundamental investment principle for a reason. In fact, diversification of concentrated stock positions can help mitigate risks while optimizing returns. The charts below illustrate the reality that single-stock investments carry significantly more downside risk than diversified portfolios. While there’s a chance for outsized returns with individual stocks, the odds are stacked against it. Over the long term, a staggering 67% of single stocks underperformed the Russell 3000 index between 1987 and 2024. And diversified portfolios offer a smoother ride, with a much lower likelihood of extreme losses. The bell curve for diversified US equities shows a tighter distribution of returns, indicating less volatility and a greater chance of achieving average market returns. By spreading investments across multiple assets, investors can mitigate risk and improve their chances of achieving long-term financial goals.
So why do investors tend to hold onto their single stock positions? Often it comes down to one or more of the following factors:
1. Emotional Attachment
Many investors develop a strong emotional connection to a single stock, especially if it represents a company they worked for or an inheritance from a loved one. The personal significance of the investment can make it difficult to part with, even when diversification would reduce financial risk.
2. Potential Tax Implications
One of the primary concerns investors face when managing concentrated stock positions is the potential capital gains tax liability. Selling a concentrated stock position often triggers significant taxes, particularly if the stock has appreciated considerably over time. Investors may hesitate to diversify due to the immediate tax burden, preferring to explore strategies like holding the stock until death to achieve a step-up in basis for heirs.
3. Optimism About Future Growth
Investors may believe that the stock will continue to outperform the market, especially if it has delivered strong historical returns. This confidence in future growth, despite the inherent risks of concentration, can lead to reluctance to sell or hedge the position.
Strategies for Managing Concentrated Stock Positions
Given the inherent risks of holding a concentrated stock position, let’s explore three strategies that can help you manage and potentially extract more value from your holdings. These approaches can assist investors in reducing risk, generating income, and/or accessing liquidity while maintaining their stock ownership. Each strategy offers unique benefits and considerations, allowing you to tailor your approach to your specific financial goals and risk tolerance.
Let’s examine these strategies in detail:
Strategy 1: Exchange Funds
Exchange funds, also known as swap funds, offer a tax-efficient strategy for diversifying concentrated stock positions. Investors contribute their appreciated stock to a partnership, receiving units representing ownership in a diversified pool of securities. This approach provides immediate diversification while deferring capital gains taxes, making it attractive for those with low-cost basis stock or significant tax liabilities. However, participants forfeit future upside potential and dividends of their original stock and must commit to a multi-year holding period. Fund managers must approve stocks for inclusion so not all positions will qualify.
Strategy 2: Covered Calls
Optic Single Stock is an actively managed covered call strategy that offers a solution for investors who wish to maintain ownership of their concentrated stock position while generating income. A covered call strategy involves selling call options against owned stock, allowing the investor to collect option premiums. This approach enables clients to retain stock ownership and continue receiving dividends while potentially enhancing returns through income generation. The Optic Single Stock strategy is particularly suitable for investors who want to maintain their stock position but desire additional income. However, it’s important to note that this strategy provides limited downside protection, primarily through the income generated from option premiums (unless an option collar with protective puts is added to the strategy). Additionally, there’s a potential for underperformance if the stock price rises significantly, as the upside may be capped by the sold call options.
Strategy 3: Optic Equity Access
Optic Equity Access combines a collar option position against the concentrated stock to secure a cash-out loan that generates immediate liquidity. This innovative and tax-efficient diversification strategy allows clients to access up to 90% of their stock’s value while maintaining ownership and access to dividend income, if there is any. The strategy implements a collar by purchasing put options for downside protection and selling call options to offset costs, establishing a floor and ceiling on stock returns. Optic Equity Access is particularly suitable for investors who want cash to diversify their portfolio or to use for other purposes, especially if they remain bullish on their stock’s long-term prospects and don’t wish to sell and potentially generate a large capital gain. When the options in the collar come due, the investor may have the option of “rolling” into another position.
Conclusion
When deciding which approach to take to manage a concentrated stock position, consider your:
- Risk tolerance
- Liquidity needs
- Tax situation
- Long-term financial goals
Managing a concentrated stock position requires careful consideration of risk, tax implications, and your overall financial picture. By leveraging strategies like exchange funds, covered calls, and equity access programs, you can potentially reduce risk, generate income, or access liquidity while optimizing your portfolio for long-term success. Remember, each strategy comes with its own set of risks and considerations. Always consult with financial and tax advisors before implementing any new investment strategy, especially when dealing with concentrated stock positions.
Sources
1Blackrock. “Return Breakdown of the individual stocks inside the Russell 3000, 1987-2024.” Blackrock. Accessed on 8/27/2024 at: https://www.blackrock.com/us/financial-professionals/investments/products/managed-accounts/concentrated-stock.
Blackrock states: “The date used is from January 1987 through April 2024. The data includes all companies listed in the Russell 3000© Index except for those with noncontinuous return histories, approximately 9% of the data. End dates correspond to bankruptcy, termination, delisting, acquisitions/mergers, or the end of the study period. The Russell 3000© Index was used due to the size and scope of its holdings. The timeframe reflects the longest historical performance based on MSCI data at the time of analysis.”
2The Enviable Dilemma: Hold, Sell, or Hedge Highly Concentrated Stock? Boyle, Loewy, Reiss, Weiss. 2004. Accessed on 8/27/2024 at: https://www.analyticalsynthesis.com/Boyle_Loewy_Reiss_EnviableDilemma.pdf
Data analysis conducted by Bernstein, which modeled 10,000 possible outcomes to come up with the expected frequency shown on the vertical axis. The horizontal axis are compound annual returns. The chart does not represent any past performance and is not a promise of actual future results.
Important Disclosures
Optic Asset Management, a division of Watts Gwilliam & Company, LLC, is a registered investment advisor.
Options Trading Risks
Options involve risk and may not be suitable for all investors. Loss of principal may occur. Before trading options, you will receive the Characteristics and Risks of Standardized Options document, which can be found at www.theocc.com. You must be approved for options trading by the custodian before implementing an options strategy with Watts Gwilliam or Optic Asset Management.
Transaction Costs and Fees
Options trading involves significant costs and fees which will impact the overall performance of the strategy. It is important to understand these expenses and consider them when evaluating the potential return on an options strategy.
Potential for Underperformance
Some Optic strategies, like Optic Single Stock, seek to provide income through the receipt of option premiums, while attempting to provide you with appreciation in your underlying stock or index. While the goal of those strategies is to participate in as much upside as possible, the performance can’t be guaranteed. Portfolios may underperform in various market conditions.
Collar Strategy
Optic Equity Access utilizes a collar, which includes a long put option and a short call option, to help secure a portfolio margin loan against a long stock position. The use of the collar may limit profit potential if the security’s price rises above the call’s strike price and may provide limited downside protection only up to the put’s strike price.
Dual Investment Risks
Reinvesting Optic Equity Access loan proceeds into other securities creates risks, including increased portfolio leverage and exposure to market volatility, which could amplify losses. Both the concentrated stock position used as collateral and the reinvested proceeds may lose value at the same time. The new investments may lack liquidity and may impact the ability to repay the loan. Reinvesting in assets similar to the original concentrated stock may not yield the intended diversification.
Loan-Related Risks
In Optic Equity Access, the cash received is a loan backed by your securities, with variable interest rates and repayment terms. Interest and fees will affect the Strategy’s net performance. You must repay the loan at collar maturity, using either securities or cash. The long stock position serves as collateral, and failure to meet the loan terms could result in a margin call or loss of collateral. Accounts using Portfolio Margin must maintain over $100,000 in equity. If Portfolio Margin is terminated, you’ll face higher Reg T margin requirements. Read the custodian’s loan disclosures carefully.
Double Fees –Conflict of Interest
In Optic Equity Access, you are charged the same management fee on both the long value of the stock position (adjusted for the net value of the collar) without any offset for the loan, and on any loan proceeds that are reinvested and managed by us. The loan frees up liquidity that, when we invest it on your behalf, results in us benefitting by charging two sets of fees. We therefore have a conflict of interest in recommending this strategy.
Tax Risks
Neither Watts Gwilliam & Company, LLC, nor its Optic Asset Management division, provides tax advice. You should consult with a tax advisor before participating in Optic Equity Access transactions, including any rollover transactions.
The IRS’s ‘constructive sale’ rules under Section 1259 of the Internal Revenue Code are complex and ambiguous, lacking clear Safe Harbor guidelines. If the IRS determines that an initial or subsequent Optic Equity Access transaction constitutes a constructive sale, you may be required to recognize any previously unrealized gains on the underlying asset immediately, rather than at its maturity.
Neither Watts Gwilliam & Company, LLC, nor its Optic Asset Management division, will be liable for any IRS decisions requiring you to recognize unrealized gains or for any related taxes, penalties, fines, or fees you may owe.
Prepaid Variable Forward Contracts
The Optic Equity Access strategy is not a prepaid variable forward (PVF) contract.
