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The Private Wealth Group hosted the Single Stock Concentration and Risk Management workshop before a fully engaged audience on September 27, 2017.
Tom Boczar, CEO of Intelligent Edge Advisors LLC moderated the panel discussion. Mark Leeds, Mayer Brown’s Partner for Tax Transactions and Consulting discussed the tax ramifications of hedging single stock concentrated positions. Elizabeth Ostrander, Managing Director of Intelligent Edge Advisors compared the payoff profiles of the hedging methods discussed below. Brian Yolles, CEO of Stock Shield LLC, introduced the Stock Protection Fund, a recently developed technique which enables a group of single stock concentrated investors to “mutualize” their individual risk.
Key Points of the Discussion
Single stock concentrations are common
Many investors consciously maintain single stock concentrated positions. Their reasons vary:
- Bullish outlook for both price appreciation and dividend growth
- Emotional attachment, particularly for a stock that has been inherited
- Restrictions on selling, particularly for company “insiders”
- Potential incurrence of significant capital gains tax liability if the stock is sold.
While common, there are inherent risks whenever an investor maintains a single stock concentrated position. According to a recent JP Morgan study, 40% of Russell 3000 stocks have, since 1980, suffered a “permanent decline” of 70%.
Protecting against a “permanent decline” – the traditional methods
Equity Puts, Collars, Variable Forward Sales and “Short against the box” structures are regarded as “traditional” short-term protection strategies. While effective, these methods involve certain considerations. Puts can be very expensive to purchase. Collars, variable forward sales and “short against the box” each limit the investors upside return. All of these strategies may trigger tax related issues such as “straddles”, “qualified dividends” and “constructive sales” which may limit the economic opportunity of the underlying stock investment.
Completeness Portfolios and Exchange Funds are regarded as “traditional” long-term protection strategies. Each has certain advantages from both a cost and tax perspective in comparison to the short-term strategies. A primary consideration, however, of completeness portfolios and exchange funds is that, ultimately, the investor is forfeiting ownership of their underlying stock position.
Protecting against a “permanent decline” – a new method
The Stock Protection Fund (SPF) addresses the risk dilemma facing investors whose portfolios include single stock concentrated position(s) by combining the concepts of Risk Pooling and Modern Portfolio Theory. A SPF is an LLC structure in which investors (LLC members) retain their individual single stock positions and, simultaneously, create a cash pool to “mutualize” their individual downside risk.
SPF members are carefully selected based on their owning different stocks in different industries, with each seeking to protect the same value of stock. Each SPF member retains their stock and contributes cash into a pooled account. Upon maturity of the SPF (at least 5 years), the cash pool is returned to the members via a “distribution waterfall” whose priority is first for those members whose stocks had negative returns and then for those remaining members whose stock had a positive return. Ultimately, the entire cash pool is returned to the members. During the Financial Crisis (2006-2011), a SPF fund was operated for 20 SPF members. For 8 members whose stocks had negative returns, each was 100% reimbursed for the amount of their negative return, benefitting from what was economically equivalent to at-the-money put options. Since the cash pool exceeded the aggregate monies paid to the negative return investors, the 12 members whose stocks had a positive return received a “return of contribution” equal to 30% of their initial contribution; therefore, the annualized cost of this protection was only 1.38% per annum.
Federal Income Tax Issues
Mayer Brown has authored a tax opinion with respect to the SPF.
SPF is not a constructive sale since the investors retain all upside potential.
SPF does not trigger a tax straddle since the investor’s stock and SPF interest do not ”vary inversely”.
Dividends remain qualified for the same reasons the SPF does not trigger a tax straddle.
For investors, the knowledge shared in this workshop potentially broadens their investment opportunity set. Many investors maintain legacy single stock concentrated positions. Many other investors may wish to create single stock concentrated position(s) for aspirational wealth purposes. The tools discussed in this workshop enable the investor to intentionally maintain a single stock concentrated position(s) within the context of a purposeful risk management strategy.