by Tom Boczar and Liz Ostrander
Public-company executives and employees, trustees of trusts, and other investors with highly appreciated stock positions often try to diversify out of their positions over time using outright sales and tools such as exchange funds, equity derivatives and charitable remainder trusts. However, for many reasons (i.e., tax and estate-planning considerations, a strong emotional attachment to the stock, restrictions on the shares, or a strong belief in the future upside potential of the stock) they often retain a significant portion of their concentrated positions as core, long-term holdings that are left unhedged and remain major risk exposures relative to their net worth.
Holding a concentrated position for a long-term period without protection is riskier than most investors realize. According to J.P. Morgan, since 1980, approximately 320 stocks were removed from the S&P 500 due to “business distress.” And according to Goldman Sachs, over the past 30 years, 25 percent of the stocks in the Russell 1000 (representing about 90 percent of the investable U.S. equity market) suffered a permanent loss of capital (i.e., lost more than 75 percent of their value and did not recover to 50 percent of their original value within the last 30-year period as of December 2015).
Investors can use equity derivatives, such as puts and collars, to mitigate their downside risk, but they are costly and used mostly for short-term protection. Exchange funds can be useful to executives who wish to diversify out of some of their company stock position but can’t be used to protect shares that an executive wishes to keep. The use of either triggers a reportable event for public-company affiliates.
Stock protection funds (SPFs) are a recent development. They can be helpful to investors who wish to keep some or all of their stock position as a core, long-term holding, by allowing them to affordably preserve their unrealized gains and keep all upside potential (check out the CFA Institute's “Take 15” video).
SPFs marry modern portfolio theory (MPT) with risk pooling/insurance. MPT demonstrates that over time there will be substantial dispersion in individual stock performance. Risk pooling makes it possible to cost-effectively spread similar financial risk evenly among participants in a self-funded plan designed to protect against catastrophic loss. By integrating these principles, SPFs provide downside protection akin to that of at-the-money or slightly out-of-the-money European-style put options, but at a fraction of the cost.
Here’s how they work. Investors, each owning a stock in a different industry and seeking to protect the same notional value of stock, contribute a modest amount of cash (not shares, which they can continue to own) into a fund that terminates in five years. The cash is invested solely in U.S. Treasury bonds that mature in five years, and on termination, the cash is distributed to investors whose stocks have lost value on a total-return basis.
Losses are reimbursed using a “reverse waterfall” methodology until the cash pool is depleted. If the cash pool exceeds the aggregate losses (approximately a 70 percent probability based on extensive back-testing), all losses are eliminated, and the excess cash is returned to investors. If the aggregate losses exceed the cash pool (approximately a 30 percent probability based on extensive back-testing), large losses are substantially reduced.
The shares being protected are not pledged or encumbered in any way, and investors can continue to own their shares, or can sell, gift, donate, pledge, borrow against or otherwise dispose of them at any time during the five-year term of the SPF.
Public-company executives and employees can use an SPF to protect both stock and stock-linked compensation, such as RSU, SAR, NQO, ISO and ESPP, and doing so does not cause a reportable event for company insiders.
A Protection Fund is tax efficient in that it doesn’t cause a constructive sale, the straddle rules don’t apply, dividends received remain qualified for long-term capital-gain treatment, and the distribution on termination of the Protection Fund will result in either long-term capital gain or currently deductible capital loss.
The use of a Protection Fund can be cashless if funded through a margin or private banking loan against the stock position being protected; therefore, the investor’s existing asset allocation needn’t be disturbed.
SPFs add a new and desirable dimension to the portfolio-construction process for investors with concentrated positions. They can continue to “chip away” at and diversify their concentrated positions over time using the traditional tools, while using a Protection Fund to cost-effectively and tax-efficiently de-risk that portion of their position that they wish to retain as a core, long-term holding. Investors can also use a Protection Fund to protect new concentrated stock investments they make based on fundamental equity research should one of their investment objectives be to create substantial, aspirational wealth.
Tom Boczar, LLM, CFA, CPWA, is CEO of Intelligent Edge Advisors. Reach him at [email protected]
Liz Ostrander, CFA, is managing director at Intelligent Edge Advisors. Reach her at [email protected]