Managing Concentrated Equity Positions
Friends – A common conversation we have with clients is how to manage a concentration they have accumulated (or are in the process of accumulating) in a single investment. A concentration can develop in a number of ways – the most common scenario is in your employer’s stock acquired through various methods (retirement plans, equity awards, exercising options, stock purchase programs, etc.), but we also see concentrations as a result of an inheritance, ongoing purchases or simply long-term outperformance of a particular investment.
And while concentrated investments can work particularly well when they move in your favor, they can also present outsized risk if they turn the other way. Which is why we make it a particular focus of conversations with clients to proactively address these risks in their financial plans. But doing so is often easier said than done – there are often significant barriers to reducing a concentration, including psychological, behavioral, financial and tax-related.
To that end, I’ve outlined a number of the steps and strategies we discuss with clients as part of the process of managing their concentrated investments.
Understand the Risk – The first step to managing a concentrated investment position is understanding the risk involved. We begin by totaling the entirety of the position across all sources – shares owned outright, in retirement plans, vested or unvested shares, etc., viewing it as a percentage of total investments and setting targets for how large to allow a concentration to become before taking action. Often this may be anywhere from 5% or more, depending on the nature of the investment, tolerance for risk, etc. And while it’s common to feel like an investment could never turn against you and will continue to grow indefinitely, especially at your employer where you may be particularly comfortable, it’s important to remember that employees likely felt similarly at Lehman Brothers and Enron before their demise.
Make Outright Sales – The most common way to reduce a concentrated position is through an outright sale to raise cash. If the investment is liquid this can be very straightforward, but you’ll want to be mindful of not trying to hang on too long and “time” the market. Often it can be helpful to schedule sales on a pre-determined basis (i.e. selling a certain number of shares quarterly). If you’re considered an insider at a publicly traded company with restrictions on when you are able to sell shares, this can be done through what is known as a 10b5-1 plan.
Donate Highly Appreciated Shares – One of the easiest and most tax-efficient ways of diversifying a concentrated equity position is by donating shares outright to favored charities, as opposed to giving cash. If the shares you donate have been held for more than one year, you are able to receive a deduction for the full present value of the shares, while also foregoing any taxes that would have been generated by realizing capital gains if you sold the shares outright.
Select the Right Tax Lots – When both selling and donating shares, it is important to understand your cost basis and holding period for various tax lots (shares acquired on a specific date at a specific price). By selling shares with the highest cost basis you can help to minimize your capital gains or even harvest a loss in some cases. By donating shares with the lowest cost basis you can forego significant capital gains and amplify the impact of your gift.
Utilize Direct Indexing – Direct Indexing is a growing strategy that offers a number of benefits, including the ability to customize your portfolio, such as by excluding a specific stock to avoid inadvertently adding to your concentration, and by systematically harvesting tax losses that could then be used to offset capital gains elsewhere in your portfolio – for example, gains generated by sales made to reduce a concentrated equity position.
Sell Covered Calls – This strategy consists of writing a call that is covered by an equivalent long stock position according to The Options Industry Council. Please see optionseducation.org/strategies/all-strategies/covered-call-buy-write for a full description on how this strategy works.
Explore Exchange Funds – Another option for extremely large concentrations is what are known as exchange funds. These funds allow you to contribute your shares, along with other investors that are contributing their concentrated positions, into a pooled investment whereby you receive ownership in a diversified pool of investments. This allows you to remain invested while diversifying some of your single investment risk and defer realizing any capital gains until you sell down the road. These products are very complex and should be thoroughly discussed to understand if they’re appropriate for your situation.
Use Hedging Techniques – Additional options strategies are available to hedge the price of a particular investment, either by paying money to buy put options to guard against an outright decline while maintaining upside potential or lower-cost collar strategies that can help to essentially freeze the price of your shares within a certain range for a certain period of time. Any strategy involving options comes with additional complexity and you should consult with appropriate professionals.
Consider Net Unrealized Appreciation – For investors retiring with significant holdings of their employer’s stock in retirement plans, a strategy called net unrealized appreciation (NUA) can help to shift some of the tax on those shares from ordinary income to capital gains treatment. The complexities involved are beyond the scope of this blog, but it is important to be aware of and seek advice on this strategy before making any decisions around your accounts when retiring.
Borrow Against Shares – A final option if you do not have any intent to sell shares is to use them as leverage to borrow against, either for diversifying investments in the case of margin borrowing or to support liquidity for other purposes through what is known as a securities- based line of credit. Both of these strategies can provide significant and important optionality and should be considered within the context of your broader plan.
If you have any questions about managing a concentration in your investments, please don’t hesitate to reach out. We’re always happy to help.
