This article is intended to provide an initial overview of some the different strategy options you may consider, with your Janney Financial Advisor, to protect and diversify highly concentrated stock positions in a way that coincides with your individual circumstances and full financial picture.
Highly concentrated stock can often mean more complexity and potential risks. Many investment professionals consider holding more that 10-15% of your investable assets in a single security to be risky. This type of concentrated stock position adds a great deal of risk and volatility by acting in a way that may reduce your overall portfolio diversification. And when the stock is your employer’s, those risks become more complex, in that it's possible that a bad turn for the business could lead to both the depletion of your wealth as well as a possible loss of your primary source of income.
Some Reasons Investors May be Reluctant to Sell
- A strong emotional connection to the stock
- Belief in the future share appreciation
- Potential tax consequences
- Loss of reliable dividend income
- Concern about market perception if they’re an ‘insider’
Fortunately, there are a variety of strategies which investors can use to manage the inherent risks of a concentrated portfolio These include outright sales, charitable gifts (outright or through a charitable remainder trust), as well as several investment solutions—depending on how you acquired the concentrated position, and your long-term goals.
Let's review six strategies to explore when considering diversification of a concentrated stock position.
1. Sell Your Shares
While selling can quickly free up funds which can then be deployed to diversify your portfolio, if you have a low cost basis, you’ll need to consider capital gains taxes. You might opt to sell shares over time—a strategy that may help to manage tax implications over time while having the opportunity to potentially participate in future growth.
- Consider setting up a systematic selling plan to sell down your stock over time. You can identify certain dates (or a frequency) to sell a specified quantity of shares.
This may have the effect of spreading your execution price over multiple transactions. You can also attempt to customize the capital gains you realize in any given year. If there are target stock prices you would like to achieve, you can set up a selling plan that is designed to sell a certain number of shares at specified price levels. While this may help increase your average selling price, the risk is that your stock may not reach the levels you set in your plan, and therefore negate any sale—leaving you exposed to the risks associated with a concentrated stock position.
- Alternatively, a transition strategy can help generate income from your stock while potentially selling it at prices above current market price. This strategy often appeals to investors who are seeking a disciplined approach to gradual selling. By utilizing call options, you create a contract between you and the buyer of the calls to sell them your stock at a specified price up until a defined expiration date. As you sell (or write) these call options, you’ll generate income from the premiums you receive. The buyer of these contracts then has the option to buy your stock at the contract price. During the selling period, your stock may be sold at higher prices, or may not appreciate. As your stock is called away, taxes will need to be paid on the realized gains.
- Are you an officer, director, large stock holder or other individual considered ‘an insider’ of the company that makes up your concentrated position? Whether you own restricted shares (or just want to avoid any perception of insider trading) you can set up a 10b5-1 plan1. The plan sets a predetermined schedule for selling shares over time—demonstrating that your selling decisions were made prior to you having any insider knowledge that could influence specific transactions.
2. Hedge Your Position
If you opt to hold on to your concentrated stock position, there are strategies you can employ to help minimize the impact of a significant price decline, otherwise known as downside protection. Here are a couple strategies to consider:
- Put Option Contract: One strategy to consider is to purchase a put option contract on the stock. A put option contract lets you sell the stock below a certain price level (the option’s ‘strike’ price). This acts as a floor that the stock price can’t go below; thereby creating your downside protection2.
- Zero-Premium Collar: A Zero-Premium Collar is another downside protection strategy in which you would purchase a put option contract. At the same time, you would also sell a call option contract that generates income for you as a result of the premium paid by the buyer. By using the call option premium to pay for the put option purchase, the transaction is zero cost.
Zero-Premium Collars are often used by investors who are legally restricted, or have practical limitations on selling their stock (e.g., restricted or unregistered stock, or stock with a low cost basis).
3. Generate Additional Yield or Income
In addition to generating income from writing covered calls, you may want to consider lending your stock to financial institutions through the Fully Paid Securities Lending Program3. In return, you receive a daily interest rate-based fee (paid to you monthly) while the stock is out on loan. The rate you earn will depend on the demand for the stock(s) available through your accounts. Of course, the downside to this strategy is that your security is being lent to cover short sale activity which can place downward pricing pressure on the stock. But that’s just one of many variables affecting the market price of a security. If you have a buy and hold approach with a long time horizon, this is an option to potentially generate additional portfolio yield.
4. Address Liquidity Needs
If you have a need for cash flow to make a large purchase, complete a home renovation, cover a tax obligation or other liquidity need, Securities-Based Lending4 has the potential to realize increased income on certain securities and does not provide any downside protection or “hedge” against the customer’s lending position(s) or portfolio.
You even may be able to utilize a strategy that lets you receive cash for a portion of your stock while deferring capital gains tax liability in a Variable Prepaid Forward contract. In this scenario, you would enter a contract that pays you cash for a portion of your stock’s current market value (generally 75-90%), in exchange for a variable number of shares in the future.
- You receive cash on a portion of the stock’s current market value—but the prepayment doesn’t trigger a realized capital gain tax as it’s essentially treated like a loan on the underlying security.
- The number of shares to be delivered or returned depends on the price of the stock at the end of the contract. You gain the possibility of protection against a stock price decline over the life of the contract, but you risk not participating in all the upside if the price appreciates over a specified level.
- The buyer of the contract does not take delivery of shares, and the seller is not required to deliver the shares until a future date (generally 2-3 years from the date of the contractual agreement).
Of course, you would be obligated to pay any capital gains, taxes upon contract settlement at expiration. Variable Prepaid Forward contracts involve complex tax and possible legal implications. Any decisions in this space should involve your tax and legal advisers where applicable to ensure all tax and legal considerations are taken into account.
5. Diversify While Minimizing Taxes
One option to consider is an Exchange Fund5. Specifically, this is a fund designed to help investors transition their concentrated stock risk in exchange for broad market exposure via the S&P 500 or S&P 1500—without paying any up-front capital gains taxes.
- You essentially give up your single stock exposure for a diversified portfolio and defer the capital gains on that stock until you liquidate money from the fund in the future;
- There are also key estate planning benefits associated with Exchange Funds, as your heirs may be able to receive a step-up in basis on the fund, without the concentration risk;
- At least 20% of the Exchange Fund must be invested in illiquid investments, generally real estate; and
- A fund may or may not accept the stock that you own.
The risk with transitioning your shares into this type of fund is if your original stock dramatically outpaces the broader market.
Another option is to consider diversifying your account by using margin lending to generate additional capital without incurring any tax consequences. You will have to pay interest on the margin loan until it’s paid back. It’s important to note, too, that when investing on margin you could be required to sell a portion of your account if you receive a ‘margin call’ because your account collateral falls below the required minimum. If a margin call occurs and you’re forced to sell positions, it could involve tax consequences due to realized gains4.
6. Donate Your Shares
If you’re charitably inclined, you might want to consider donating some or all of your concentrated stock to a Donor Advised Fund (DAF)6. Using a DAF, you would:
- Contribute stock to the fund and then make charitable donations from the fund over time;
- Proceeds of any stocks sold in the DAF are typically available to then be reallocated to a diversified portfolio;
- Depending on the size of your contribution and your AGI, you may be able to deduct the entire contribution to the DAF in the year it’s made, and then take time gradually making gifts.
If you’re charitably inclined but also would like to use your stock to generate income, consider transferring your shares to a Charitable Remainder Trust (CRT)7. With this strategy:
- You receive an immediate tax deduction when you make the contribution, but the donation is irrevocable;
- Typically, the trust sells the stock without paying capital gains taxes and reinvests the proceeds to provide you with an income stream. You can set a payout rate that meets both your income and charitable goals;
- When the trust is terminated, the charity receives the principal from the trust.
Conversely, with a Charitable Lead Trust (CLT)8, the charity receives the trust income stream for a specified time; after which, the principal reverts to your beneficiaries.
Keep in mind that there are costs associated with creating and maintaining trusts. You receive no tax deduction for transferring assets unless you name yourself the trust's owner, in which case you will pay taxes on the annual income. Other philanthropic options include donating your stock directly to a charity or private foundation and taking a tax deduction.
A Strategy Customized for You
There are various strategies available to create a properly diversified portfolio—often integrating multiple strategies—in order to align with your unique needs and preferences. We’re here to help you navigate possible alternative courses of action, providing detail and insight to help you understand the complexities and draw connections to your full financial picture. We’ll work together with you, leveraging Janney’s specialists and extensive resources, to craft and execute a plan to help you achieve your goals in a tax-efficient and cost-effective manner. You may also want to consult with your accountant and/or tax attorney for additional guidance on the possible risks and advantages of these strategies.
Working With Janney
Depending on your financial needs and personal preferences, you may opt to engage in a brokerage relationship, an advisory relationship or a combination of both. Each time you open an account, we will make recommendations on which type of relationship is in your best interest based on the information you provide when you complete or update your client profile.
When you engage in an advisory relationship, you will pay an asset-based fee which encompasses, among other things, a defined investment strategy, ongoing monitoring, and performance reporting. Your Financial Advisor will serve in a fiduciary capacity for your advisory accounts.
For more information about Janney, please see Janney’s Relationship Summary (Form CRS) on www.janney.com/crs which details all material facts about the scope and terms of our relationship with you and any potential conflicts of interest.
By establishing a relationship with us, we can build a tailored financial plan and make recommendations about solutions that are aligned with your best interest and unique needs, goals, and preferences.
Contact us today to discuss how we can put a plan in place designed to help you reach your financial goals.
1. 10b5-1 Plans: For more information about 10b5-1 plans, please visit: https://www.sec.gov/rules/final/33-7881.htm
2. Options: For more information on options, please visit: https://www.janney.com/wealth-management/disclosures-agreements/disclosures-agreements-service/equities/options For additional information on the characteristics and risks of options please refer to the OCC website: https://www.theocc.com/Company- Information/Documents-and-Archives/Options-Disclosure-Document
3. Fully Paid Securities Lending: Fully Paid Securities Lending may not be appropriate for all investors. Reclassification of dividend income from loaned securities may have implications on tax responsibilities, and voting proxy rights are forfeited. Clients should consider the potential counterparty risk, reinvestment risk, market risk, liquidity risk, and operational risk, among other considerations. The examples provided are hypothetical and do not take into account any specific situations.
This information was prepared from sources believed to be reliable but is not guaranteed as to accuracy and is not a complete summary or statement of all available data. There are no guarantees that any investment or investment strategy will meet its objectives or that an investment can avoid losses. Investment products offered are not insured by the FDIC or any other government agency.
They are not deposits or obligations of, or guaranteed by the financial institutions where offered. They also involve investment risk, including the possible loss of principal. Past performance is not an indication of future results.
For more information on fully paid securities lending, please visit: https://www.janney.com/wealth-management/disclosures-agreements/ disclosures-agreements-service/margin-lending/fully-paid-securities-lending--- client
4. Margin Lending: Margin lending is not available for retirement accounts, annuities, UGMA/UTMA accounts, money market funds, CDs, many international securities, certain managed accounts, and certain other securities. There are significant risks to margin borrowing which should be understood before embarking on a margin strategy. Your Janney Financial Advisor can provide you with further information to inform your investment decisions.
For more information on margin lending, please visit: https://www.janney.com/wealth-management/disclosures-agreements/disclosures-agreements-service/margin-lending/margin-disclosure
5. Exchange Funds: For more information about exchange funds, please visit: https://www.janney.com/wealth-management/education/detail/education/2022/05/13/what-is-an-exchange-traded-fund
6. Donor Advised Funds: For more information about donor advised funds, please visit: https://www.janney.com/wealth-management/education/detail/education/2022/05/13/donor-advised-funds
7. Charitable Lead Trusts: For more information about charitable lead trusts, please visit: https://www.janney.com/wealth-management/education/detail/education/2022/05/13/charitable-lead-trust
8. Charitable Remainder Trusts: For more information about charitable remainder trusts, please visit: https://www.janney.com/wealth-management/education/detail/education/2022/05/13/charitable-remainder-trusts
This is intended for use with sophisticated investors who are capable of understanding the risks associated with the investments described herein and may not be appropriate for you. If you believe you have received this document in error, please contact your Financial Advisor.
You should consult with your accountant and/or tax attorney for additional guidance on the possible risks and advantages of the strategies mentioned herein.
Janney Montgomery Scott LLC, its affiliates, and its employees are not in the business of providing tax, regulatory, accounting, or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any taxpayer for the purpose of avoiding tax penalties. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.