Investors can enhance the yield of a concentrated stock position while decreasing its volatility by writing covered calls against some or all of the shares.
Investors typically sell call options with a strike price that is above the current price of the stock and in return receive premium income. The amount of premium received will vary depending on a number of factors, including the volatility of the stock, the strike price, and the maturity. The investor retains any dividends received on the shares and voting rights.
The strategy effectively allows the investor to establish a liquidation value (the strike price) for the shares he or she writes call options against. However, the investor does retain full downside exposure to the shares (to the extent the stock price decreases by more than the premium received) and has capped the upside potential (the call strike price plus the premium received).
Covered call writing is often viewed as attractive if the holder believes the stock will be stuck in a trading range for the foreseeable future. Covered call writing can be a good substitute for a structured selling program. Many financial advisers recommend that investors simply set multiple price targets today and sell a fixed number or percentage of their shares if and when the stock price reaches the previously established price targets.
Perhaps the most significant benefit of implementing a covered call writing program, even if only on a portion of the concentrated position, is that it can psychologically prepare the owner to dispose of those shares.
Tax-optimized equity strategies seek to combine investment and tax considerations in making investment decisions. They start with the generic concept of tax efficiency and quantitatively incorporate dimensions of risk and return in the investment decision-making process.
Two tax-optimization equity strategies combine tax planning with investment strategy.
- Index tracking with active tax management. Cash from a monetized concentrated stock position is invested to track a broad market index on a pretax basis and outperform the index on an after-tax basis. For example, if dividends are taxed at a higher rate than capital gains, the tracking portfolio could be structured with a lower dividend yield but higher expected price appreciation.
- A completeness portfolio structures the other portfolio assets for greatest diversification benefit to complement (complete) the concentrated position. For example, if the concentrated position is an auto stock, the rest of the assets are selected to have low correlation with auto stocks such that the resulting total portfolio better tracks the return of the chosen benchmark.
Both of these tax-optimization strategies allow the investor to retain ownership of the concentrated position but may take time and sufficient other assets and funds to implement
This strategy is certainly one way for an investor to diversify out of a concentrated position, but it does come with certain risks and costs.
First, and most importantly, this strategy is intended to be implemented over time, so the investor continues to retain the company-specific risk of the remaining, albeit a progressively diminishing, concentrated stock position.
Second, in a perfect world, the best possible result will be that the client moves from holding a single low-basis stock to holding a diversified portfolio of lower-basis stocks. Hence, when this diversified market portfolio needs to be liquidated, there could be a tax associated with it.
In certain circumstances, it may not be possible for an investor to directly hedge a position.
A cross hedge may be used instead. The investor who holds a large position in an auto stock but finds it cannot be shorted to create a hedge could consider three cross hedge possibilities:
- Short shares of a different auto stock or another stock that is highly correlated with the concentrated position. The highly correlated short position will increase (decrease) in value to offset decreases (increases) in the auto stock.
- Short an index that is highly correlated with the concentrated position. Shorting a different stock or an index will introduce company-specific risk. A negative event could affect the concentrated position but have no offsetting effect on the value of the short position.
- Purchasing puts on the concentrated position is also considered a cross-hedge in that the put and stock are different types of assets.
By using a cross hedge, the investor is at least able to hedge market and industry risk. However, the investor retains all of the company-specific risk of the concentrated position.
An exchange fund is an investment fund structured as a partnership in which the partners have each contributed their low-basis concentrated stock positions to the fund. Each partner (contributor to the fund) then owns a pro rata interest in the partnership potentially holding a diversified pool of securities. Participating in the exchange fund is not considered a taxable event; the partners’ cost basis in the partnership units is identical to the cost basis of the contributed concentrated stock positions. For tax purposes, each partner must remain in the fund for a minimum of seven years, after which he or she has the option to redeem his or her interest in the partnership and receive a basket of securities at the discretion of the fund manager equal in value to the pro rata ownership of the partnership or continue his or her investment in the fund.