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Many people who have worked for a company for a long time — including executives — often
accrue a concentrated stock holding in one company (usually their employer). This can often
pose a problem for the investor in terms of lack of diversification, tax issues and liquidity. A
highly concentrated stock position exposes the investor to significant risk exposure to the
fortunes of a single company. In addition, selling the entire position may not be a tax-
efficient option if there have been significant capital gains accrued on the position.
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To manage these problems, there are four strategies that can usually be taken to minimize
the risk to your net worth.
Not everyone can take advantage of the strategies discussed in this article. Most of the
financial instruments described will typically require the investor to be considered an
"accredited investor" underSecurities and Exchange Commission (SEC) Reg D. This generally
restricts the use of these tools to high net worth investors who have a significant non-
diversified stock position that they want to hedge.
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1. Equity Collars
The first approach is a very common hedging strategy and one that may be familiar to many
investors. The equity collar method involves the purchase of a long-dated put option on the
concentrated stock holding combined with the sale of a long-dated call option. The collar
should leave enough room for potential gains and losses, so it is not construed as a
constructive sale by the Internal Revenue Service (IRS) and subject to taxes.
In an equity collar, the put option gives the owner the right to sell their non-diversified stock
position at a given price in the future, providing them with downside protection. The sale of
the call option provides the investor with premium income that they can use to pay for the
purchase of the put option. Often, many will opt for a "costless" collar, where the premium
from the sale is just enough to cover the entire cost of purchasing the put option, resulting in
zero cash outflow required from the investor.
Alternatively, if you want additional income, you also have the choice to sell a call option
with a higher premium, which creates a net cash inflow for the investor. However you want
to do it, the equity collar will effectively limit the value of the stock position between a lower
and upper limit over the time horizon of the collar.
Depending on the performance of the stock, in the market, the number of shares sold at the
future date would vary in a range. At higher stock prices, fewer shares would need to be sold
to satisfy the obligation, and vice versa with lower stock prices. This variability is one reason
the use of a VPF is not considered a constructive sale by the IRS.
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The benefit of this approach is the immediate liquidity received from the cash advance. In
addition, the use of the VPF allows for the deferral of capital gains and flexibility in choosing
the future sale date of the stock.
The exchange fund method takes advantage of the fact that there are a number of investors
in a similar position with a concentrated stock position who want to diversify. So, in this type
of fund several investors pool their shares into a partnership, and each investor receives a
pro-rata share of the exchange fund. Now the investor owns a share of a fund that contains a
portfolio of different stocks – which allows for some diversification.
This approach not only achieves a measure of diversification for the investor, it also allows
for the deferral of taxes. However, exchange funds typically have a seven year lock-up period
to satisfy the tax deferral requirements, which could pose a problem for some investors.
As an example of the completion fund, suppose you own $5 million worth of ABC Corp.
stock, and you want to reduce your exposure to this stock. The stock position has
appreciated significantly over time, and you don't want to sell all of the $5 million in one
transaction because of the amount of immediate taxes you would have to pay. Instead, you
could choose to sell 15 percent of the position each year, and use the proceeds to diversify
into other stocks. So, over time the investor achieves a fully diversified portfolio aligned with
their risk tolerance.
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Partner Links
Related Terms
Exchange Fund Definition
An exchange fund is a fund that lets investors diversify their concentrated stock positions without
being taxed in the process. more
Collar Agreement
A collar agreement is a series of financial transactions aimed at locking key variables within a range of
outcomes, hence, a collar. more
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