A new hedging dilemma has arisen—is it better for an investor to achieve a slightly better price for a collar by using exchange-traded options, but remain subject to tax-inefficiency such as the possibility of recognizing phantom income on the collar? Or is it better to accept a slightly less robust price for the collar by using OTC derivatives, but eliminate the possibility of recognizing phantom income on the collar? It’s not necessarily an easy decision.
There certainly are advantages of exchange-traded options, such as less counterparty credit risk and greater transparency. On the other hand, OTC derivatives offer a level of tax-efficiency and customization that’s not possible with exchange-traded options. In today’s high tax rate environment, the issue is whether the tax-efficiency of OTC derivatives should trump the non-tax advantages of exchange-traded options.
As fiduciaries, it’s our responsibility to thoughtfully and objectively explore both alternatives—exchange-traded and OTC derivatives—and work with investors to implement a collar with the tool that delivers the best result for them, given their objectives.
In a similar vein, Investors with highly appreciated stock positions often use sales, derivatives and exchange funds to diversify over time. However, for reasons such as emotional attachment, tax and estate planning, and restrictions on selling, they often retain some stock as a core, long-term holding, which is held unhedged and remains their biggest investment risk. Because of its cost-effectiveness, a new single-stock risk mitigation methodology—stock protection funds (SPF)—can be “married” to such retained shares, providing affordable, long-term, downside protection, and thereby mitigating what is often the investor’s biggest investment risk. Just as with collars, as fiduciaries, it’s our obligation to thoroughly and impartially explore both alternatives—holding the retained shares unhedged versus protecting such shares with a Stock Protection Fund--and work with investors to implement the strategy (unhedged long stock versus long stock + SPF) that delivers the best result for them, given their longer-term objectives.
Thomas Boczar, LL.M., CFA, CPWA, is CEO of Intelligent Edge Securities and can be reached at 212.308.3345 or [email protected]. Elizabeth Ostrander, CFA, is managing director and head of business development at Intelligent Edge Securities and can be reached at 212.308.3343 ext. 1001 or [email protected].