In the wealth management industry, advisors are increasingly concerned about concentrated stock positions given how heavily weighted the S&P 500 has become to just a handful of companies. Indeed, entering June, a full 22% of the index’s value was contained in just five stocks.
The truth is that while concentration in indices is a common feature, it only garners episodic media interest. What’s also common, and a more important issue for investors, is low basis in positions in the liquid portion of ultra-high-net-worth portfolios.
In both cases, advisors have few solutions they can utilize. However, quickly gaining in prominence is the power listed derivatives can play to mitigate both idiosyncratic and market risks while avoiding tax friction.
Family offices and ultra-high-net-worth advisory clients often find themselves with an overconcentration in certain names. It’s a price of success. After all, good managers pick good stocks. Indeed, the reason indices are market-capitalization weighted, like the S&P 500, is to allow for the companies driving growth and profitability to continue growing shareholder value, thus leading to outsized weightings in the index through time. It’s natural that outperforming portfolios will become overweight in these exact same names.
Yet, concentration happens for other reasons in wealthy families. Many families have derived their wealth through building businesses, some of which have gone public themselves or exited to a public strategic acquiror. Others have accumulated stock via executive compensation plans that offered employee stock options. Across generational wealth, these concentrated holdings are often gifted, and, crucially, those gifts of stock carry the original, low-cost basis for the recipients.
Using option-based strategies has often been the most tax-efficient way to mitigate the effects of concentration. As most advisors know, simply selling the concentrated shares is the least effective move and surest way to destroy value. This almost always triggers a steep tax bill, forcing one to pay at least 23.8% of growth in taxes, a permanent impairment of capital. By placing an option overlay on the portfolio, advisors can protect their clients from sudden moves in the concentrated stock, hedging against market fluctuations that could have an outsized impact on assets. It also means that these same investors can potentially use option strategies around concentrated holdings to monetize their positions in more than one way.
To address concentration issues, the financial services industry also created exchange funds. Exchange funds, or swap funds, allow investors to swap shares of their concentrated holdings in exchange for shares in a more diversified privately held asset pool. Since this is an exchange of holdings as opposed to a sale, investors normally defer any capital gains implications while reducing their concentrated positions.
This works well for some, but exchange funds have fallen short in a few elements. Given how the markets have themselves been driven by a small number of names, exchange funds are limiting the ability to accept shares of companies like Apple, Alphabet and Microsoft, which are responsible for many portfolios’ concentration. In addition, like with a straight sale of stock, an investor is also potentially sacrificing the upside that could remain with that stock.
Evaluating all investor circumstances, options usually will conclude as the best vehicle to address concentration, and by design each situation can be customized to meet each investor’s goals with respect to income, downside protection, tax sensitivity and broader portfolio construction at the forefront of both near and longer-term objectives. This can be best achieved in separately managed accounts, thus allowing the concentrated holdings in the most popular names to have a safe harbor, with the investor’s goals and tax efficiencies curated.
Many are presently facing a precarious capital markets backdrop and uncertainty surrounding inflation, equity valuations and interest rates. Those individuals who are fortunate enough to have built wealth through equities will have a low basis tax problem and will face profound tax implications should they look to sell a portion of their holdings. Solving such a dilemma with option-based strategies may have never more prudent. These strategies in the hands of a professional will permit customization to individual circumstances, while solving for the lack of accessibility to exchange funds.
Eric Metz is CEO of SpiderRock Advisors, a Chicago-based registered investment advisors that specializes in options and derivatives strategies.