Ultrawealthy investors face many of the same issues as those with more modest portfolios. They fail to diversify their investments, build emotional attachments to a single stock and let an aversion to taxes dominate investment decisions. It often takes a shake-up in the markets to start a conversation about how to handle the risk inherent in a concentrated stock portfolio.

A concentrated stock position is one that represents more than 20% of the investor's net worth. The typical client holding millions in a single stock may have come into wealth unprepared to deal with the investment issues. Whether it is a case of a highly successful IPO, the receipt of an acquiring company's stock as part of a buyout or an executive compensation package heavily weighted in employee stock options, this investor must tend to the health of his or her golden goose.

There are several ways to handle a concentrated stock portfolio. The initial step is to gauge the client's attachment to the stock. There may be resistance to selling if his or her history is tied to the company's success. Or the client may be bullish on the stock's prospects. It might also be that the stock has appreciated highly, which means an initial tax hit the client doesn't want to face. But this means that the tax tail is wagging the dog.
Some of the common techniques to help clients achieve diversification are discussed below.

Equity Collars As A Hedge

The two most common hedging strategies are the equity collar and the variable prepaid forward sale. Both typically have minimum transaction sizes of $1 million.
The equity collar is probably the easiest to implement. This concept involves buying a put and selling a call. Purchasing the put ensures that if the stock's price drops, the investor could sell it at a predetermined price. At-the-money puts can cost 10% to 20% of the value of the stock annually. At the same time, the investor sells a call, giving someone else the right to buy the stock at a predetermined price if the stock value should rise. A call might sell for 15% to 20% of the current stock price. The premium earned on the call offsets the cost of the put, thus earning the name zero-premium collar.

Buying a put is designed to provide downside protection, while selling the call may allow you to capture at least some upside appreciation (with the added benefit of offsetting the cost of the put). And no taxes are incurred. On the downside, if the price of the stock were to soar, the holder would buy the investor's stock at the agreed-upon price and resell it for an immediate profit. The investor, therefore, has limited his or her participation in the appreciation of the stock.

A collar is only part of the strategy. The second part is to borrow against the hedged position in order to reinvest in a diversified portfolio. If the purpose of the loan, or monetization, is to raise capital to diversify the investor's portfolio, the loan is limited to 50% of the current market value of the shares.

Equity collars have several hurdles to consider. First, when you hedge away too much risk, the IRS considers it a constructive sale. It is as if you had sold and immediately repurchased the same stock, meaning you incur taxes on any gains. There must be some element of possible loss or gain to avoid the constructive sale rule. Second, entering into a hedge transaction puts a pause on the capital gain clock. The one-year holding period for long-term capital gains is interrupted by the duration of the collar. Because there is a possibility that the call will be exercised, it is best to use this technique with stock held longer than one year before you enter into the collar.

Finally, you may experience the whipsaw effect. You cannot deduct the losses until all positions have closed-when the collar expires, is exercised, is bought or is sold out. On the other hand, gains are taxed as soon as the call option expires unexercised. If the call closes before the put, you may recognize capital gains without the benefit of the offsetting loss.

While the term zero-premium collar seems to indicate that the cost has been eliminated, a 1% spread usually goes to the dealer to put the transactions together. In addition, there are borrowing transaction costs and interest.
In the end, while the strategy is designed to protect stock you currently own, there is always the risk that you will be forced to cover the call by liquidating your stock.

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