The stock market has performed impressively in recent years, and many executives and employees have received company stock and other stock-based compensation that have increased significantly in value. Many executives and employees want to continue holding some positions, not only because a sale would cause an immediate and substantial capital gains tax (which, in some instances, could be eliminated with a step-up in tax cost basis when they die), but also because they have a strong emotional attachment to, and confidence in, the upside potential of their stock. They might also have corporate governance policies that either encourage or require company stock ownership.

Ideally, executives and employees in this position would like to: 1) preserve their unrealized gain at an affordable cost; 2) avoid triggering taxes or tax problems; 3) retain all future price appreciation and dividends; and 4) avoid triggering a reportable event.

For many years, investors have managed the risks of owning single stocks by using equity derivatives such as puts, collars and prepaid variable forwards (PVFs). But because of regulatory changes (such as the Dodd-Frank Act) and the current state of the capital markets (in which investors face low interest rates and an unfavorable volatility skew), these tools have become considerably more expensive since the financial crisis. Therefore, fewer executives and investors are currently employing them, and those who are using them are doing so opportunistically, in a shorter-term, tactical manner.

Investors have also long used exchange funds to tax-efficiently diversify out of their stock positions; but these aren’t helpful to investors who wish to protect shares they wish to retain as core, long-term holdings. In addition, the use of any of these risk-mitigating tools triggers a reportable event for company affiliates (such as senior officers, board members and 10% shareholders).

So with the stock market setting all-time highs (and facing many risks), executives and investors who don’t wish to, or can’t, sell their highly appreciated stock are on the lookout for new tools and techniques.

One recent innovation is the stock protection fund, sometimes referred to as a stock protection trust.

These funds take a non-traditional approach to concentrated stock risk management. They are based on the principles of both modern portfolio theory and risk pooling. Modern portfolio theory reveals that over time there will be a substantial dispersion in individual stocks’ performance. Risk pooling, meanwhile, shows it’s possible to cost-effectively spread similar financial risk evenly among the participants in a self-funded plan designed to protect against catastrophic loss.

By combining these properties, stock protection funds dampen the risks of holding single stocks by allowing executives and investors to diversify or “mutualize”—and therefore eliminate or substantially reduce—a stock’s downside risk while retaining all of its future price appreciation and all dividend income, at an affordable cost.

Conceptually, stock protection funds have some similarities to exchange funds. The latter enable executives and investors to mutualize, and therefore substantially reduce, their company stock risk, in that the investors obtain the benefit of diversification similar to that achieved through an investment in a mutual fund or ETF. Economically, it’s as if each investor sold his or her shares of stock on a tax-deferred basis and immediately reinvested the proceeds into a diversified portfolio. Going forward, each investor is exposed to the upside potential and downside risk associated with the portfolio, rather than solely to their contributed stock.

Conversely, a stock protection fund permits executives and investors to continue to own and retain all of the upside potential of their stock positions while mutualizing only the downside risk. Investors, each owning a different stock in a different industry, and each seeking to protect the same notional value of stock, contribute a modest amount of cash (not their shares, which they continue to own) into a fund that will terminate in five years. The cash pool is invested in U.S. government bonds that mature in about five years, and upon termination, the cash pool is distributed to investors whose stocks have lost value on a total return basis using a “reverse waterfall” methodology. Losses are paid until the cash pool is depleted. If the cash pool exceeds total losses (a 70% probability), all losses are eliminated, and the excess cash is returned to investors. If, on the other hand, total losses exceed the cash pool (a 30% probability), the large losses are substantially reduced. The two charts on the prior page compare and contrast stock protection funds with exchange funds.

Stock protection funds complement the more traditional tools that executives and employees use to manage single-stock risk and add a new dimension to the portfolio construction process for investors with concentrated company stock positions. Executives and investors often use the traditional tools to diversify out of their positions over time; however, for many reasons they usually retain a position in their stock as a core, long-term holding that is unhedged and remains a major risk exposure relative to their net worth. Given its affordability, a stock protection fund can be “married” to the retained stock position, thereby mitigating the investors’ biggest investment risk. They can continue to use the traditional tools to “chip away” at their positions while using a stock protection fund to cost-effectively protect that portion of their stock position that they wish to retain as a core, longer-term holding.

The use of a stock protection fund can be cashless if funded through a margin or private banking loan against the company stock position being protected (with a 12% loan to value, for example); therefore, the existing asset allocation needn’t be disturbed.

Key Benefits
Stock protection funds provide affordable downside protection, akin to that of at-the-money or slightly out-of-the-money European-style put options but at a fraction of the cost, while allowing executives and investors to retain all future appreciation and dividends.

Stock protection funds are also tax-efficient; they don’t constitute a constructive sale or straddle (any gain is a long-term capital gain and any loss is currently deductible) and dividends remain qualified (and taxed as long-term capital gains). The shares aren’t pledged or encumbered in any manner and can be held in custody wherever the investor chooses; therefore, the investor can sell, gift, borrow against or otherwise dispose of the shares at any time. There’s no dealer counterparty credit risk.

Furthermore, stock protection funds are easy to understand and completely transparent. Finally, the use of a stock protection fund should not trigger a reportable event for affiliates (i.e., company insiders), and can be used to protect both stock and stock-linked compensation such as restricted stock units and stock options.

Audited Performance Results
A real money stock protection fund protecting 20 stocks and requiring an up-front cash contribution of 10% (2% per annum for five years) of the value of the stock protected was operated through the financial crisis from June 1, 2006, to June 1, 2011 (it was audited by the accounting firm StarkSchenkein). Of the 20 stocks, eight incurred losses, some of which were significant (37%, 32%, 24%, 18%, 13%, 8%, 5% and 1%). All the losses were reimbursed (i.e., the maximum stock loss was 0%), with the remaining cash returned to the investors. Each investor received the equivalent of at-the-money put protection on their stock, and the amortized pretax cost of that protection was only 1.38% per annum.

In this way, a stock protection fund permits public company executives and employees and other investors and trusts committed to the continued ownership of a portion of their stock position as a core, long-term holding, to cost-effectively and tax-efficiently preserve their unrealized gains while retaining all future upside potential, without causing a reportable event.

Thomas J. Boczar, Esq., LL.M., CFA, CPWA, is CEO of Intelligent Edge Advisors, LLC.