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Concentrated Stock Positions

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Clients who have worked for a company for a long time often accrue a concentrated stock holding in their employer’s company. This can pose a problem for investors in terms of lack of diversification, tax issues and liquidity. A highly concentrated stock position creates significant risk exposure to a single company. Also, selling the entire position may not be tax-efficient if there has been significant capital gains accrued on the position.

To manage these problems, there are three strategies that CTA uses to minimize the risk to your net worth:

Stock Collaring

The equity collar is a common hedging method that 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 put option gives the owner the right to sell their 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. Most clients 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.

Exchange Fund

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. The investor then 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.

Tax Managed Fund

Tax managed funds diversify a single position by selling the concentrated holding gradually, and reinvesting the money to purchase a more diversified portfolio. Contrary to the exchange fund, the investor remains in control of the assets, and can complete the desired diversification within a specified time frame and spread the tax burden over several years. Capital losses are aggressively harvested from the diversified portfolio to offset capital gains from the concentrated stock sales.

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