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Concentrated Stock Positioning Strategies & Reducing Portfolio Risk
By Patrick Hejlik
Managing Director, Investments
By Patrick Hejlik
Managing Director, Investments
12 minute read
Table of Contents
Holding a concentrated stock position — where a single stock represents more than 10% to 20% of the portfolio value — is known as “the enviable problem.” Enviable because the stock has generated significant wealth for the holder. A problem because as the concentration of stock grows, so, too, does the risk.
In this article, we’ll explore the risks of concentrated stock positions, why holders are often slow or unwilling to reduce their risk, and strategies to diversify concentrated stock positions.
The Challenge of Concentrated Wealth
There are a number of ways someone might end up with a concentrated stock portfolio, including:
- Investment Advisory, including access to private investments
- Accounting and Reporting
- Financial Planning
- Insurance Analysis and Management
- Family Governance and Education
- Tax Advisory and Regulatory Compliance
- Philanthropic Planning
- Estate Planning
- Concierge Services
The upside of a concentrated stock position is that it created substantial wealth. The downside is it introduces added risk to the holder’s portfolio, making their wealth vulnerable to a single-stock event. Just because a stock has performed well in the past doesn’t mean it will continue to do so. In fact, history suggests diversifying is the more prudent option long-term.
Investors often underestimate how common large drawdowns are among individual stocks. Even over long investment horizons, many companies experience substantial declines, and a significant number never recover to their former valuations.
Given these risks, which are well-documented by data and research, if the holder wants to safeguard their wealth for the future, there is a fundamental need to diversify. However, it’s common for holders to resist diversification due to behavioral and psychological biases such as:
- Anchoring: Assuming future success based on past returns.
- Regret Avoidance: Fear of missing out on future gains if the stock is sold.
- Tax Avoidance: Taking outsized risk to avoid paying the immediate capital gains tax associated with diversifying a low-basis position.
Working with a trusted advisor can help the holder move past any potential resistance and start reducing concentration to a manageable level through an advanced, holistic tax strategy.
Tax-Focused Strategies for Risk Mitigation and Diversification
To manage concentration risk, improve liquidity, and optimize tax outcomes, a combination of concentrated stock position strategies is typically used. Ideally, these strategies are selected based on the holder’s unique circumstances, including the value of their shares, the unrealized gain, liquidity needs, and time horizon.
Custom Tax-Efficient Diversification
This strategy can be used to systematically divest a concentrated holding over time in a manner designed to be tax-neutral. Diversification is accomplished by utilizing sophisticated managed accounts that employ custom tax-loss harvesting to strategically offset realized gains from the sale of the low-basis concentrated stock. This method accomplishes broad equity diversification without incurring a large near-term tax impact, but does take time (e.g., five to seven years). There is also increased complexity, potential for higher tracking error, and less protection from near-term drawdown.
Leveraging Option-Based Strategies (Hedging and Income)
Options strategies can be used for income generation, risk collaring, or strategic sales of stock over time. Benefits may include increased certainty of outcomes with high levels of customization and liquidity.
- Zero Cost Collar: This strategy involves purchasing a protective put (downside floor) and simultaneously selling a call option (limiting upside) to fund the cost of the put. The combination of positions helps provide the investor the right to sell shares at a specified price but caps potential upside gains. While this option may defer taxes and preserve the potential step-up in basis, strict care must be taken to navigate the tax straddle rules and avoid triggering a “constructive sale.” Although these are separate tax provisions, misunderstanding either can undermine the intended tax benefits of the strategy.
- Covered Call Writing (Yield Enhancement): With this strategy, the holder is selling the right to purchase the stock at a specified price in exchange for an upfront premium. The collected premiums can be strategically utilized to offset capital gains incurred from a separate planned sale of the concentrated equity.
- Risk Swap: Using coordinated collar strategies, the holder is able to exchange stock-specific risk (e.g., a single company stock) for diversified market risk (e.g., an index ETF).
Exchange Funds
Exchange funds for concentrated positions allow the holder to swap concentrated stock for shares in a diversified portfolio without immediately triggering a taxable event. This provides tax-deferred growth and simplifies estate planning, as the fund units qualify for a step-up in cost basis upon transfer to heirs. However, investors generally must commit to a minimum holding period of seven years to realize the potential advantages.
Accessing Liquidity Through Capital Markets Solutions
In some cases, an investor may not be ready to sell a concentrated stock position but still needs liquidity for spending needs, tax payments, real estate purchases, or other investment opportunities. Capital markets borrowing strategies can allow the holder to access cash while potentially deferring a taxable sale.
One common approach is margin lending, where the concentrated stock position serves as collateral for a loan. This can provide relatively quick access to liquidity without immediately realizing capital gains. However, investors should carefully consider borrowing costs, collateral requirements, and the risk of a margin call if the stock price declines significantly.
For larger and more complex concentrated positions, advanced lending strategies such as prepaid variable forward contracts (PVFs) and box spread financing may be appropriate. A prepaid variable forward allows the investor to receive cash upfront in exchange for agreeing to deliver a variable number of shares at a future date, subject to predetermined pricing parameters. When properly structured, a PVF can provide liquidity, downside protection, and tax deferral benefits while retaining some participation in future stock appreciation. Box spread financing uses offsetting option positions to create synthetic borrowing at a predetermined financing rate and may offer an alternative source of liquidity for sophisticated investors.
Because these strategies involve legal, tax, regulatory, and market considerations, they should only be implemented with guidance from experienced advisors and capital markets specialists. Borrowing against concentrated stock can be a valuable tool within a broader diversification plan, but it does not eliminate the underlying concentration risk associated with the position.
Planning for Liquidity Events and Wealth Transfer
Prior to a stock buyback, company sale, or other liquidity event, it’s important to consult and coordinate with a trusted financial professional. Doing so will help to optimize the liquidation schedule while minimizing tax impact.
Supporting philanthropic causes can also help reduce the tax burden of diversification. However, similar to liquidity events, advance planning with a qualified advisor is strongly recommended, as these charitable giving options often involve irrevocable decisions.
Strategic Liquidation and Execution
Strategic liquidation combines the need for immediate liquidity with fundamental criteria (time, price targets) to reduce the concentrated position strategically. Factors include volatility, cost basis, total estate value, client age, and liquidity needs. Execution requires an analysis of the trade-offs between block trades (speed, price certainty, but likely a discount) and agency execution (potential for better price, but gradual and market-dependent).
Integrating Charitable Giving for Tax Optimization
For the philanthropic-minded, there are two options to help optimize tax efficiency while giving back to meaningful causes.
- Charitable Remainder Trusts (CRTs): CRTs are exempt from federal income tax, enabling the trust to sell the appreciated concentrated stock and reinvest the proceeds tax-free. This provides the grantor with annual income distributions (taxed under a tiered system) while allowing the family to diversify the concentrated asset immediately, helping solve a major tax hurdle. In addition, funding a CRT generally provides a partial charitable income tax deduction in the year of the contribution, further enhancing tax efficiency.
- Donor Advised Funds (DAFs): Contributing highly appreciated, low-basis stock to a DAF results in an immediate income tax deduction. This allows the donor to avoid paying capital gains tax on the appreciation of the donated stock while receiving a deduction for the fair market value (subject to AGI limits).
Trust Solutions for Multi-Generational Planning
Vehicles like dynasty trusts and charitable trusts can be leveraged to achieve goals related to diversification, income generation, asset protection, and tax-efficient wealth transfer. However, coordinating trust administration and estate planning with the overall tax strategy is crucial.
The Holistic Approach: Integrating Tax, Liquidity, and Life Goals
Before a concentrated portfolio strategy is created, the first step is to work with a trusted advisor to conduct comprehensive due diligence. This process should include detailed goal identification (tax planning, philanthropy, time horizon) and a review of financial considerations (cash flow, total assets).
From there, the advisor can begin developing an optimized plan that aligns strategies with the client’s objectives, including consideration of regulatory and securities law compliance (e.g., corporate blackout periods, Rule 144 compliance).
Because concentrated stock management requires a seamless integration of services such as wealth strategy, tax strategy and planning, and banking and lending, working with a family office may be the most efficient option. A family office can provide the diverse expertise and knowledge necessary to address a family’s complex financial needs and execute custom solutions all in one place. In addition, because a family office is a fiduciary, they must have the client’s best interests in mind at all times.
Frequently Asked Questions
What is a concentrated stock?
A concentrated stock position generally refers to a single stock representing more than 10%–20% of a portfolio’s value, although the specific threshold may vary depending on the investor’s circumstances and objectives.
What is the risk of a concentrated position?
Concentrated stock positions are vulnerable to single-stock events. When compared to the broader market, large drawdowns are more likely and more permanent for single stocks.
What is an example of a concentrated portfolio?
A concentrated portfolio might consist of an investor whose total portfolio is worth $10 million, with $6 million invested in a single stock or the stock of their employer. Because 60% of the portfolio’s value depends on the performance of one company, the investor faces significant concentration risk if that stock experiences a sharp decline.
What is an exchange fund for concentrated stock positions?
An exchange fund is a special-purpose vehicle that offers holders the ability to diversify their investments by exchanging stock positions — often in highly appreciated or restricted stock — for shares of a diversified portfolio.
What is a collar for a concentrated position?
A zero-cost collar is a common strategy for diversifying a concentrated position. The investor receives an upfront premium from selling a call to purchase a protective put option for zero cost. The combination of positions helps provide the investor the right to sell shares at a specified price but caps potential upside gains.
How do you protect a concentrated stock position?
To protect wealth created by a concentrated stock position, it’s important to diversify the holder’s portfolio while also mitigating risk.
How can concentration risk be reduced in a portfolio?
There are a number of strategies available, including tax-efficient diversification, exchange funds, strategic liquidation, and more.
How do you divest from concentrated stocks?
Divesting from concentrated stocks requires expert planning, guidance, and execution. It’s best to consult with a qualified, trusted advisor before taking any action.
To learn more about how Cresset is managing concentrated stock wealth for clients, please contact us.
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