What to do when your investment portfolio has too many eggs in one basket?
Most investors understand that having a huge chunk of their wealth bound up with the fate of a single company is risky. But that’s exactly where many wind up—often because a significant amount of their compensation has been in the stock of their company, or they’ve sold a business to a company that has paid in stock.
“Overconcentrations often lead to binary outcomes,” says Reed Smith, a Houston-based managing director in Merrill Lynch’s private wealth management business. “They can be really good, or they can be really bad.”
Smart investors avoid extreme bets, so unless there’s a good reason to hold a disproportionate percentage of your portfolio in one stock—a high-profile executive may need to signal commitment to the firm, for example—you’ll probably need to diversify. But to do so, you must first sell, which can trigger a painful federal capital-gains tax of up to 20%, plus, in most cases, state taxes.
One solution is known as an exchange fund. Structured as private placement limited partnerships or limited liability corporations, the funds serve as a clever mechanism for diversifying while staying out of reach of the taxman.
Exchange funds are typically created by banks or investment companies. A number of investors transfer shares from their respective concentrated holdings into the fund; the fund’s manager curates the incoming transfers with an eye toward creating a diversified mix of high-quality stocks.
Once that’s achieved, the fund closes, and each investor receives a proportionate ownership stake. Voilà! Concentrated positions have been turned into diversified stock portfolios without triggering capital gains.
Now, the caveats. Exchange-fund participants must be qualified purchasers, or those with at least $5 million in total investible assets. And participants must remain in the fund for seven years to be entitled to the tax benefit. Furthermore, they can be expensive, with annual fees around 1%, as well as an upfront sales commission.
Those details might cause you to opt to sell your shares in the open market. If that’s your plan, however, you may find yourself sweating the timing: No one wants to sell a big position on a day that the stock happens to be tanking. Or the day before, which might raise some eyebrows. One solution is an equity collar.
Equity collars effectively allow you to lock in the value of your stock within a range so you can sell it when you’re ready. By buying a put option—or an option to sell at a certain price by a certain date—you create a price floor for your shares. And by selling a call—the right to buy your shares at a certain price by a certain date—you create a price ceiling. Why sell the call and limit your upside? Because the premiums you earn can be used to pay for the put.
After selling, of course, you’ll have to buy stocks, bonds, and perhaps other assets to create a diversified portfolio. That should be done within the context of a financial plan specific to your personal goals, time horizon, and risk appetite, says Smith. “A 100% diversified portfolios will mitigate concentration risk,” he says, “but not overall stock market risk.”
Remember that proceeds from a stock sale shouldn’t necessarily be redeployed into other stocks. If income is the goal, preferred shares or munis might be on your shopping list, Smith says.
Finally, you may not need all of that company stock to achieve your investing goals. A portion of it may be adequate for your needs, and you may have income available from other investments, as well.
One tax-savvy idea is to gift shares to nonprofits. The recipient in this case pays no tax on the gift, and the donor gets the deduction for the stock’s market value at time of donation. If you go this route, make sure to donate the most highly appreciated shares, which usually means the ones you’ve owned the longest. That way, you’ll maximize your tax savings while feeling good about yourself.
There’s no one-size-fits-all rule about whether and how to diversify a concentrated position, Smith stresses. Part of deciding on a course of action involves understanding the role that emotion may play. Investors often transfer feelings of loyalty to their company onto the company stock. Big mistake. The feelings of those shares won’t be hurt if you sell, but your kids will be if their value plummets.
“You should think hard about that concentration and what [your] reason for having that concentration is,” says Smith.