By Thomas J. Boczar, LLM, CFA, CPWA

Executives, trusts, and other investors with highly appreciated stock positions often try to diversify out of their positions over time using outright sales and tools such as exchange funds, equity derivatives, and charitable remainder trusts. But for many reasons (such as tax and estate planning considerations, an emotional attachment to the stock, or a belief in the upside potential of the stock), they almost always retain a significant portion of their concentrated position that’s left unhedged and remains a major risk exposure relative to their net worth.

Holding a concentrated position without protection is riskier than most investors realize. According to J.P. Morgan, since 1980 about 320 stocks were removed from the S&P 500 due to “business distress.”¹ According to Goldman Sachs, over the past 30 years, 25 percent of the stocks in the Russell 1,000 (representing about 90 percent of the investable U.S. equity market) suffered a permanent loss of capital (i.e., lost more than 75 percent of their value and did not recover to 50 percent of their original value within the 30-year-period as of December 2015).²

Investors have long used equity derivatives such as puts and collars to mitigate company-specific risk, but they are costly. They are used today mostly for tactical, short-term protection or to generate additional income.

Stock protection funds (protection funds) are a recent development.³ They can be helpful to those who wish to keep some or all of their stock position as a core, long-term holding by allowing them to preserve unrealized gains and keep all upside potential in a cost-effective manner.

Protection funds marry modern portfolio theory with risk pooling/insurance. Modern portfolio theory demonstrates that over time there will be substantial dispersion in individual stock performance. Risk pooling makes it possible to cost-effectively spread similar financial risk evenly among participants in a self-funded plan designed to protect against catastrophic loss. By integrating these principles, protection funds provide downside protection akin to at-the-money or slightly-out-of-the-money European-style put options, but at a fraction of the cost.

Here’s how it works. Twenty investors – each owning a stock in a different industry and wishing to protect the same notional value of the 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 is invested in U.S. government bonds that mature in five years. Upon termination, the cash is distributed to investors whose stocks have lost value on a total return basis. Losses are reimbursed until the cash pool is depleted. If the cash pool exceeds total losses, all losses are eliminated, and the excess cash is returned to investors. If, on the other hand, total losses exceed the cash pool, large losses are substantially reduced.

Losses are reimbursed using a “reverse waterfall” methodology. That is, the largest loss is reimbursed first to the level of the second-largest loss. Next, these two losses are reduced to the level of the third-largest loss. Next, these three losses are reduced to the level of the fourth-largest loss, and so on. This process continues until either all losses are reimbursed or the cash pool is depleted. The largest remaining loss at this point defines what is referred to as the “maximum stock loss” for all investors who have incurred losses (stated as a percentage of the notional value of stock being protected on day one).

The maximum stock loss is akin to the strike price of a long put protecting a stock position. For instance, if the maximum stock loss is 15 percent, an investor whose stock lost 80 percent of its value would be reimbursed from the cash pool, reducing that loss from 80 percent to 15 percent. But an investor whose stock lost 10 percent of its value would not receive any reimbursement. If the maximum stock loss is 0 percent, both the investor’s stock loss of 80 percent and the investor’s stock loss of 10 percent would be fully reimbursed by the cash pool.

Executives and employees can use a protection fund to protect both stock and stock-linked compensation, and doing so does not constitute a reportable event (they can voluntarily disclose if they wish).

The protection fund is tax-efficient in that it doesn’t cause a constructive sale, the straddle rules don’t apply, dividends received remain qualified for long-term capital gain treatment, and the distribution upon termination of the protection fund will result in either long-term capital gain or currently deductible capital loss.

The use of a protection fund can be cashless if funded through a margin or private banking loan against the stock position being protected; therefore, the investor’s existing asset allocation needn’t be disturbed.

Protection funds add a new dimension to the portfolio construction process for investors with concentrated stock positions. Investors can continue to chip away at their positions over time using the traditional tools, while using a protection fund to cost-effectively and tax-efficiently protect that portion of their position they wish to retain as a core holding.

¹ J.P. Morgan Asset Management, The Agony & The Ecstasy--The Risks and Rewards of a Concentrated Stock Position, September 2014.
² Goldman Sachs Asset Management, FactSet, 2016.
³ See U.S. patents: Nos. 7,720,736; 7,739,177; 7,987,133; 8,229,827; and 8,306,897.

Thomas J. Boczar, LLM, CFA, CPWA, is chief executive officer of Intelligent Edge Advisors in New York, N.Y. He can be reached at tboczar@intelligent-edge.com.