Managing Concentrated Holdings

Concentrated positions, whether publicly traded or privately held, have implications on clients’ financial plans. They can arise from equity/option grants from employment, entrepreneurship, a successful investment, or inheritance. The potential solutions are wide ranging, dependent on a multitude of factors, and involve tradeoffs between diversification and taxes. In this post, I will discuss different concentrated holding scenarios that an advisor might encounter, and the solutions that they can employ.

Publicly Traded Securities

Concentrated positions in publicly traded securities are far easier to manage than privately held businesses. Generally, a client’s concentrated position will have a low cost-basis – meaning unless it is held in a qualified account, there are tax consequences to selling it. When a client has a concentrated position in a publicly traded security, advisors have a few options:

Building the rest of the portfolio around the holding.

• Exclude exposure similar to the concentrated holding. For example, if the client has a concentrated position in AAPL – the advisor can reduce exposure to the technology sector in the rest of the portfolio.

• This strategy comes with increased concentration risk (either a pro or a con depending on the assessment of the security), less diversification, and more tax efficiency.

Selling the concentrated holding and moving into a diversified portfolio.

• Paying long term capital gains, either all at once or on a pre-defined schedule using an annual capital gains budget, is the simplest option and should be considered.

• This strategy removes concentration risk, allows for diversification into a model portfolio, but comes with a tax bill.

Creating a hedging strategy

• If the client wants to retain exposure to the security but is willing to pay to adjust the range of possible outcomes, hedging strategies can be employed using in the options market. These can include, but are not limited to, protective puts, put spreads, and collars.

• This strategy allows the client to retain concentration risk and reduce the probability and/or magnitude of “worst case outcomes”, but typically comes at a cost and can be a drag on returns.

Privately Held Businesses

Whether or not to diversify out of a privately held position is a complex and difficult decision. While this post will not cover in detail the reasons for doing or not doing so, here are some factors to consider:

• Stability and diversification of the business

• Value of having control over the business, cash flows, etc.

• Management quality

• Valuation of the business

• Tax liability upon sale

• Any fees related to selling the business.

The categories of how to manage portfolios around privately held businesses are like the categories for publicly traded securities, but the details and execution may differ.

Building the rest of the portfolio around the holding.

• Example - a client owns a manufacturing business that is highly exposed to growth and declines in nominal GDP. In the public markets portfolio, the advisor can overweight sectors (e.g., consumer staples) and asset classes (e.g., long term bonds) that tend to outperform when the privately held business tends to suffer.

Selling the concentrated holding and moving into a diversified portfolio.

• This, for obvious reasons, is far trickier to do with a privately held business than a public market security.

• The advisor should discuss the pros/cons of exiting with the client to give them a framework for deciding.

Creating a hedging strategy

• This, again, is trickier for privately held businesses. Since there are generally not options on privately held securities, the advisor will need to find a security that is highly correlated with the privately held business and decide whether an options strategy is pursuing. For example, an owner of a small regional bank may use options on the KRE exchange traded fund.

• This approach comes with “basis risk”, meaning that there may be a mismatch between the asset and the hedge.

The Bottom Line

Managing a client’s concentrated holding(s) effectively is a great way for an advisor to add value and earn their fees. Invariant collaborates with advisor partners to create and implement a range of possible solutions in these scenarios.