Strategies for Managing Concentration Risk

April 28, 2023

There are many risks that we need to be aware of as investors. Concentration risk as it relates to this article will be referring to having too much exposure to one company. The recent zeroing out of equity holders who were exposed to Silicon Valley Bank and Signature Bank of New York are brutal reminders of what can happen when we lose sight of this risk. So how do people arrive at this problem and what do we do about it? There are three common ways that people end up with too much exposure to one company.

The first way would be through various types of equity grants and incentives that many publicly traded companies offer their employees as a form of income. If your employer is a well-run company that is appreciated by the markets, this can be a fantastic benefit. For those less fortunate, such as employees of Silicon Valley Bank, they would have benefited from a well thought out diversification plan. This may be out of your control in the case of recently received and unvested forms of equity grants. At the executive level, if this is not handled or dealt with early on then the problem can be exacerbated.

Another possibility is that you purchase a stock, and it becomes a wildly successful investment. We have seen examples of concentrated equity holdings in companies like Apple or Microsoft, which have appreciated significantly over time. There may be nothing materially wrong with the company which requires an investor to sell, but due to its relative size in a portfolio we would make the recommendation to reduce exposure and diversify. Many people are reluctant to sell to delay the tax impact, but the last thing you want to happen is to wait long enough that those gains eventually become losses. GE is a perfect example of this, where long term investors of a once great company ended up getting hurt, especially those with too much exposure[1].

The last major reason people end up with large exposure to a stock is through a buyout. You have built or have equity in a successful company and have now accepted a buyout offer that comes with a catch- you get paid with a combination of cash and stock. After the celebration has died down, you now have to worry about a new major concentration risk. Mark Cuban is one of the most famous examples of the right way to approach concentration risk. He hedged against the Yahoo stock that he received as compensation for his company, right before the tech bubble burst[2].

The specific strategy we recommend to clients depends on many factors, such as; 1) how severe the concentration risk is, 2) what tax bracket the client is in, and 3) the overall goals and risk tolerance of the person, among other things. All of these strategies are predicated on a willingness to eventually sell a position and realize any potential tax implications in addition to other factors.

Scheduled Sales – This strategy is as simple as it sounds. For those concerned about tax implications, selling the position in chunks over a few years is generally more acceptable as you are spreading out the tax burden. If we are in a year such as 2022, where there were many losses to harvest due to overall market performance, we can speed up this process depending on how many losses can be realized. For those who have concentrated positions in tax-deferred accounts, there may be sentimental value associated with positions, and this helps to soften the blow in winding those down even if there are not any tax complications.

Advanced Order Types – For those who have a minimum acceptable price or range they are willing to let a company trade down to before selling or have a target price above the current price that they are willing to sell at, this strategy can be utilized. Your downside order options are stop-loss or stop-limit, and each have pros and cons. A stop-loss triggers a sale at the next available market price once the trigger price is reached, and a stop-limit triggers a limit-sell order once a trigger price is reached. The stop-loss is guaranteed to get filled, although it may not be at your stop price. The stop-limit is not guaranteed to get filled, but if filled will be at the exact price you set. The limit-sell would typically be your upside trade, where you sell at or above a predetermined sell price once triggered. These can be used in combination and would be considered a bracketed order if used simultaneously.

Hedging with Derivatives – A distant cousin to the advanced order types would be utilizing options to hedge against a sharp move in a concentrated position. Purchasing a put contract would be analogous to a stop-limit, and selling-to-open a call contract would be analogous to a limit-sell. One option contract represents 100 shares of common stock, so if you were to own 100 shares of XYZ corporation and wanted to protect yourself on the downside, you would purchase one put contract in a strategy called a “married put” or “protective put”. Options come in different strike prices and expiration dates, which allows you to customize your ‘insurance’. As with all insurance, it comes at a cost based on how much protection you want. If XYZ were trading at $50 per share, and you wanted to protect losses below $45 per share, this would be much more expensive than protecting losses below $40 per share. Let’s say you purchased a put contract with a strike price of $45 that expires in one month and the stock were to drop below your strike price prior to expiration. Your contract would increase in value and you can either sell those contracts and pocket the difference to help soften the blow, or you can exercise the contracts and receive the $45 per share minus what you paid for the contract up front. If the stock remains above your strike price your puts will expire worthless, and you will need to purchase more to maintain the expired protection.

Calls options work inversely, where they increase in value when the stock goes up. To continue the limit-sell analogy, you can sell-to-open one contract at a price where you are willing to sell, let’s say that is $55 per share in our example. You receive a premium up front for selling contracts to the open market in exchange for giving up your shares above $55, if the stock is at that level or above on expiration date. If your calls expire and the stock is below $55, you keep your shares and the premium you received as an extra form of income, and you will need to re-establish the trade with new contracts to attempt to sell again. This is called a “covered call” strategy. This does not protect you from a swift downward move, but it can soften the blow to a degree and provide price points where you are comfortable selling your stock.

If you are not happy with the idea of paying for insurance, you can combine these strategies by selling a call above the current price and use that premium income to pay for a put which is below the current price. This strategy is called a “collar” and is analogous to a bracketed order.

Gifting – For the charitably minded, you can gift a stock held in a taxable account directly to a charity, a Donor Advised Fund, or a Charitable Remainder Trust. This will allow you to avoid paying capital gains taxes in exchange for the eventual use of these proceeds going to charitable purposes. Each of the charitable strategies come with their own set of pros and cons that will be situationally dependent.

Company Stock Plans – For those who are regularly receiving company stock in one form or another as compensation, the strategy would be to proactively utilize all forms of liquidity as they become available. As an example, a 10b5-1 plan provides liquidity windows which attempt to prevent insiders from acting immediately on information the public may not be aware of. This plan allows insiders to place advance limit orders should they want to sell company stock. For some, there may be a simple liquidity window attached to a restricted stock unit that has recently vested, where shares can be sold on the open market. The specifics will depend on each company’s policy, but the point is to be aware of your options and act preemptively before a position becomes overly concentrated.

Many of these strategies are customizable to your situation and can be used in conjunction with one another. If you have any questions about concentration risk, reach out to your wealth advisor at GYL to discuss potential options and which of these strategies may make sense to explore.

The views contained in this presentation represent the opinions of GYL Financial Synergies, LLC as of the date hereof unless otherwise indicated. This and/or the accompanying information was prepared by or obtained from sources GYL Financial Synergies, LLC believes to be reliable but does not guarantee its accuracy. The report herein is not a complete analysis of every material fact in respect to any security, mutual fund, company, industry, or market sector. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance does not guarantee future results. CAR20230427CRAFJG

[1]The Wall Street Journal: GE What Went Wrong, Nov. 13, 2021

[2] How Mark Cuban Saved Billions Yahoo Windfall Dotcom Crash, June 12, 2020