You Made A Fortune In One Investment. Now What?

The Pareto Principle states that roughly 80% of consequences come from 20% of the inputs. This concept was developed by economist Vilfredo Pareto in the 1800s and has multiple applications in business, including management, marketing strategy, customer service, and investing. In the finance world, application of this principle lends itself to the theory that the vast majority of an investor’s gains come from a small percentage of their total investments, while most of their portfolio will underperform the broad market over long time horizons.

Many investors find themselves in the enviable predicament of having too much exposure to one or a few companies because of their outperformance versus the market. A theoretical buy-and-hold investor who bought a big position in Apple AAPL 10+ years ago would be a good example of this. Yes, the rest of their portfolio has likely appreciated over that timeframe, but AAPL has far outpaced the market. As a result, a large portion of this person’s wealth is now tied to one company. Other examples of this phenomenon include employees of a company who have accumulated significant wealth via stock options and others who have inherited sizeable stock positions. Holding such positions dramatically increases risk and leaves them vulnerable to significant drawdowns. Numerous studies have shown that portfolios with concentrated positions are destined to underperform – it’s only a matter of time. 

Someone looking to rebalance into a diversified market portfolio has to make the important choice of how to reallocate their funds. There are generally four options: 1) Sell the shares and take a big hit to the portfolio value via capital gains taxes, 2) Use traditional tax-loss harvesting methods and sell some losing positions to offset the gains in their concentrated position, 3) Transfer their position into an exchange fund, or 4) Use option overlays to mitigate or eliminate tax liability. Let’s take a look at each of these methods.

An outright sale of the shares is by far the most punitive of the above choices. Federal long-term capital gains tax rates in 2023 are 15% for married couples earning over $83k per year and reach 20% for those earning more than $553k annually. Additionally, 42 of 50 states tax capital gains as income and the tax rates range from 2.9% to 13.3%, with most landing in the mid-single digits.  Selling the shares outright can be viewed as an immediate loss of 15-25% of that position’s value, and the tax bill can be significant in many situations. Limiting such liabilities is obviously optimal for long-term wealth appreciation.

Traditional tax-loss harvesting is a very popular method employed by wealth managers, but it has its shortcomings. Generally applied near the end of the year, advisors will look to rebalance their client portfolios and avoid taxes due by selling both losing and winning positions. If you can accrue losses equal to the amount of gains that have been booked, then the effective tax liability is zero. However, this requires that the client actually has significant paper losses that can be harvested. The end of 2022 was a very popular time for this method because of the large number of companies that experienced significant declines, but loss harvesting won’t always be a viable option. This flies in the face of the traditional methodology of “buy low, sell high,” as you’re selling both losing and winning positions. Lastly, wash sale rules require that the investor can’t buy the position back for 30 days after it’s sold.

Exchange funds have become popular vehicles for tax optimization among ultra-high-net-worth individuals. An investor looking to reduce a concentrated position can move it into an exchange fund, which is basically a pool of other concentrated positions that have been aggregated by an asset manager. The investor is “exchanging” their holding in one or a few positions for a pro-rata allocation of the pool of assets. This diversifies their portfolio, reduces risk, and allows the holder of one or a few stocks to now own a percentage of the fund without having to sell their concentrated holding and pay capital gains taxes. While this may sound like the perfect solution for concentration issues, exchange funds have their problems. Most have a minimum position size of $5M, which effectively eliminates this option for a huge percentage of investors. For those able to meet the minimum asset requirement, entering into an exchange fund requires a seven-year commitment. Any asset sales before the end of this lockup period will result in penalties due to the fund, and in some instances the fund will just transfer the original concentrated position back to the investor. For anyone who may have short-term liquidity needs over the next seven years, this makes such a time commitment a difficult proposition. Lastly, exchange funds can be expensive, with many charging a management fee of 150-200 basis points annually. Despite these shortcomings, exchange funds can still make sense for some individuals who have significant tax liabilities and low liquidity needs.

Option overlays are the final (and in our biased opinion, best) solution for mitigating tax liability and concentration issues. An investor holding a large position in one company can use covered calls or collars as tools to reduce volatility, generate yield, and in many instances completely eliminate tax liability over time. The strategies offer a great deal of flexibility and can be tailored to meet the specific needs of each individual investor. An option overlay program can be either systematic or tactical, which can create the potential for excess alpha generation and isn’t a drain on liquidity. Depending on volume and transaction size, the costs to implement these programs are often minimal when compared to those of an exchange fund. The use of options will require the investor to pay commissions to their broker, and of course there are management fees assessed. However, in many cases, the total cost to the investor may be significantly less than the price of other solutions.  The cost is also usually minimal when compared to the tax savings that can be realized. Most option overlay strategies can be implemented for 50 basis points annually or less, and this cost is oftentimes only a small fraction of the total tax liability.

Options provide a value-add to an advisory practice and its clients, but they can be complex. Additionally, the tax code is difficult to navigate and these overlays will require constant attention and rebalancing. The team at Exceed Investments has over 40 years of professional derivatives experience and can streamline this process for you and your clients, allowing them to efficiently grow their wealth.

This blog post is for informational or educational purposes only and is not intended as investment advice.  Any discussion of investment strategy or approach is intended only to illustrate investment concepts and in no case does the discussion represent Exceed Advisory’s investment performance or the results of any Exceed Advisory portfolio.  We provide investment advice only to clients and only after entering into an advisory agreement and obtaining information concerning individual needs and objectives. We think the information provided is accurate, but accuracy is not guaranteed. All investing in securities involves risks, including the risk of loss.