[Editor’s note: the author is the CEO of a registered broker-dealer.]
Public-company executives and employees holding highly appreciated company stock often diversify out of some positions over time via outright sales of their shares and by using tools such as exchange funds, equity derivatives, and charitable trusts. However, for many reasons — contractual and securities-law restrictions, tax and estate-planning considerations, strong emotional attachment, belief in the stock’s upside — they typically retain some portion of the stock as a core, long-term holding.
The problem is, that remaining position is unhedged and a major risk exposure relative to executives’ net worth.
Why so risky? Since 1980, approximately 320 stocks have been removed from the S&P 500 due to “business distress,” according to J.P. Morgan. Also, over the past 30 years, according to Goldman Sachs, 25% of the stocks in the Russell 1000 (which represents about 90% of the investable U.S. equity market) suffered a permanent loss of capital (i.e., lost more than 75% of their value and did not recover to 50% of their original value within the last 30-year period as of December 2015).
And after an eight-year climb, stocks are pricey, interest rates are rising, and the world is in turmoil.
All that said, corporate executives and employees with highly appreciated company stock positions don’t wish to “relive” 2008-09, so many of them are searching for innovative and more affordable ways to protect against a catastrophic stock loss.
Executives and employees can use equity derivatives such as puts, collars, and variable forward contracts to mitigate their downside risk, but they are expensive and used today mostly for short-term (i.e., tactical) protection and to generate additional income. Exchange funds can help those who wish to diversify out of some of their stock position but can’t protect shares an investor wishes to keep. The use of either strategy triggers a reportable event for company insiders.
“Stock protection funds” are a recent innovation. They can help executives and employees who wish to keep some of their company stock position as a core, long-term holding by allowing them to affordably preserve their unrealized gains and keep all upside potential. (See a CFA Institute video here.)
Protection funds wed modern portfolio theory (MPT) and risk pooling. MPT demonstrates that over time there will be substantial dispersion in individual stock performance. Risk pooling reveals that it’s 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 that of at-the-money or slightly out-of-the-money put options, but at a fraction of the cost
Investors, each owning stock in a different industry and each seeking to protect the same notional value of the stock, contribute a modest amount of cash (not shares, which they can continue to own) into a fund that terminates in five years. The cash is invested solely in U.S. Treasury 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 the aggregate losses (approximately a 70% probability based on extensive back-testing), all losses are eliminated and the excess cash is returned to investors. If the aggregate losses exceed the cash pool (about a 30% probability), large losses are substantially reduced.
The back-testing results suggest that the cost of such protection should be approximately 1.25% per annum. Along these lines, a protection fund was operated from June 1, 2006, to June 1, 2011, protecting 20 investors with stocks in different industries, each protecting the same stock value. The upfront cash contribution was 10% (2% per annum for 5 years) of the stock value protected.
Of the 20 stocks, 8 incurred losses (37%, 32%, 24%, 18%, 13%, 8%, 5%, and 1%). All losses were reimbursed and the remaining cash returned to investors. Each investor received the equivalent of 5-year “at-the-money” put option protection on their stock, with an amortized cost of 1.38% per annum. Needless to say, it would’ve been cost-prohibitive for these 20 investors to roll put options during the same period (which included the entire financial crisis) to achieve at-the-money put option protection.
The shares being protected are not pledged or encumbered, and investors can continue to own their shares, or they can sell, gift, donate, pledge, borrow against, or otherwise dispose of them at any time during the protection fund’s five-year term.
Assuming company policy permits it, public-company executives and employees can use a protection fund to protect both stock and stock-linked compensation. Such compensation includes restricted stock units, stock appreciation rights, non-qualified stock options, incentive stock options, and employee stock-purchase plans. Taking advantage of the dual protection should not cause a reportable event for company insiders (although they are free to voluntarily disclose).
A protection fund is tax-efficient in that it doesn’t cause a common law or statutory constructive sale; the “straddle” rules don’t apply; dividends remain taxed at the long-term capital gain rate; and the cash distribution upon termination of a protection fund results in a long-term capital gain or currently deductible capital loss.
The use of a protection fund can be cashless if it’s 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.
In sum, stock protection funds add a new and desirable dimension to the wealth-structuring and portfolio-construction process for executives and employees with concentrated company stock positions. They continue to “chip away” at their highly appreciated positions over time using the traditional tools, while using a protection fund to cost-effectively and tax-efficiently derisk that portion of their company stock that they wish to retain as a core, long-term holding.
Thomas Boczar is CEO of Intelligent Edge Securities, a registered broker-dealer and member of FINRA and SIPC. Elizabeth Ostrander is the firm’s managing director and head of business development. Intelligent Edge Securities is a wholly owned subsidiary of Intelligent Edge Advisors, a provider of investment banking and corporate advisory services.