CONCENTRATED SINGLE-ASSET POSITIONS: OVERVIEW The three major types of “concentrated position in a single asset” include: 1 Publicly traded single-stock positions: Concentrated positions
Trang 1Reading 11 Concentrated Single-Asset Positions
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A concentrated position occurs when an investor owns
an asset that represents a large percentage of his/her
overall portfolio or net worth Concentrated position in
an investor’s portfolio reduces portfolio diversification
and exposes the investor to significant idiosyncratic (or
company-specific) risk and sector-specific risk In
addition, sale of a concentrated position may raise
substantial concerns about tax and liquidity
The objective of managing a concentrated position is to hedge the investor’s portfolio against price declines and diversify it in a tax-effective manner In order to best meet this objective, the investor must match his goals and objectives with different hedging tools and techniques by considering the benefits and drawbacks
of each tool/technique
2 CONCENTRATED SINGLE-ASSET POSITIONS: OVERVIEW
The three major types of “concentrated position in a
single asset” include:
1) Publicly traded single-stock positions: Concentrated
positions in publicly traded single-stock may occur as
a result of
• Stock or stock options received by senior company
executives as part of their compensation;
• A large position in a single stock inherited by family
members;
• Stock received by the seller of a privately owned
business in lieu of cash when the buyer is a publicly
traded company;
• A successful long-term buy-and-hold investing
strategy;
• An IPO of a private company;
• A heavy allocation of a pension fund in a sponsor’s
company stock;
• A significant amount of shares of another publicly
traded company held by a publicly traded
company for business or investment purposes
2) A privately owned business (including family-owned
businesses): It refers to ownership in privately owned
businesses that is transferred down from one
generation to the next
3) Commercial or investment real estate: Concentrated
positions in investment real estate can be derived as
a result of
• A significant percentage of the value of a private
business enterprise represented by commercial or
industrial real estate;
• A standalone investment of private clients (i.e real
estate developers) in commercial real estate;
• Inheriting investment real estate or receiving a gift or
bequest;
• Lack of other investment opportunities in certain
jurisdictions;
2.1 Investment Risks of Concentrated Positions
The concentrated positions in a single asset expose an investor to systematic risk and non-systematic risk (either company or property-specific risk) Besides risk,
concentrated positions also affect return of an investor because holding under-performing company stock or non-income-producing land involve greater opportunity costs and some concentrated positions may not
generate fair risk-adjusted returns
Concentrated positions cause owners to underestimate the risk of their concentrated position and significantly overestimate the value of that asset
2.1.1) Systematic Risk Systematic risk/non-diversifiable/market risk is the risk that affects the entire market or economy and cannot be reduced through diversification For example, risk associated with interest rates, inflation, economic cycles etc
Different sources of systematic risk include:
• Equity market risk
• Business cycle risk (i.e risk associated with unexpected changes in the level of real business activity)
• Inflation risk (i.e risk associated with unexpected changes in inflation rate) etc
Note that when the risk of human capital is the same as the systematic risk exposures associated with a
concentrated position (e.g founder of a securities firm with a concentrated position in the firm’s shares), then the investor would face portfolio losses and decrease in job earnings at the same time
2.1.2) Company-Specific Risk Company-specific risk is the risk that affects a single company or industry It is also known as non-systematic risk, industry specific or idiosyncratic risk e.g failure of a drug trial A concentrated position in a single stock exposes an investor to a higher level of
Trang 2company-specific risk The level of company-company-specific risk is
positively related to volatility of returns, all else equal
Company-specific risk can be reduced or avoided
through diversification i.e investing in different asset
classes and/or securities
2.1.3) Property-Specific Risk
Property-specific risk is a type of non-systematic risk that
affects a particular piece of real estate For example,
• A potential environment liability associated with a particular property;
• Risk associated with renewal of leases and time period involved in finding new tenants;
• Credit risk associated with smaller, non-investment-grade tenants;
3 GENERAL PRINCIPLES OF MANAGING CONCENTRATED
SINGLE-ASSET POSITIONS
3.1 Objectives in Dealing with Concentrated
Positions (covering Section 3.1.1-3.1.2)
1) Typical Objectives: Typical objectives include goal
• To reduce the concentration risk while minimizing
any costs associated with risk reduction
• To generate liquidity in order to diversify and to
satisfy spending needs
• To optimize tax-efficiency, that is, to achieve the
above two objectives in the most tax-efficient
manner
2) Client Objectives and Concerns: The concentrated
position can be used in conjunction with gifting
strategies to meet wealth transfer objectives i.e
leaving a bequest or giving charity etc
In managing risks of concentrated positions, advisors
must also consider rationale for holding such positions
Rationale for holding concentrated stock positions: An
investor may prefer to retain concentrated stock
positions because of
• Selling constraints imposed on company executives
to hold shares for a long time period in an attempt to
encourage them to work hard for the growth of the
company;
• Emotional attachment to the stock
• Concerns about the tax implications of selling i.e to
defer capital gains or to eliminate capital gains
• Desire to maintain effective voting control of the
company
• Desire to participate in the stock’s future returns
• Lock-up period constraints or insider restrictions on
the selling of shares
• Illiquidity of the stock
Rationale for holding concentrated positions in privately
owned businesses: The business owner
• May find it premature to sell the company because
it has just entered its growth phase;
• May have a desire to maintain total control of the
company;
• May have a desire to give senior management and
other key employees the opportunity to eventually acquire control of the business;
• May wish to transfer control of the business to the next generation;
Rationale for holding concentrated positions in investment real estate: The investor may prefer to retain concentrated positions in real estate
• To maintain control of the property for the successful operation of a business enterprise;
• To transfer ownership of the real estate to the next generation;
• To generate profit through price appreciation of the property;
3.2 Considerations Affecting All Concentrated
Positions (Covering Section 3.2.1-3.4.2)
Various constraints faced by owners of concentrated positions that restrict their flexibility to either sell or hedge their shares are as follows
1) Tax Consequences of an Outright Sale: Simply selling the concentrated positions with highly appreciated current market values compared to their original cost (cost basis) result in an immediate taxable capital gain (selling price – tax cost basis) and associated tax liability for the owner
2) Liquidity: Concentrated position in a publicly traded stock is illiquid when the size of the concentrated position is large relative to the trading volume of the company’s shares or when the owners have legal constraints with regard to the timing and amount of any sales Concentrated position in privately traded shares is illiquid because private company’s shares have no readily available market Similarly, direct ownership of investment in real estate is also illiquid due to large transaction size and lack of availability and timeliness of information
3) Institutional and Capital Market Constraints: They can further be classified as follows:
a) Margin-Lending Rules: Margin-lending rules are the rules that determine the maximum amount that a bank or brokerage firm is allowed to lend against
Trang 3the securities positions owned by their customers
Certain types of secured lending that is reported as
“off-balance sheet” debt (i.e prepaid variable
forward, discussed below) are considered as
“sales” for margin rule purposes (but not for tax
purposes; implying that capital gains taxes can be
deferred or eliminated) and are therefore NOT
subject to margin rules
There are two types of Margin Regime
i Rule-based system: In a rule-based system, the
maximum amount that can be lent against the
security owned by the customer (investor)
depend on strict rules regarding the purpose of
the loan For example, in U.S if the loan
proceeds will be used to buy additional
securities, then the bank can lend a maximum
of 50% of the value of the stock
ii Risk-based system: Under a risk-based system if
the stock is completely hedged by a long put,
then bank or brokerage firm can lend 100% of
the put strike to the investor even if the loan
proceeds will be used to buy additional
securities Portfolio margining is an example of a
risk-based margin regime The risk-based rules
provide greater flexibility to advisors with regard
to obtaining desired economic and tax
outcomes
b) Securities Laws and Regulations: Company insiders
and executives are subject to various regulatory
selling constraints i.e prohibition from selling during
black-out periods, or when in possession of material
nonpublic information; disclosure/reporting
requirements; restrictions regarding the timing and
volume of sales or hedging transactions
c) Contractual Restrictions and Employer Mandates&
Policies: Contractual restrictions include IPO
“lock-up” periods Employer mandates and policies
include a prohibition from buying/selling during
“blackout period”; “right of first refusal” that require
equity-holders of a private company to first give
other equity investors the right to buy the interest at
the same price and under the same conditions as
being offered to a third party before selling their
investment to a third party These restrictions and
mandates tend to reduce the liquidity of an
investment holding
d) Capital Market Limitations: Factors that affect
dealers’ decision to execute collars or use other
hedging techniques include:
critically important for the dealer to manage its
counterparty risk The investor executing the hedging
transaction with the dealer can lend its “long” shares
to the dealer (provided that the investor has no
restrictions on lending); however, for tax purposes,
the transaction is considered as a “sale”
very important for the dealer to periodically adjust its
hedge
trading volume of the stock is important for the dealer to analyze shares’ propensity to move in upward or downward direction This implies that dealers prefer to enter into a hedging transaction for
the shares of a company with an established trading
history/pattern
4) Psychological Considerations: Psychological considerations of clients that negatively affect the decision making of holders of concentrated positions and act as constraints to dealing with concentrated positions include:
a) Emotional Biases: For example,
• Overconfidence and familiarity (illusion of knowledge)
• Status quo bias
• Nạve extrapolation of past returns
• Endowment effect
• Loyalty effects b) Cognitive Biases: For example,
• Conservatism
• Confirmation
• Illusion of control
• Anchoring and adjustment
• Availability heuristic Emotionally biased clients should be advised differently from the clients with cognitive errors i.e emotionally biased clients should be advised by explaining the effects of investment program on various investment goals and by determining a deceased person’s objective in owning the concentrated position and bequeathing it; whereas clients with cognitive errors should be advised by providing quantitative measures e.g S.D and Sharpe ratios
NOTE:
Behavioral biases are discussed in detail in Reading 6 and 7
3.5 Goal-Based Planning in the
Concentrated-Position Decision-Making Process Investment advisors can incorporate psychological considerations of their clients holding concentrated positions into asset allocation and portfolio construction decisions using “Goal-based Planning” Goal-based planning involves dividing a portfolio into following three
notional “risk buckets” addressing different investment
goals and then determining appropriate asset allocation Practice: Example 1,
Volume 2, Reading 11
Trang 4consistent with each risk bucket and its corresponding
goals
1) Personal Risk Bucket: The goal of personal risk bucket
is to protect the client from poverty or significant
decrease in standard of living Hence, asset
allocations to this bucket focus on investing in low-risk,
low-return investments for the purpose of minimizing or
eliminating loss These low-risk investments include
client’s primary residence, certificates of deposits,
Treasury bills, and other “safe haven” investments
2) Market Risk Bucket: The goal of market risk bucket is to
maintain the current standard of living Hence, asset
allocations to this bucket focus on investing in assets
with average risk-adjusted market returns, e.g stocks
and bonds
3) Aspirational Risk Bucket: The goal of aspirational risk
bucket is to increase wealth substantially Hence,
asset allocations to this bucket focus on investing in
high-risk, high-return assets e.g client’s concentrated
positions (i.e privately owned businesses, investment
real estate, concentrated stock positions, stock
options etc.)
• Owner’s Primary Capital: Owner’s primary capital is
the assets owned by the client other than the
concentrated position It comprises assets that are
allocated to his or her personal and market risk
bucket
• Primary capital requirement: The capital needed to
be allocated to client’s personal and market risk
buckets is referred to as primary capital requirement
• Owner’s Surplus Capital: It is the capital in excess of
the primary capital requirement It comprises assets
that are allocated to his or her aspirational risk
bucket
Goal-based planning approach helps investors in
identifying concentration risk and in determining
whether a sale or monetization will enable the investor to
meet his/her financial goals
• For example, if investor’s goal is to maintain its
current standard of living after retirement, then
he/she should allocate a significant amount of the
portfolio to the personal risk and market risk buckets
as well as should diversify his/her concentrated
position in a single asset
• The sale or monetization of the concentrated
position should generate sufficient after-tax
proceeds to help investor achieve financial
independence, i.e meet his/her lifetime spending
needs and desires
Various factors are considered to determine the ability
of the sale or monetization of the concentrated position
to achieve financial independence for the owner i.e
i The lifetime spending needs and desires of the client after the sale or monetization of the concentrated position;
ii The primary capital requirement, i.e present value of the capital needed to meet client’s lifetime
spending needs with low or zero probability of running out of money
iii Current value of the concentrated position The value of concentrated position will vary depending
on the type of monetization strategy used by the investor
iv Current value of owner’s primary capital
v The current value of the concentrated position under one or more of the monetization strategies to
determine whether it is sufficient to meet client’s primary and surplus capital requirements
3.6 Asset Location and Wealth Transfers
Asset location and wealth transfers are the two tools available to investors for addressing their concentrated positions
Asset location decision refers to locating/placing
investments (different asset classes) in appropriate accounts Asset location decisions primarily depend on the tax regime governing the investor
Implications of asset location for the owners of concentrated positions:
• Assets that are taxed heavily/annually should be
held in tax deferred and tax exempt accounts
• Assets that are taxed favorably (i.e at lower rates) and/or tax deferral should be held in taxable accounts
Wealth transfer planning refers to determining the most tax-efficient method and timing of wealth transfer
at the time before substantial appreciation of the value of the concentrated position include:
A Direct gifts to family members
B Direct gifts to long-term trusts
C Ownership transfer estate freeze (or an early of an estate): This strategy seeks to transfer future appreciation (typically of a corporation, partnership, or limited liability company) to the next generation at little or no gift or estate tax cost Under this strategy, only the current market value (not the future appreciation) of the equity Practice: Example 2,
Volume 2, Reading 11
Trang 5position is subject to gift or wealth transfer tax
In a typical corporate estate tax freeze involving a
recapitalization of a closely held family-owned
corporation,
• The older generation owning all of the stock of the
company exchanges their existing company’s stock
for two newly issued classes of stock i.e
is equal to the current value of 100% of the
corporation These shares are held by the older
generation These shares pay a fixed rate like
bonds; thus, their value does not appreciate
greatly
nominal value and are gifted to the next
generation The value of common shares increase
with the future appreciation in the value of the
corporation However, the appreciation is not
subject to any gift or estate tax until the common
shares are passed by gift or bequest to the next
generation
• Due to the voting power attached to preferred
shares, the control of the company is retained by the
older generation
• The preferred shares can be redeemed and voting
rights may be provided to common shareholders
upon retirement or death of the older generation
NOTE:
The corporate estate tax freeze is not allowed in all
jurisdictions
It must be stressed that it is highly important for an
advisor to plan the management of an owner’s
concentrated positions as early as possible because
over time, as the concentrated position appreciates in
value, wealth transfer tools (although still useful) tend to
be less efficient, more complex, and expensive to
implement
concentrated position, the transfer tax can be
minimized by contributing the concentrated position
to a limited partnership and gifting the limited
partnership interests to the next generation
• The value of a limited partnership interest is typically
less than the proportionate value of the underlying
assets (discount of 10-40%) due to the following two
reasons:
partnership interests are restricted and difficult to
sell outside the family
partnership (as represented by general
partnership interest) and the concentrated
position within it is retained by the parents, the
value of limited partner’s non-controlling interest is
low
• Contributing the concentrated position to a limited
partnership generate gift tax savings at the time of
transfer as well as estate tax savings if the value of concentrated position appreciates by the time the parent dies
Example:
Suppose the value of concentrated position is $10 million and the combined discount is 30% The parents decide
to transfer 25% interest to their children Hence, Value of interest gifted to children = 25% × $10 million ×
(1 – 30%)
= $1.75 million
If the value of $10 million concentrated position increases to $35 million by the time the parent dies, Value of interest held by children = 25% × $35 million
= $8.75 million Gift tax valuation = $1.75 million
3.7 Concentrated Wealth Decision Making: A
Five-Step Process
Step 1
•Identify, establish , &
document objectives &
constraints of the owner of the concentrated position
as well as the impact of those constraints
Step 2
•Identify tools or strategies that can be used to meet owner's objectives consistent with constraints
Step 3
•Thoroughly compare tax advantages and disadvantages of each tool or strategy
Step 4
•Thoroughly compare
non-tax advantages
and disadvantages of each alternative tool or strategy
Step 5
•Formulate and document an overall strategy that best meets client's objectives after comparing tax & non-tax advantages and disadvanatges of each alternative tool
Practice: Example 3, Volume 2, Reading 11
Trang 64 MANAGING THE RISK OF CONCENTRATED SINGLE-STOCK
POSITIONS
Common Tools/strategies that can be used to mitigate
the risks of any concentrated position are as follows
These tools may vary depending on the jurisdiction
A Outright sale: It refers to simply selling the security to
reduce concentrated position
Advantages:
• It is the simplest method
• It provides investors the maximum flexibility with
regard to disposition or reinvestment of sale
proceeds
• It facilitates the owner to reduce overall portfolio risk
and achieve diversification
Disadvantages:
• It incurs tax liability (i.e capital gains tax)
• It is most suitable for publicly traded shares and for
positions with no sale restrictions
• An outright sale eliminates any upside price
potential associated with the concentrated position
and also results in loss of dividends and voting
power
B Monetization strategies: Monetization strategies
facilitate owners to mitigate the risks of a
concentrated position without incurring tax liabilities
Examples of monetization strategy that involve
borrowing include:
• Margin loan: It is a loan against the value of a
concentrated position
• Recourse and non-recourse debt
• Fixed and floating rate debt
• Loans embedded within a derivative (e.g a prepaid
variable forward)
Other monetization strategies include:
• Short sales against the box
• Restricted stock sales
• Public capital market-based transactions i.e debt
exchangeable for common offerings
• Rule 10b 5-1 plans and blind trusts (U.S.)
• Exchange funds (U.S.)
C Hedging: This strategy involves hedging the value of the concentrated asset using derivatives i.e
exchange-traded instrument (i.e options or futures) or
an over-the-counter (OTC) derivative (i.e OTC options, forward sale or swap) However, such hedging transactions must not be deemed as
constructive sale to avoid incurring taxes Transactions
that may be deemed as constructive sale of an appreciated stock include:
• A short sale of the same or substantially identical property;
• An offsetting notional principal contract on the same or substantially identical property;
• A futures or forward contract to deliver the same or substantially identical property;
4.1 Introduction to Key Tax Considerations
The risk of a concentrated asset (e.g stock) can be mitigated by shorting the stock directly or by using derivatives Either method generates the same economic outcome; but they are taxed differently Most
of the tax regimes that govern taxation of financial instruments are comprehensive in nature However, they
are not always internally consistent, i.e tax treatment of
different tools varies depending on tax regimes The internal inconsistency of tax codes allow investors to reduce their tax risk or generate significant tax savings
by selecting the tool that provides the most efficient economic and tax result
4.2 Introduction to Key Non-Tax Considerations
(Covering Section 4.2.1-4.2.6) Non-tax considerations that must be considered with regard to selecting the optimal derivative instrument for hedging the concentration risk include:
1) Counterparty Credit Risk: In an OTC derivative the investor is exposed to counterparty credit risk In contrast, exchange-traded derivatives are not subject
to credit risk of counterparty or have lower counterparty credit risk
2) Ability to Close Out Transaction Prior to Stated Expiration: Since exchange-traded derivatives are highly liquid, investors can easily close-out the transaction by entering into offsetting transactions before contract’s stated expiration Whereas in OTC derivatives, early termination of a particular contract usually involves a concession in return
3) Price Discovery: Exchange-traded derivatives facilitate price discovery due to their standardized terms and conditions By contrast, in OTC derivatives, price is determined through negotiation by the parties involved in a transaction
4) Transparency of Fees: Fees (commissions) and expenses in exchange-traded transactions are
Trang 7relatively more transparent than that of OTC
transactions
5) Flexibility of Terms: Due to customized nature of OTC
derivatives, they are relatively more flexible to meet
the specific needs of counterparties compared to
standardized exchange-traded instruments
6) Minimum Size Constraints: Exchange-traded
derivatives typically have a smaller minimum size
constraint than OTC derivatives
Three primary strategies that can be used to mitigate risk
of a concentrated position in a common stock are as
follows
1) Equity monetization
2) Hedging
3) Yield enhancement
4.3.1) Equity monetization
Equity monetization involves borrowing against the value
of the concentrated stock position and reinvesting the
loan proceeds to achieve diversification It allows an
investor to cash out the appreciated value of a
concentrated stock position without incurring any tax
liability at the time of cashing out When the stock
position is hedged, an investor can achieve a high
loan-to-value (LTV) ratio
Advantages of Equity monetization:
• It allows an investor to transfer the economic risk and
reward of a stock position without actually
transferring the legal and beneficial ownership of
that asset; implying that they do not constitute a sale
or disposition of the appreciated concentrated
position As a result, the capital gain tax on the
appreciated long position can be deferred
• It helps the owner to mitigate concentration risk by
generating the same amount of cash as that by an
outright sale but without incurring an immediate tax
liability
• This strategy is useful for stock positions with sale
restrictions or contractual restrictions
• This strategy is preferred to use when the owner (with
a large % of share holdings) wants to retain control
of the company or do not want another investor to
acquire a large block of company shares
Types of tools/strategies of Equity Monetization (Covering
Section 4.3.1.1)
A A short sale against the box: A short sale against the
box is a transaction in which an investor actually owns
the stock and protects its long position by short selling
the same stock (i.e settles the sale with borrowed
shares) The short sale proceeds can be invested in a
diversified portfolio of securities
• Due to long and short position in the same number
of shares of the same stock, any future change in the stock’s price will have no effect on the investor’s economic position Also, any dividends or other distributions received on the long shares are transferred to the lender of shares
Advantages:
• The short sale against the box enables an investor to lock in a profit without recognizing the related capital gains tax
• The short sale against the box creates a riskless
position due to simultaneous long and short position
in the same stock As a result, the investor can earn a
money market rate of return on the stock position
and can borrow with a high loan to value (LTV) ratio against the position (e.g up to 99% of the value of the hedged stock) with no restrictions on the use of the loan proceeds
• A short sale against the box helps investors to potentially defer the capital gains tax on a concentrated position
• It is the least expensive technique as:
o It has low net cost of borrowing because the interest earned on the hedged stock position can
be used to pay the interest expense of the margin loan
o It has low dealer fees compared to synthetic short sales transactions
B A total return equity swap: It is a bilateral contract in which an investor agrees to pay out the total return of the equity, including its dividends and capital
appreciation or depreciation, to the dealer; and in return, receives a regular fixed or floating cash flow (i.e any loss in the value of the equity + One-month LIBOR - Dealer spread)
• Due to derivative dealer spread paid by the investor, the money market rate of return earned by the investor will be slightly less than that of a short sale against the box
• Because the stock position is completely hedged, an investor can borrow with a high LTV ratio against the position
C Options (forward conversion with options): It involves
constructing a synthetic short forward position against
the long position in the asset
Synthetic short Forward = Long Put + Short Call Where, the long put and short call options are on the same underlying asset with the same strike price and the same termination date
• When the stock price falls to zero investor exercises the long put option delivers the stock to the dealer and receives the put strike price
• When the stock price increases the counterparty exercises the call option investor delivers the stock
to the counterparty and receives the call strike price
Trang 8Advantage:
• Synthetic short forward position is riskless; as a result,
the investor can earn a money market rate of return
on the position and can borrow with a high loan to
value (LTV) ratio against the position
• Capital gains tax on the appreciated long position
can be deferred if the long and short (or synthetic
short) position is treated separately for tax purposes
D An equity forward sale contract or single-stock futures
contract: It is a bilateral contract where the investor
agrees today to exchange the stock at some future
date at a fixed price; and in return, receives the
“forward price” from the dealer at some future date
Advantage:
• An equity forward sale position is riskless; as a result,
the investor can earn a money market rate of return
on the position (represented by forward price) and
can borrow with a high loan to value (LTV) ratio
against the position
Disadvantage:
• If at contract termination, market price of the stock
> forward price, investor receives the forward price
and loses any upside price potential
4.3.1.2 Tax Treatment of Equity Monetization Strategies
The investor should select the most tax-efficient equity
monetization strategy
Characteristics of a Tax-efficient hedging tool:
• Unwinding or cash settlement of the hedging
transaction results in a long-term gain rather than
short-term gain
• Unwinding or cash settlement of the hedging
transaction results in a short-term and currently
deductible loss
• The physical settlement of the contract generates a
long-term gain rather than a short-term gain
• Monetization strategy has carrying costs that are
currently deductible
• Hedging transaction has no impact on the taxation
of dividends or distributions received on the shares
General Income Tax Regimes
A Common Progressive Regime: Under this regime,
ordinary income is taxed at progressive tax rates
whereas all three investment income (i.e dividends,
interest, & capital gains) are taxed at favorable tax
rates It is the most common tax regime
B Heavy Dividend Tax Regime: Under this regime,
• Ordinary income is taxed at progressive tax rates
• Interest and capital gains are taxed at favorable tax
rates
• Dividends are taxed at ordinary rates
C Heavy Capital Gain Tax Regime: Under this regime,
• Ordinary income is taxed at progressive tax rates
• Interest and dividends are taxed at favorable tax rates
• Capital gains are taxed at ordinary rates
It is the least common tax regime
D Heavy Interest Tax Regime: Under this regime,
• Ordinary income is taxed at progressive tax rates
• Dividends and capital gains are taxed at favorable tax rates
• Interest income is taxed at ordinary rates
E Light Capital Gain Tax Regime: Under this regime,
• Ordinary income, interest, and dividends are taxed
at progressive tax rates
• Capital gains are taxed at favorable tax rates
It is the second most commonly observed tax regime
F Flat and Light Regime: Under this regime,
• Ordinary income is taxed at flat tax rates
• Interest, dividends, and capital gains are taxed at favorable tax rates
G Flat and Heavy Regime: Under this regime,
• Ordinary income, dividends and capital gains are taxed at flat tax rates
• Interest income is taxed at favorable tax rates 4.3.2) Lock in Unrealized Gains: Hedging Hedging provides protection against downside risk of the concentrated position but without losing the upside price potential associated with the stock
Two major hedging approaches (Covering Section 4.3.2.1 – 4.3.2.2):
1) Purchase of puts: This strategy is referred to as
“protective put”
Protective Put = Long stock position + Long Put position
• Purchasing put option requires the payment of cash
up front in the form of option premium The put option premium depends on various factors i.e
stock, the higher (lower) the put option premium
will be
strike price of a put option, the higher (lower) put
Trang 9option premium but the smaller (greater) the
downside risk will be
lower (higher) the put option premium will be
Advantages:
• A long put option on the concentrated stock
position provides downside protection (by setting a
floor price) while retaining the upside potential but
without recognizing the related capital gains tax
• A long put option on the concentrated stock
position enables an investor to retain any dividends
received and voting rights
Strategies that can be used to reduce the cost of
acquiring puts (i.e option premium) are as follows:
• Buying at-the-money or slightly out-of-the-money
put options with relatively lower option premium
• Using “put-spread” strategy that involves buying a
put option with a higher exercise price and selling an
otherwise identical put option with a lower strike
price but with the same maturity as the long puts
o Selling put generates some premium income,
which can be used to partially finance the cost of
long put
o However, by selling put option, investor faces
downside risk whenever the underlying stock price
further declines below the strike price of the short
put
• Using a “Knock-out” put option in which once the
stock price increases to a certain level, the
downside protection disappears before its stated
expiration date As a result, it has lower option
premium than that of “plain vanilla” put It is an
“exotic” option and is traded only over-the-counter
for fairly large positions
• Using a cashless or zero-premium collar (discussed
below)
2) Cashless (or zero-premium) Collar: In a cashless
collar, an investor purchases an out-of-the-money put
option (i.e with a strike price ≤ current stock price) on
the underlying position and simultaneously sells a call
option with the same maturity but with the same strike
price > current stock price
Cashless collar = Long Put + Short Call
• An investor receives premium income by selling a
call option, which can be used to fully finance the
purchase of the put option
• However, the short call option puts a cap on the
opportunity for unlimited capital appreciation by
setting a ceiling price established by the covered
call* It must be stressed that using a cashless equity
collar reduces, not eliminates, the investment risk
• When stock price > call strike price, call option is
exercised and the investor delivers his long shares
and receives
Call strike price + Call premium received – Put
premium paid
• When at expiration, stock price lies between strike price of put and call option, both options expire worthless and the investor receives (Call option premium received – Put option premium paid)
• When stock price < put strike price, the investor exercises put option and delivers his long shares and receives
Put strike price + Call premium received – Put
premium paid
*The upside potential can be increased using different approaches i.e
selling call option with a higher strike price because
the lower the put strike price, the lower the put option premium whereas the higher the call strike price, the lower the call option premium
selling a call option of the same maturity: Selling a
put generates some premium income that can be used to partially finance long put option However, investor faces downside risk whenever the underlying stock price further declines below the strike price of the short put but will have more upside potential than with a plain vanilla cashless collar
iii Using a Debit collar: It involves paying a portion of
put premium “out of pocket” Using debit collar allows investor to sell a call with a higher strike price
in order to finance the net cost of the put
Important to Note: In Exchange-traded options, the
premium received on short call option is taxed as a short-term capital gain in the year of expiration of option
4.3.2.3 Prepaid Variable Forwards
A pre-paid variable forward (PVF) is a forward contract
in which the investor agrees to sell a specific number of
shares in the future at pre-specified future date in return
for an upfront cash payment from the counterparty The number of shares to be actually delivered at maturity will be determined by some preset formula e.g based on long put strike price and a short call strike price That is,
• If the share price at pre-specified future date is < put strike price:
o When PVF is physically settled: An investor has to deliver all of its shares
o When PVF is cash settled: An investor has to pay the dealer the then-current value of shares in cash
• If the share price at pre-specified future date is greater than put strike price but less than call strike price:
o When PVF is physically settled: An investor has to deliver shares worth put strike price
o When PVF is cash settled: An investor has to pay the dealer put strike price in cash
• If the share price at pre-specified future date is >
Trang 10call strike price:
o When PVF is physically settled: An investor has to
deliver shares worth (put strike price + value of
shares in excess of the call strike price)
o When PVF is cash settled: An investor has to pay
the dealer [put strike price + (then-current price of
shares – call strike price)]
An investor can enter into another PVF to generate the
liquidity to meet its obligations under the original PVF
4.3.2.3 Choosing the Best Hedging Strategy
The optimal hedging strategy is the one that is most
tax-efficient Unlike common shares, restricted company
shares and employee stock options are taxed similar to
other forms of compensation income (salary & bonus)
i.e at significantly higher rates than long-term capital
gains income
Mismatch in Character: When the investor has ordinary
income on the concentrated position but capital loss on
the hedge, it is referred to as a mismatch in character
Due to this mismatch in character, the capital loss on the
hedge may not be currently deductible because capital
losses are generally deductible against capital gains, not
against ordinary income In the U.S., mismatch in
character can be avoided by using a swap with an
optionality of a collar embedded within it
4.3.3) Yield Enhancement
In order to enhance the yield of a concentrated stock
position while decreasing its volatility, investors can write
covered calls against some or all of the shares
Covered Call = Long stock position + Short call position
(with a strike price > current stock price)
• Writing a covered call generates cash up front in the
form of option premium but provides limited upside
potential (i.e call strike price + premium received)
• The downside protection on share price is limited to
the option premium received on the front-end of the
transaction However, covered call strategy may
help in psychologically preparing the owner to
dispose off those shares
• This strategy is preferred to use when the stock is
owned by the investor and when the stock price is
expected to move in a trading range for the
foreseeable future
• Covered call strategy involving short calls with
staggered maturities and strike prices can be used
as an alternative to a structured selling program 4.3.4) Other Tools: Tax-Optimized Equity Strategies With regard to managing risk of a concentrated stock position,
1) Tax-optimized equity strategies can be used as an
index-tracking strategy with active tax management:
An index-tracking separately managed portfolio is quantitatively designed to closely (not perfectly) track
a broad-based market index on a pre-tax basis, and outperform it on an after-tax basis
• An index-tracking separately managed portfolio is funded by cash, from the partial sale of the investor’s concentrated stock position, from the monetization proceeds derived from the hedged stock position, or a combination of any of these
• These strategies use opportunistic capital loss
harvesting and gain deferral techniques that can be
used by the investor to sell a commensurate amount
of concentrated stock without incurring any capital gains taxes
2) Tax-optimized equity strategies can be used in the
construction of completeness portfolios: Constructing
a completeness portfolio is a strategy in which an investor “completes” investment in a single security (i.e concentrated stock position) by purchasing a basket of other liquid securities (having low correlation with the concentrated stock) to hold a portfolio that tracks the broadly diversified market benchmark By combining a concentrated stock position with additional liquid securities, the concentration risk is reduced and the portfolio may
behave like some desired index
• Completeness portfolio uses capital loss harvesting that facilitates the investor to sell a commensurate amount of concentrated stock without incurring any capital gains tax
• With the passage of time, the size of the concentrated stock position declines to zero and the investor ends up holding a diversified portfolio of lower-basis (not current) stocks
Limitations:
• Completeness portfolio strategy is only suitable for investors who have access to other liquid assets besides their concentrated stock position because constructing a completion portfolio requires significant liquidity
• Implementing a completeness portfolio strategy tends to require significant time
• Liquidation of a diversified market portfolio incurs a capital gain tax
Practice: Example 5,
Volume 2, Reading 11
Practice: Example 4,
Volume 2, Reading 11