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Many corporate executives, investors and trusts own highly appreciated stock they don’t wish to, or can’t, sell. Ideally, they’d like to:
- Preserve unrealized gains at a reasonable cost
- Retain all upside potential
- Avoid adverse tax consequences
- For company insiders, avoid triggering a reportable event
Investors can utilize equity derivatives such as puts and collars to mitigate company-specific risk, but they are costly, and therefore, not practical to use for a prolonged period. They are generally tax-inefficient. Investors can use exchange funds to diversify on a tax-deferred basis, but not to protect shares they wish to keep. The use of either causes a reportable event for company insiders.
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Stock protection funds (SPFs), a marriage of modern portfolio theory (MPT) and risk pooling, may help such investors. MPT demonstrates that over time there will be substantial dispersion in individual stock performance. Risk pooling makes it possible to cost-effectively spread financial risk evenly among participants in a self-funded plan that is designed to protect against catastrophic loss. By integrating these key principles, SPFs provide downside protection akin to that of at-the-money or slightly out-of-the-money European-style put options, but at a fraction of the cost.
SPFs permit investors to retain full ownership of their shares, including all of their stocks’ upside, while mutualizing only their stocks’ downside risk. Investors, each owning a stock in a different industry and seeking to protect the same notional value of stock, contribute a modest amount of cash (not shares, which they can continue to own) into a fund that will terminate in five years. The cash is invested solely in U.S. Treasury bonds that mature in five years, and upon termination, the cash is distributed to investors whose stocks have lost value (on a total-return basis).
Losses are reimbursed using a “reverse waterfall” methodology until the cash pool is depleted. If the cash pool exceeds the aggregate losses (a 70% probability), all losses are eliminated, and the excess cash is returned to investors. If, on the other hand, the aggregate losses exceed the cash pool (a 30% chance), large losses are substantially reduced.
The shares being protected are not touched. Investors can continue to own their shares, or can sell, gift, pledge, borrow against or otherwise dispose of them at any time during the five-year term of the fund.
By Tom Boczar, read the full article here.