Substantially reduce your stock's downside risk while preserving its unlimited upside potential
Since the lows of the Great Recession in February 2009, the U.S. stock market has more than tripled. Because of these gains over the past eight years, many investors find themselves owning highly-appreciated stock positions. However, for tax planning and many other reasons, investors are often reluctant to sell these positions.
Continuing to hold a large concentrated stock position (without any form of risk management) is extremely risky. According to J.P. Morgan, since 1980, approximately 320 stocks have been removed from the S&P 500 due to “business distress” – and fully 40% of Russell 3000 stocks suffered a permanent decline (i.e. impairment) of 70% or more from peak value.
At the same time, the traditional techniques investors have come to rely upon to manage risk (such as put options, collars, and prepaid variable forwards) have become much more expensive in recent years due to the aftermath of regulatory change (Dodd-Frank) and the overall condition of the capital markets (historically low interest rates and unfavorable volatility skew). Therefore, investors today tend to employ these techniques opportunistically only in a short-term, tactical manner, leaving long-term stock positions unprotected against a very real, very large risk.
With the stock market near its all-time high but showing signs of stress, investors who don’t wish to, or cannot, sell their highly appreciated shares are on the lookout for new tools to help them cost-effectively protect their unrealized gains.
A Stock Protection Trust is a new single-stock risk management capability that’s affordable, tax-efficient, simple to use, easy to understand, and completely transparent. A Protection Trust empowers investors who are committed to continued ownership of some or all of their highly appreciated stock positions to inexpensively seek to preserve their gains on a long-term basis.
- Protection Trusts are a new approach to equity risk management
- Protection Trusts are based on the time-tested principles of both Modern Portfolio Theory (MPT) and Risk Pooling
- MPT tells us that over time, there will be substantial dispersion in individual stock performance
- Risk pooling enables cost-effective spreading of similar financial risk across participants in a self-funded plan designed to protect against equity losses
- By combining the powerful benefits of MPT and Risk Pooling, Protection Trusts fundamentally transform single-stock risk by enabling investors to “mutualize” – and therefore substantially reduce – a stock’s downside risk, while retaining all future price appreciation and dividend income, all at an affordable cost
Affordable Protection for Core Stock Holding
Investors with concentrated stock positions are often disinclined to sell more than a modest amount of their shares for a variety of reasons (e.g. tax and estate planning considerations, a belief the shares will appreciate further, an emotional attachment to the stock, etc.). Yet others must confront restrictions on selling imposed by securities laws or contractual provisions. Regardless of the reason, for investors who view their concentrated position as a long-term, core holding, Protection Trusts offer greater assurance that a catastrophic drop in stock price won’t decimate their net worth.
The traditional tools investors have used to manage single-stock risk are tax-inefficient in that, generally, gains are taxed as short-term capital gains, losses aren’t currently deductible (i.e. they are deferred), and dividends are taxed as ordinary income. Protection Funds are tax-efficient; they don’t trigger a constructive sale or constitute a straddle, and therefore any gain is long-term capital gain and any loss is immediately deductible, and dividends remain “qualified” and taxed as long-term capital gain.
Prudent and Timely Stock Protection
For investors who don’t wish to, or cannot, sell their highly appreciated shares, Protection Trusts can deliver powerful results. First, investors can help protect their accrued stock gains. Second, investors are able to defer the capital gains tax (and potentially eliminate it by holding the shares until death to achieve a stepped-up tax-cost-basis). Third, investors get to keep all future appreciation and dividends earned on their shares.
Easy to Understand
Protection Trusts are much simpler, easier to understand, and more transparent than traditional solutions (e.g. variable-share prepaid forwards). Investors don't need to pledge or encumber their shares in any way and can custody their shares anywhere they wish. Importantly, investors retain the freedom to sell their shares anytime they wish.
Frequently Asked Questions
Protection Trusts are designed for investors who don't want to, or cannot, sell their concentrated stock positions. While still retaining all of your stock's unlimited upside potential, Protection Funds substantially reduce your risk of suffering an unexpected loss. According to J.P. Morgan, between 1980 and 2014, 40% of Russell 3000 stocks suffered a permanent decline of 70% or more from their peak value. Many of these were stocks thought to be "safe" and incapable of losing substantial value.
For a 5-year Protection Trusts, each investor contributes cash equal to 2% of the value of the position he/she is protecting per year, plus a one-time 2% placement agent fee, all payable at the closing. Under no circumstances will investors be required to contribute additional capital. Depending on the performance of the 20 protected stocks, up to 100% of the annual 2% cash contribution could be returned to the investor at the end of the 5-year Protection Period. The net amortized cost to an investor can therefore range from as low as 0.4% per year (if all 20 stocks gain value) to as high as 2.4% per year (if losses exceed available cash). This cost range compares favorably to that of other strategies and is stated on a pre-tax basis; the after-tax cost is likely to be even lower. We urge you to consult your tax advisor.
On August 1, 2016, the Wall Street Journal reported that the cost of a three-month 95% put option on the S&P 500 index (i.e. protection lasting three months and covering 95% of the value of the underlying position) had fallen to a one-year low. At this one-year low, the cost of that protection was 1.3%, meaning that on an annualized basis, the cost of put protection (as of August 2016) was approximately 5.2% (i.e. 1.3% multiplied by 4). This compares to the Stock Protection Fund with an annual cost between 0.4% and 2.4%, as described above. In other words, the Stock Protection Trust can cost between 54% and 92% less than put contracts.
The Wall Street Journal further noted that as recently as January 2016, the cost of this three-month 95% put contract was as high as 3.3%, i.e. 13.2% on an annualized basis. This compares to the Stock Protection Trust with an annual cost between 0.4% and 2.4%, as described above. In this case, the Stock Protection Trust would be between 82% and 97% less expensive than put contracts.
While put contracts provide "guaranteed" protection (subject to counterparty risk), this guarantee often causes put protection to be cost-prohibitive for long-term investors. In addition, put contracts are tax-inefficient (disqualifying dividend income and triggering the straddle rules). Put contracts also do not provide the opportunity for a refund of contributed cash. Even if put-protected stocks gain in value, investors forfeit their premiums to their counterparty. In contrast, the Stock Protection Trust is mutualized protection, so if many protected stocks gain in value, a substantial refund is possible.
As noted above, all costs are stated on a pre-tax basis; after-tax cost could result in additional savings. We urge you to consult your tax advisor.
Any one investor setting aside cash lacks the benefit of risk pooling, which is the key benefit of the Protection Trust strategy. If you set aside cash yourself, in the event of loss, only your own money will be available to reduce your loss, rather than the combined pool of deposits from all participants in the Protection Trust.
Protection Trusts are only available to Accredited Investors, who are, for our purposes, generally individuals with a net worth of at least $1 million (not including the value of their primary residence) or individuals who have had an income of at least $200,000 each year for the last two years (or $300,000 together with their spouse if married) and have the expectation of making the same amount this year.
In addition to being accredited, investors must own shares (or have received or have the right to receive other stock-based compensation) of an eligible stock (e.g. a constituent of the S&P 500 Index) valued at $1 million or more.
Yes, there is an "inspection period" (five business days) similar to that of an exchange (i.e. swap) fund, during which time each potential investor receives a list of the other stocks to be protected by a given Series of the Protection Trust. During this inspection period, each investor has the right to “opt-out” if for any reason he/she is not comfortable with any of the other protected stocks. There is no penalty associated with opting-out.
Protection Trust participants are free to do as they wish with their shares throughout the term of the Protection Trust (e.g. sell or borrow against them, write covered calls against them, gift or donate them, etc.).
Investors who sell their shares prior to maturity of the Protection Trust remain investors in the fund; their cash remains in the cash pool, and they are still entitled to any cash distribution they would otherwise be owed at maturity, regardless of whether they still own their shares. All distributions are based on the performance (Total Shareholder Return) of the 20 protected stocks over the term of the trust.
Protection Trusts can perhaps best be thought of as the inverse of Exchange Funds.
An Exchange Fund enables investors to mutualize, and therefore reduce, single-stock risk; investors obtain the benefit of diversification similar to that achieved through an investment in a mutual fund. Economically, it’s as if each investor sold his or her shares tax-free and immediately reinvested the proceeds into a diversified portfolio. Going forward, each investor is exposed to the upside potential and downside risk associated with the portfolio, rather than solely to the stock that was contributed.
In contrast, a Protection Trust permits investors to continue to own their shares and retain all of the upside potential of their stock positions while mutualizing only the downside risk. Investors, each owning a different stock in a different industry, contribute a modest amount of cash (not their shares, which they continue to own) into a fund that will terminate in five years. The cash pool is invested in U.S. government bonds that mature in about five years, and upon termination, the cash pool is distributed to investors whose stocks have lost value on a total return basis, using a precise methodology. Losses are paid until the cash pool is depleted. If the cash pool exceeds total losses, all losses are eliminated, and the excess cash is returned to investors. If, on the other hand, total losses exceed the cash pool, large losses are substantially reduced.
An Exchange Fund could be useful for investors and trusts which own highly appreciated stock, and wish to exit completely from their positions in a tax-efficient manner, so that they can diversify into a portfolio of other publicly traded stocks. This could be appealing to investors who have turned bearish on the highly appreciated stock positions they own.
A Protection Trust, on the other hand, could be beneficial for investors and trusts which hold highly appreciated shares and would like to continue to own their positions to capture future appreciation and dividend growth, but would like to help safeguard their unrealized gains. This may be attractive to investors who remain bullish on the highly appreciated stocks they own.
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