Three practical ways to dilute a concentrated investment position

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Concentrated investment positions, often found in publicly traded stocks, privately owned businesses and real estate, play a pivotal role in the wealth accumulation of ultra-high-net-worth (UHNW) individuals. These positions present unique opportunities, but also challenges that necessitate careful navigation.

While there’s no universal definition, a concentrated position is generally recognized when an investor holds more than 10 per cent of his or her wealth in a single asset.

Despite promising substantial returns, these concentrated positions also pose considerable risks to the preservation and growth of wealth over time. Thus, understanding and effectively managing them are crucial for UHNW individuals.

Several strategies can help manage concentrated positions, with the chosen path always tailored to the holding, the investor, their circumstances, goals, and overall portfolio. This management broadly involves reducing, hedging, or retaining exposure.

Reducing the exposure

Reducing exposure to the concentrated position in favour of investing into a diversified strategic asset allocation may reduce risk and improve potential long-term risk-adjusted returns.

Holdings could be transitioned all at once, which is often the simplest and preferred approach for most investments. Alternatively, a staged diversification process can be employed to address timing risks, with the sale occurring in multiple tranches.

For public equity holdings, covered call options can serve as an enhanced disposal strategy, similar to placing limit orders in the market at a higher price than today’s, while still maintaining full downside risk exposure.

Charitable contributions present another strategy. An individual contributing a publicly listed security with accumulated capital gains not only allows for the elimination of capital gains tax but also enables the donor to benefit from a tax credit for the donation.

Hedging the exposure

Implementing hedging strategies could help preserve the potential value of holdings, although this should be weighed against the cost of implementation.

For example, a collar strategy involves purchasing a protective put option and selling a covered call option simultaneously, limiting economic exposure to a chosen range of upside and downside movements.

Alternatively, a total return swap with a counter-party can be explored, exchanging the total return of the concentrated equity position for a predetermined payment, although with exposure to counter-party risk.

Another option is a bull put spread, capping downside risk while retaining partial upside potential. These are most likely to be implemented against public equity holdings.

Retaining the exposure

In certain situations, retaining the holding is the only viable option. Retained holdings can be strategically leveraged through margin finance arrangements or mortgage financing – reinvesting the proceed in a diversified portfolio.

An alternative approach could involve creating an aware portfolio — a multi-asset allocation around the concentrated position. This strategy aims to reduce overall portfolio risk by allocating more heavily to asset classes and sectors with lower correlations to the concentrated position.

While correlations can change over time, this approach may potentially lead to higher risk-adjusted returns and offer more consistent performance across market conditions, even if it results in a material divergence from a benchmark and relative underperformance.

Key factors to consider

When selecting a strategy, key factors to consider include the extent of the concentration, the position’s volatility and downside risk, the investor’s tax basis and rate, the liquidity of the position, the investor’s time horizon and any imposed restrictions.

For instance, if 90 per cent of an investor’s wealth is concentrated in a single holding, constructing an aware portfolio might not yield significant results. In such cases, a combination of diverse approaches outlined below should be considered.

Non-financial factors, such as emotional attachment, often pose substantial challenges. Frequently, these positions symbolize the original source of wealth for individuals or families, leading to hesitancy in selling. Potential pitfalls include underestimating downside risk, neglecting tail events such as bankruptcy, gravitating toward long-shot opportunities with overly optimistic expectations of low probability outcomes, or establishing arbitrary price targets before contemplating a sale.

In conclusion, successfully managing concentrated positions demands a personalized strategy that accounts for factors such as concentration, volatility, tax implications and emotional attachment. Whether it involves reducing exposure through strategic diversification, hedging to preserve value, or retaining exposure through borrowing, the chosen path should align with the investor’s unique circumstances and goals.
Recognizing emotional ties and non-financial considerations underscores the need for a rational approach, and navigating these challenges effectively requires a comprehensive understanding of the client’s situation.

Citi and its employees are not in the business of providing, and do not provide, tax or legal advice.  Any statement in this article regarding tax matters is not intended or written to be used.  Readers should seek advice from an independent tax advisor.

Samuel Vallières is an Investment Counselor at Citi in Montreal, where he is responsible for managing assets and providing comprehensive investment strategies for ultra-high-net-worth individuals. He leverages Citi’s global network spanning more than 160 countries to provide institutional-level product and services to his clients. Additionally, he serves as an adjunct professor at the John Molson Business School at Concordia University, teaching in their MBA in Investment Management program. Samuel holds the Chartered Financial Analyst (CFA), Financial Planner (F. Pl.) and Chartered Investment Manager (CIM) designations. He graduated with a bachelor’s degree in Business Administration, Finance (BAA) and a master’s degree in taxation (MTax).

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