Diversification Tactics for Concentrated Positions

In terms of the mechanics of diversification, this is where the CFA Level 3 reading on concentrated positions can start to get in the weeds. So we'll point out things that are important but also be mindful that you should move fairly quickly here and not get bogged down in the details.

This is particularly true with the option strategies presented as this material will be covered in more detail in its own dedicated section.

In terms of goals, we've covered this before, but there are three main strategic families for diversifying: outright sale, monetization strategies, and hedging.

Each strategy falls somewhere in the spectrum of trying to minimize the tax implications while also achieving the core objectives of diversification and liquidity.

Strategy 1: Outright Sale

So the first one is an outright sale. Obviously, this has the maximum flexibility. You sell, you're done, you're out. You can use the cash that you generated for whatever purposes, but the downside is that you're going to incur immediate and often significant tax liabilities.

Strategy 2: Monetization Strategies

Then there's monetization strategies. These are strategies that involve borrowing funds and then reinvesting those funds into new assets without actually selling the underlying position which avoids triggering a tax event.

Strategy 3: Hedging

And then there's hedging. Hedging involves taking a position that mitigates any movement in the underlying asset against you. Hedging is most frequently accomplished with derivatives.

Summarizing Hedging, Monetization Strategies, and Outright Sales

So here's a summary of some of those main strategies and how they play out.

Diversification tactics for concentrated positions - CFA

We're going to go into hedging in a bit more detail. But if you look at exchange funds, these are core examples of monetization strategies where you're basically pooling your concentrated position with those of other investors, and holding this underlying basket that's more diversified. So worth pointing out.
And then with hedging, we'll cover this again in a second but there is this constructive sale rule which just says that unless you can lose money your position might be treated like a sale (even if you aren't actually selling). .In other words, if you completely hedge away all downside risk, then even if you haven't sold the underlying position it might be treated as a sale for tax purposes and trigger capital gains taxes. Something to be mindful of and the concept is testable on the CFA L3 exam.

Unpacking Hedging

In terms of hedging, there's really two types of hedges. A perfect hedge, where the constructive sale rule might apply, is essentially taking an equal and offsetting perfect short position in the underlying asset. And then there's a cross hedge where you might not directly hedge using the same asset, but basically you're hedging with something similar. So if I own a factory and I'm holding that underlying factory, that's my long position and I might diversify or hedge my downside risk by shorting an underlying pool of all the publically traded factories in my area, for example. That's a good cross-hedge.


Exchange Funds and Equity Monetization
And then exchange funds, we talked about this pooling strategy. So let's dive into a more specific type of strategy, and this is equity monetization. And equity monetization really involves a strategy that looks to turn a concentrated position into cash without triggering an outright sale. And the way we do this usually is by hedging the underlying position, which basically removes a lot of the downside risk. And then with that risk removed, borrowing against the position and generating cash. And you know this is an effective strategy if you're able to borrow at a high LTV ratio, which you can only do if there's a good hedge in place.
These strategies can help accomplish a couple of other secondary goals. First, you want to maintain control of the company usually, and because you're not selling it, you might actually avoid lockup provisions or any constraints against the sale.

Understanding Equity Monetization Strategies 

There's four main strategies here. Strategy number one involves a short sale against the box. So this is where you short the shares you own and then invest those proceeds. So you short the shares, you generate cash, and then you invest that cash in a diversified portfolio. So that's one way to do it.

You can also do a total equity swap and this is probably pretty straightforward. We're going to see this later in the curriculum as well in much more depth. But this is a contract in which you agree to pay the return on your stock in exchange for specified payments that are either fixed or floating, it could be liable to pull some premium, it could be an underlying equity index, whatever you have.
An equity forward sale, another strategy here where you're selling a forward contract on the stock. By doing that, you're guaranteeing a future price. So you're selling at a future date for a specified price. If the market price is higher than the forward price at the end of the contract, you're still going to receive the forward price, but you're not going to have as much upside. But conversely, you're protected from the market price declining, because you've specified a price at which you're going to sell in the future.
And then that equity forward sale is not an immediate sale, so it defers the tax gain, right. And then there's a forward conversion with options where you build a synthetic short forward position against the underlying long asset. What does that mean? It means you buy a put and sell the call with the same strike price. So you long the put, short the call. That locks in the future price for the asset no matter what happens to the underlying position, and then because of that, you can borrow with a high LTV ratio. And we'll get into option strategies in more detail later.
But again, going back to that constructive sale rule from a tax perspective, all of these monetization strategies depend on whether the underlying government would treat these strategies as a sale, a constructive sale. So if you perfectly hedge, that could trigger capital gains taxes.
So in short, equity monetization strategies are all about creating a riskless position and that's with a direct or synthetic short. And then generating a money market rate of return on your long position, and borrowing as cheaply as possible against the hedge to invest in a diversified portfolio.


Hedging Techniques for Concentrated Positions

Okay, cool. So we're going to get more in the weeds now, if you can believe it, with using derivatives to manage concentrated positions. And for the most part, we're talking about options here, and options come up later in the curriculum in a way that's much more testable. So we'll move quickly.

Hedging concentrated positions - CFA L3

A couple of strategies here. So protective put. So you're buying at the money put. It's basically an insurance premium, because it's at the money, it's very expensive. A knock out put, because you're buying something that's more out of the money, it's cheaper. You can combine different positions, long and short puts, to try to reduce the upfront premium you have to pay. That does expose you to more risk as the strike prices are further away from the underlying price.

You can also combine puts and calls. You can use a prepaid variable forward. And so this is a pretty interesting one. And again, it's very in the weeds but essentially, you're going to retain some upside with a PVS strategy versus completely hedging. And then covered calls are essentially used to generate income on the underlying position, and that premium that you receive for writing the call essentially can help offset against any short term declines. The downside here is if the position rises, it could be called away and you would lock in your upset at a lower value.


Specific Tactics for Private Businesses and Real estate

And finally, there's some specific tactics that are listed for private businesses and real estate. So private businesses, we covered this, but they're complicated in terms of liquidity, finding buyers, etc. and then this cartoon exemplifies. Let's say I'm an outside buyer. I don't have control and I'm unhappy. What can I do, right? I'm a minority owner. So there's a control discount baked in. So it's complicated essentially, but there are a number of strategies here and these strategies are differentiated in terms of strategic outcome, but also price that you receive. So there is selling to third party. And you're probably going to receive the highest price if you sell to a strategic buyer, so someone in your industry, another company that views your business as accretive to theirs, and so that synergy could drive up your purchase price. Versus selling to a financial buyer such as a private equity firm, that's probably going to be lower.
A recap. A recapitalization essentially is where you maintain partial position but sell some back to the company or a third party, and this is staged. So you're gradually diversifying, you're not triggering your full capital gains taxes. There's management buyouts as well, or basically selling to your employees. So because your employees often don't have a ton of money, this final price could be lower, but they also know the business really well. So if you are preserving some of the upside, that can be interesting.
You could sell non-core assets. So essentially generating cash, using that cash to diversify, but retaining the ownership and the core position, using the company to borrow or going IPO, right.
And then in terms of real estate, this is super in the weeds, frankly, but there's taking out loans with essentially using the underlying position as collateral. There's a sale and lease back strategy, which is pretty self-explanatory, right. You're selling the property, then leasing it back. Your lease payments are actually tax deductible. So that can be a nice tax benefit. And if you do put your real estate position in a charitable trust, you might still have use of it, but you're not going to trigger a tax event.