Learning Outcomes
After reading this article, you will be able to identify the risks of concentrated positions, describe the rationale behind diversification and monetization, and evaluate hedging and staged diversification techniques. You will understand derivative-based risk reduction, loan-backed monetization, and the key tax, liquidity, and control considerations relevant to the management of concentrated public equity and business positions for CFA Level 3 exam application.
CFA Level 3 Syllabus
For CFA Level 3, you are required to understand how to manage concentrated positions, especially in public equities, privately owned businesses, and real estate, for private wealth clients. Focus your revision on:
- Recognizing the risks of concentrated single-asset positions
- Outlining and evaluating diversification, monetization, and hedging strategies (including the use of derivatives and structured products)
- Assessing the tax impact and liquidity constraints of different techniques
- Explaining staged sales, completion portfolios, zero-cost collars, and monetization loans
- Recommending appropriate strategies considering client-specific objectives (tax, liquidity, control, non-financial constraints)
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
- Identify three core risks associated with holding a concentrated single-asset position.
- What is a zero-cost collar and how does it help manage equity concentration risk?
- Why might an investor monetize a concentrated equity position using a loan instead of selling outright?
- Explain how the choice of hedging instrument (put, swap, forward) might impact tax outcomes.
Introduction
Concentrated positions—large holdings in a single stock, business, or property—often result from business success or long-term compensation. While these assets may be the source of wealth, they expose portfolios to significant company-specific, liquidity, and tax risk. Managing these exposures without triggering large tax liabilities or losing control is a common challenge in private wealth management. This article explores the main techniques—diversification, hedging, and monetization—aligned to the CFA Level 3 exam.
Risk and Tax Considerations for Concentrated Positions
A concentrated holding in a single asset, such as company stock, a business, or a property, introduces substantial risks:
- Company-specific risk: A material event tied to the company or asset can severely impact wealth.
- Liquidity risk: Converting a large block of shares or an illiquid asset to cash may be costly or time-consuming.
- Portfolio efficiency loss: Lack of diversification often means a lower risk-adjusted return.
- Tax risk: Sale often involves realizing substantial capital gains at once.
Key Term: concentrated position
A holding so large relative to total wealth or portfolio size that it materially increases unsystematic (idiosyncratic) risk, liquidity risk, or constrains diversification and asset allocation options.Key Term: monetization
Converting an illiquid or concentrated position into cash or cash-like value—often without triggering immediate capital gains taxes—frequently via loans, derivatives, or structured transactions.Key Term: staging (staged diversification)
The systematic process of selling a concentrated position in tranches over time—typically to manage both market timing and tax consequences.Key Term: completion portfolio
A portfolio or index-based allocation constructed to complement (complete) the remaining concentrated holding so that, when combined, the portfolio tracks a chosen benchmark with lower risk.
Diversification Approaches
Sell and Diversify
The simplest route is to sell all or a large part of the concentrated position and reinvest in a diversified portfolio. While effective, it typically triggers a capital gains tax and may not suit clients seeking to retain control, avoid large taxable events, or fulfill emotional or other non-financial preferences.
Worked Example 1.1
A client holds $2 million in single-stock with a $400,000 tax basis and faces a 25% long-term gains tax rate. What is the after-tax amount available for diversification if 100% is sold?
Answer:
Realized gain: $2,000,000 – $400,000 = $1,600,000. Tax: $1,600,000 × 25% = $400,000. After-tax proceeds = $2,000,000 – $400,000 = $1,600,000 available for diversification.
Staged Diversification and Tax Loss Harvesting
For clients who wish to reduce risk but control the timing and size of taxable events, staged diversification (partial sales over multiple tax years) spreads the realized gains, potentially across lower marginal tax brackets and market cycles. Tax loss harvesting in the remainder of the portfolio can further offset realized gains.
Worked Example 1.2
A $1 million position is sold in four equal parts ($250,000 each) over four years; the tax basis of each part is $50,000. Assuming a 20% capital gains tax rate and stable prices, what is the annual tax liability per tranche?
Answer:
Gain per tranche: $250,000 – $50,000 = $200,000; Tax: $200,000 × 20% = $40,000 per year.
Hedging and Monetization Techniques
When immediate diversification is not desirable, risk can be managed or monetized using derivative-based or structured approaches.
Hedging with Derivatives
Clients may hedge downside risk without triggering a taxable sale by:
- Buying put options (protective puts)
- Selling forward contracts or engaging in equity swaps
- Creating zero-cost collars (long put, short call, same expiry, both out-of-the-money)
A zero-cost collar is especially common—it costs little or no premium and locks in a minimum value while capping the upside, reducing the position’s risk exposure.
Worked Example 1.3
A client owns 15,000 shares of ABC Corp, each worth $70. She buys a one-year put with a $65 strike (cost $2) and sells a one-year call at $80 (receiving $2). Illustrate the payoff if price falls to $55, ends at $70, or rallies to $90 at expiry.
Answer:
- At $55: Put exercised, receives $65 per share. Downside limited; call expires.
- At $70: No option exercised. Keeps shares; no net premium cost.
- At $90: Call exercised, must sell at $80, capping gains.
The zero-cost collar caps upside and floors downside.
Exam Warning
If the hedge is so complete that it eliminates all economic exposure, some tax authorities may deem it a constructive sale, treating the position as if it were sold for tax purposes. This can trigger immediate taxation. Hedging must preserve some downside risk to avoid this.
Equity Monetization
Monetization converts a hedged concentrated position to cash or loan proceeds without selling the original asset. Common structures:
- Borrowing against a hedged position—since risks are reduced, higher loan-to-value is possible.
- Using prepaid variable forwards or total return swaps (receiving cash in exchange for future delivery of the asset).
- Collateralizing and then borrowing against the asset, using hedges to manage residual risk.
Loan proceeds can be invested immediately in a diversified portfolio or used for liquidity needs. The position remains open for tax and (often) voting rights.
Key Term: zero-cost collar
An options strategy involving the simultaneous purchase of a put (strike below current price) and sale of a call (strike above current price) to hedge a position’s value with little or no cash outlay, commonly used to manage concentrated equity holdings prior to monetization.
Completion Portfolios
After partial sale or hedging of a concentrated position, a completion portfolio is often constructed to bring the total exposure closer to a model benchmark. This allows diversification while accounting for sectors, factors, and correlations excluded by the remaining concentration.
Special Considerations
- Liquidity constraints: Large or illiquid positions may require a multi-year or structured solution.
- Tax deferral: Strategies seek to avoid immediate gain realization but may result in deferred tax liabilities or complexity.
- Control/voting rights: Some owners may wish to retain control or fulfill legal holding requirements—for example, key executive status.
- Non-financial objectives: Emotional attachment, reputation, or legacy concerns may override financial efficiency.
Summary
Managing concentrated positions involves assessing and neutralizing unsystematic risk, balancing tax efficiency, liquidity, and client goals. Staged diversification, derivative hedges, and monetization techniques—including zero-cost collars, swaps, and loans—are primary solutions. A completion portfolio may further reduce exposure and tracking error versus the benchmark.
Key Point Checklist
This article has covered the following key knowledge points:
- Identified company-specific risk, liquidity risk, and tax risk in concentrated positions
- Explained staged diversification and tax-aware sale sequencing
- Described derivative-based hedges, zero-cost collars, and their roles in risk management
- Outlined monetization through borrowing or prepaid forward structures
- Demonstrated use of completion portfolios to reduce residual concentration risk
- Highlighted core tax and control challenges in public and private holdings
Key Terms and Concepts
- concentrated position
- monetization
- staging (staged diversification)
- completion portfolio
- zero-cost collar