Many investors have amassed vast wealth by acquiring and holding concentrated stock. Some were bequeathed stock. Others acquired stock via liquidity events, or throughout their careers at public companies. Some investors, like Warren Buffett, famously employ concentrated stock investing (CSI). There’s considerable empirical evidence to support CSI’s outperformance.[i]

The premise underlying CSI runs counter to the Efficient Market Hypothesis and modern portfolio theory — investors can’t beat the market and diversification is the essential ingredient for successful long-term investing. While diversification is important, some argue it can be overdone, like the many investors who’ve shifted almost entirely into index mutual funds and ETFs in recent years.

Aspirational Wealth Isn’t Achieved Through Indexing

Within a goals-based planning framework, the purpose of investing is to create wealth commensurate with future spending needs and desires. Indexing preserves investors’ standard of living by delivering market-level returns, and belongs in their “market risk” bucket. Investment strategies with steeper risk/reward profiles, and the potential to generate sizable returns, substantially increasing one’s wealth, belong in investors’ “aspirational risk” bucket.

Despite the popularity and benefits of indexing, many are loath to “give up” on their endeavor to create aspirational wealth. CSI is one strategy investors might consider to potentially amass significant wealth.

Can Investors Prudently Employ Both Index and Concentrated Stock Investing?

Instead of allocating all investable assets to indexing, an investor might employ it for most (i.e. 80-90%), but allocate a portion (i.e. 10-20%) to CSI. The investor is exposed to company-specific risk for each position in the concentrated portfolio, but what if that idiosyncratic risk can be significantly diminished?

The Greater Risk of Concentrated Stock Investing Can Be Muted With Stock Protection Funds

Stock protection funds (SPFs) are a recent invention.[ii] They help investors preserve unrealized gains on highly appreciated stock positions they already own (CFA Institute video here).[iii] They can also be used to protect new concentrated stock investments.

SPFs marry MPT with risk pooling/insurance to provide protection akin to at-the-money or slightly out-of-the-money put options, at a fraction of the cost.[iv] Investors retain all upside of the stock while mutualizing its downside risk.

Investors, each owning a stock in a different industry and protecting the same stock value, contribute a modest amount of cash into a fund terminating in five years. The cash is invested in U.S. Treasury bonds maturing in five years. Upon termination, the cash is distributed to investors whose stocks lost value on a total return basis. Losses are reimbursed through a “reverse waterfall” methodology until the cash is depleted. If the cash exceeds the aggregate losses, all losses are eliminated, and the excess cash is returned to investors. If the aggregate losses exceed the cash, large losses are substantially reduced.

The protected shares aren’t pledged or encumbered. Investors can continue to own their shares, or can sell, gift, donate, pledge, borrow against or otherwise dispose of them any time.

Because the straddle rules don’t apply and dividend holding period rules aren’t suspended, investors can “age” their newly purchased shares from short-term to long-term (for capital gain/loss purposes), and “qualified” dividends remain taxed as long-term capital gain.

SPFs can help investors who want to keep the bulk of their investable assets allocated to indexing, but wish to pursue an active, fundamental research-driven, buy and hold, stock-picking strategy with a modest portion of their investable assets in a calculated bid to build significant (i.e. aspirational) wealth, while substantially reducing the downside risk associated with the stock (or stocks), at an affordable cost. It’s similar to the “married put” strategy, but more cost-effective and tax-efficient. SPFs can also help investors protect highly appreciated stock positions they already own and don’t wish to dispose of.

Summary

SPFs add a desirable facet to CSI. Due to their affordability, SPFs can be married to new concentrated stock investments, as well as highly appreciated stock positions investors currently own, substantially mitigating the downside risk associated with their positions, while still allowing them the opportunity to create meaningful wealth. If the idiosyncratic risks associated with CSI are diminished by SPF, this (CSI + SPF) could be an attractive and prudent investment strategy for those investment funds investors wish to allocate to achieve aspirational wealth.


[i]  See Cohen, Randolph, Christopher Polk, and Bernhard Silli. “Best Ideas.” Working paper, London School of Economics, May 2010. Cremers, K.J. Martijn and Antti Petajisto. “How Active Is Your Fund Manager? A New Measure That Predicts Performance.” Review of Financial Studies, September 2009. Elton, Edwin J., Martin J. Gruber, Stephen J. Brown, and William N. Goetzmann. Modern Portfolio Theory and Investment Analysis. John Wiley & Sons, 2009. Petajisto, Antti. “Active Share and Mutual Fund Performance.” Financial Analysts Journal, July/August 2013. Yeung, Danny, Paolo Pellizzari, Ron Bird, and Sazali Abidin. “Diversification versus Concentration …and the Winner is?” Working paper series, University of Technology Sydney, September 2012.

[ii] See U.S. patents: Nos. 7,720,736; 7,739,177; 7,987,133; 8,229,827; and 8,306,897.

[iii]  Kochis, Timothy, “Managing Concentrated Stock Wealth” (2nd ed., Wiley, 2016, pages 160-162) “For clients who own highly appreciated stock and for certain reasons wish to keep some portion of their concentrated position as a core, long-term holding, the Stock Protection Fund can be a very attractive alternative and an excellent choice”. Janus Capital Group, “2017 Wealth Advisor’s Guide”, page 19 “A Stock Protection Fund is a new tool that allows a group of investors to continue to own their shares and retain all of the upside potential while mutualizing the downside risk”. Kennedy, William, “Bear Cage”, Fieldpoint Private, Spring 2016 “The Stock Protection Fund is a simple, transparent and repeatable strategy for mitigating this risk without incurring excessive expenses or taxes”.

[iv] A “real money” Stock Protection Fund was operated during the 5-year period from June 1, 2006, to June 1, 2011. The fund protected 20 investors with 20 stocks in different industries, each looking to protect the same notional amount of stock. The upfront cash contribution was 10% (2% per annum for 5 years) of the notional value of the stock being protected. Of the 20 stocks protected, eight incurred losses (37%, 32%, 24%, 18%, 13%, 8%, 5%, and 1%). For investors participating in the Fund, all stock losses were reimbursed (i.e., the maximum stock loss was 0%) and the remaining cash was returned to the investors. Therefore, each of the 20 investors received the economic equivalent of 5-year “at-the-money” put protection on their stock, and the amortized cost of that protection was only 1.38% per annum pre-tax or about 1% after-tax.