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2013, Study Session # 4, Reading # 13

LOW-BASIS STOCK
EF = Exchange Funds
1. DEFINING THE PROBLEM

 Basis price that serves as the basis for the computation of capital gains
(might be different from the initial cost).
 Low basis holdings in an individual portfolio may arise through:
 Entrepreneurial success:
 Significant shares in a founded company.
 Cost equals to original investment in the venture.
 Executive success:
 Usually through equity compensation.
 Value of these holdings may have risen substantially above the cost.
 Investment success:
 Portfolio comprising of several substantially appreciated securities.
 Challenges while dealing with low-basis holdings:
 Psychological attachments.
 Investment issues (e.g. risk return tradeoff & taxes).

2. UNDERSTANDING STOCK RISK

Market Risk Specific Risk Residual Risk

 Affect all securities.  Security specific. Counterparty Risk Regulatory Risk


 Cant diversify away.  Can be diversified away.
Risk due to Risk that tax
dependence on a authorities may
counterparty to reject a tax
complete a treatment chosen.
transaction

Stages of Equity Holding Life

Entrepreneurial Stage Executive Stage Investor Stage

 Very high specific risk.  The investor enters the  Multi security portfolio.
 Single security dealing. executive stage once the  Two stages:
 Immature company. business is public.  Diversified investor stage.
 Specific risk is somewhat lower  Indexing stage.
but still high.
 Less diversified equity holdings.

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2013, Study Session # 4, Reading # 13

3. APPLYING THE MODEL TO INDIVIDUAL CIRCUMSTANCES

The Entrepreneurial Stage The Executive Stage The Investor Stage

 No diversification desire.  Diversification desire is linked to  Investor strongly requires


 Look for ways to minimize the degree of control. diversification.
transfer costs.  The individuals position in the  Advisor should focus on
organization,  specific risk investors psychology.
tolerance.

4. REDUCING A CONCENTRATED EXPOSURE

 Two fundamental strategies.


 Financial strategies.
 Charitable strategies.

Financial Strategies

Outright Sale Exchange Funds

 Simple & often most expensive. Public EF Private EF


 Capital gains tax.
 Maximum flexibility.
 Eliminates all residual risks.  Partnership for a minimum of seven years.  Usually involve a single security.
 20% illiquid assets.  Investor or investors with concentrated
 Each partner receives proportional low basis stock positions join partnership
distribution. with an unrelated party who buys the
 Shortcomings: same holdings.
 High management cost.  Benefits:
 Lack of control.  Create opportunity to borrow.
 Inflexibility.  No exposure to illiquid assets.
 Flexibility.

Completion Portfolios Hedging Strategies

 Utilized by investors with other, liquid assets in addition to the  Law often prohibits constructive sale (offsetting position).
large low-basis position.  Illiquid portfolios can be effectively monetized.
 Investors goal is to reach a desired target portfolio (e.g. index).
 Tax loss harvesting to shelter the capital gain realized each time
any low-basis stocks is sold.
 May be time taking strategy.

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2013, Study Session # 4, Reading # 13

Two Alternatives

Pure Hedging Strategy Pure Monetization Strategy

 Protect gains & let profits run.  Get the money out of a position
 Reduce or eliminate downside (without taxable event).
risk  Reinvesting proceeds in a
desired way.

Equity Collars Variable Prepaid Forwards

 Buying put selling call option.  Forward sale of a contingent no. of low cost basis
 Principal requirement no constructive sale. shares in exchange for advance cash today.
 Collar may have +ve, zero or negative cost.  No constructive sale requirement.
 Collar sets the minimum value (serve as collateral), so
monetization is easy.

5. SUMMARY AND IMPLICATIONS

Useful for investors & advisors to


think in terms of diversification

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