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Top 3 Ways to Incorporate Options Into Your Practice

Options are broadly misunderstood and underutilized as tools in many wealth management practices. Most retail investors and even many advisors have an immediate negative reaction to just hearing the word “Options.”  Many investors simply think of the options market as a personal casino with the potential to win and lose fortunes. We’ve all heard horror stories about a friend or colleague who took a big risk on an option position and lost it all – but it is so much more than that.  What many fail to realize is that options are extremely flexible instruments that can be used to create an income stream, dampen volatility, and even reduce or eliminate capital gains tax liability.  When used properly, options can provide significant benefits to wealth managers and their clients.

Equity markets have struggled for the past year and a half as inflation concerns, geopolitical issues, and recession fears continue to dominate the headlines. This environment has many investors looking for new ways to produce returns. One method to generate diversified yield is to sell covered calls against core stock holdings. Someone who writes (sells) calls against their stock position is limiting their upside over a specified timeframe but receives payment in the form of option premium for doing so.  Practitioners of this strategy will generally sell calls at or above a price level that they deem unlikely to be seen over the life of the option. This allows the stockholder to still participate in share price appreciation, while also generating an income stream and lowering volatility.

Options are widely used by institutional investors for hedging their exposure but are largely overlooked by financial advisors and retail investors for that same purpose. While hedging may be unsuitable for some investors, it can make a lot of sense for those who have reduced risk tolerance. If an advisor has a client concerned about a specific position or the market in general, a simple hedge using options can be used to de-risk the position and help everyone rest easy at night.  Using options offers a great deal of flexibility as to how the hedge can be structured, and oftentimes this can be done at little or no cost with collars. These strategies aren’t for everyone. There are transaction costs involved—which are often higher for options than for other securities. Similarly, hedging trades can erode profits on positions that continue to appreciate, and the option contract itself is a wasting asset.

Arguably the most valuable yet least used application of options is for tax optimization within a portfolio. Many buy-and-hold investors find themselves in the position of being heavily exposed to one or a few companies. Assume a hypothetical investor purchased a sizeable position in a stock like AAPL, NFLX, or MSFT many years ago and has never rebalanced their portfolio to avoid paying capital gains taxes. These holdings are likely now a large percentage of their investable wealth and create the potential for excess volatility and large losses. Option overlays can be used to combat this concentrated stock risk and potentially eliminate capital gains tax liability over time. These strategies can be structured to meet the exact goals of each client without being a drain on liquidity.

Options offer a wide variety of benefits to an advisory practice but are generally overlooked because of their complexity and attention required. In addition to this, there are a very specific set of rules that must be followed to realize their potential tax benefit. The team at Exceed Advisory has over 40 years of professional derivatives experience and can help simplify this process and add value for your clients.

 

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IMPORTANT DISCLOSURE: The information in this blog is intended to be educational and does not constitute investment advice. Exceed Advisory offers investment advice only after entering into an advisory agreement and only after obtaining detailed information about the client’s individual needs and objectives. Hedging does not prevent all losses or guarantee positive returns. Transaction costs and advisory fees apply to all solutions implemented through Exceed.

Where are Those “Top 10” Companies Now? – “2010” Focus

“Top” companies can seemingly do no wrong during their ascent. Whether filtered by top US companies by market cap or fastest growing over the last decade, these companies tend to be household names with a ton of caché. Right now, the top US company by market cap is Apple (AAPL). The fastest growing for the last decade (2010s) is Netflix (NFLX). Some of the luster has already caught up to Netflix as competitors have filled the gap. Apple, though, still seems to dominate. Will that be the case in five years? 10 years? When a fifty-something is ready to retire and dip into their nest-egg?

The only sure thing in investing is uncertainty, but maybe we can learn something from history. How have the “Apples” and “Netflixes” of the past performed over time? Today, let’s look back to 2010 and see if there are any important lessons for investors.

Below is a list of the ten largest companies by market capitalization as of 1/4/2010, and their performance since. These return numbers include dividend reinvestment and consider a hypothetical $100,000 investment in each security using closing prices on 12/31/2009. The ending value is as of 12/31/2022. We’ve also provided information on the results of the SPDR S&P 500 ETF Trust (SPY), representing large-cap US equities, and the Invesco QQQ Trust (QQQ), an ETF with holdings of mostly large-cap stocks from the Nasdaq 100, during the same period. The performance shown in this table is for illustrative purposes only and is not intended to represent the performance of Exceed Advisory or any of its clients.

The hypothetical performance shown in the table above is for illustrative purposes only and is not intended to represent the performance of any Exceed Advisory portfolio or of Exceed as a firm.

 

This decade was a great time to be invested in equities, as the economy was recovering from the Great Financial Crisis with the aid of quantitative easing and historically low interest rates.  Most of the damage from 2008-2009 was repaired in a matter of a couple years, and the era of dominance by technology stocks was underway. Despite this backdrop and a raging bull market, investments in only a small percentage of these companies would’ve yielded superior performance to a passive index investment – only AAPL and MSFT were the outliers.  Investments in GOOGL, BRK.B or JPM would’ve resulted in performance similar to that of their respective indices, while the remaining five companies on this list significantly underperformed the broad market.  In a previous blog we looked at the bear-market period from 2000-2010 and it showed that being diversified was critical for loss mitigation and volatility reduction. This has also held true during strong bull markets – very few investors are able to pick stocks that are long-term outperformers, and from the list above there was only a 20 percent chance that an investment in any of these names would’ve resulted in material outperformance. Choosing to hold a concentrated portfolio raises its risk profile, which in turn increases the potential for underperformance versus a diversified market portfolio.

Below is the current list of the ten largest U.S. corporations. We will continue to look at different slices of time in future blogs as we did above, but the theme remains consistent – historically, most of the biggest companies have underperformed the broad market over long periods of time.  It seems unfathomable that any of these companies could be poor investments going forward, but history suggests otherwise. That said, it’s also true that past performance isn’t a guarantee of future results, so we don’t know for sure what the future will bring. We do, though, think caution is warranted when assuming that today’s top performers will continue to be tomorrow’s top performers.

The solution to combat a concentrated portfolio of mega-cap stocks is simply to reduce position sizes and rebalance into a diversified market portfolio.  Multiple studies have shown that concentrated portfolios often underperform over long time periods, and the optimal portfolio decision is to rebalance and reduce volatility and exposure. 1Nathan Sosner, “When Fortune Doesn’t Favor the Bold. Perils of Volatility for Wealth Growth and Preservation. The Journal of Wealth Management Winter 2022, jwm.2022.1.189; DOI: https://doi.org/10.3905/jwm.2022.1.189 2Baird’s Private Wealth Management Research, “The Hidden Cost of Holding a Concentrated Position. Why diversification can help to protect wealth.” https://www.bairdwealth.com/siteassets/pdfs/hidden-cost-holding-concentrated-position.pdf  If you or your clients have concentrated positions with significant tax liability in any of the above companies, Exceed Investments can help. Exceed’s tools can be implemented to hedge large investments, and in many cases reduce them to a desired level without having to pay capital gains tax.  Contact us for a consultation.

 

 

IMPORTANT DISCLOSURE: The information in this blog is intended to be educational and does not constitute investment advice. Exceed Advisory offers investment advice only after entering into an advisory agreement and only after obtaining detailed information about the client’s individual needs and objectives. Hedging does not prevent all losses or guarantee positive returns. Transaction costs and advisory fees apply to all solutions implemented through Exceed.

You Made a Fortune in One Investment. Now What?

The Pareto Principle states that roughly 80% of consequences come from 20% of the inputs. This concept was developed by economist Vilfredo Pareto in the 1800s and has multiple applications in business, including management, marketing strategy, customer service, and investing. In the finance world, application of this principle lends itself to the theory that the vast majority of an investor’s gains come from a small percentage of their total investments, while most of their portfolio will underperform the broad market over long time horizons.

Many investors find themselves in the enviable predicament of having too much exposure to one or a few companies because of their outperformance versus the market. A theoretical buy-and-hold investor who bought a big position in Apple (AAPL) 10+ years ago would be a good example of this. Yes, the rest of their portfolio has likely appreciated over that timeframe, but AAPL has far outpaced the market. As a result, a large portion of this person’s wealth is now tied to one company. Other examples of this phenomenon include employees of a company who have accumulated significant wealth via stock options and others who have inherited sizeable stock positions. Holding such positions dramatically increases risk and leaves them vulnerable to significant drawdowns. Numerous studies have shown that portfolios with concentrated positions are destined to underperform – it’s only a matter of time. 1Baird’s Private Wealth Management Research, “The Hidden Cost of Holding a Concentrated Position. Why diversification can help to protect wealth.” https://www.bairdwealth.com/siteassets/pdfs/hidden-cost-holding-concentrated-position.pdf 2Nathan Sosner, “When Fortune Doesn’t Favor the Bold. Perils of Volatility for Wealth Growth and Preservation. ”The Journal of Wealth Management Winter 2022, jwm.2022.1.189; DOI: https://doi.org/10.3905/jwm.2022.1.189

Someone looking to rebalance into a diversified market portfolio has to make the important choice of how to reallocate their funds. There are generally four options: 1) Sell the shares and take a big hit to the portfolio value via capital gains taxes, 2) Use traditional tax-loss harvesting methods and sell some losing positions to offset the gains in their concentrated position, 3) Transfer their position into an exchange fund, or 4) Use option overlays to mitigate or eliminate tax liability. Let’s take a look at each of these methods.

An outright sale of the shares is by far the most punitive of the above choices. Federal long-term capital gains tax rates in 2023 are 15% for married couples earning over $83k per year and reach 20% for those earning more than $553k annually. Additionally, 42 of 50 states tax capital gains as income and the tax rates range from 2.9% to 13.3%, with most landing in the mid-single digits.  Selling the shares outright can be viewed as an immediate loss of 15-25% of that position’s value, and the tax bill can be significant in many situations. Limiting such liabilities is obviously optimal for long-term wealth appreciation.

Traditional tax-loss harvesting is a very popular method employed by wealth managers, but it has its shortcomings. Generally applied near the end of the year, advisors will look to rebalance their client portfolios and avoid taxes due by selling both losing and winning positions. If you can accrue losses equal to the amount of gains that have been booked, then the effective tax liability is zero. However, this requires that the client actually has significant paper losses that can be harvested. The end of 2022 was a very popular time for this method because of the large number of companies that experienced significant declines, but loss harvesting won’t always be a viable option. This flies in the face of the traditional methodology of “buy low, sell high,” as you’re selling both losing and winning positions. Lastly, wash sale rules require that the investor can’t buy the position back for 30 days after it’s sold.

Exchange funds have become popular vehicles for tax optimization among ultra-high-net-worth individuals. An investor looking to reduce a concentrated position can move it into an exchange fund, which is basically a pool of other concentrated positions that have been aggregated by an asset manager. The investor is “exchanging” their holding in one or a few positions for a pro-rata allocation of the pool of assets. This diversifies their portfolio, reduces risk, and allows the holder of one or a few stocks to now own a percentage of the fund without having to sell their concentrated holding and pay capital gains taxes. While this may sound like the perfect solution for concentration issues, exchange funds have their problems. Most have a minimum position size of $5M, which effectively eliminates this option for a huge percentage of investors. For those able to meet the minimum asset requirement, entering into an exchange fund requires a seven-year commitment. Any asset sales before the end of this lockup period will result in penalties due to the fund, and in some instances the fund will just transfer the original concentrated position back to the investor. For anyone who may have short-term liquidity needs over the next seven years, this makes such a time commitment a difficult proposition. Lastly, exchange funds can be expensive, with many charging a management fee of 150-200 basis points annually. Despite these shortcomings, exchange funds can still make sense for some individuals who have significant tax liabilities and low liquidity needs.

Option overlays are the final (and in our biased opinion, best) solution for mitigating tax liability and concentration issues. An investor holding a large position in one company can use covered calls or collars as tools to reduce volatility, generate yield, and in many instances completely eliminate tax liability over time. The strategies offer a great deal of flexibility and can be tailored to meet the specific needs of each individual investor. An option overlay program can be either systematic or tactical, which can create the potential for excess alpha generation and isn’t a drain on liquidity. Depending on volume and transaction size, the costs to implement these programs are often minimal when compared to those of an exchange fund. The use of options will require the investor to pay commissions to their broker, and of course there are management fees assessed. However, in many cases, the total cost to the investor may be significantly less than the price of other solutions.  The cost is also usually minimal when compared to the tax savings that can be realized. Most option overlay strategies can be implemented for 50 basis points annually or less, and this cost is oftentimes only a small fraction of the total tax liability.

Options provide a value-add to an advisory practice and its clients, but they can be complex. Additionally, the tax code is difficult to navigate and these overlays will require constant attention and rebalancing. The team at Exceed Investments has over 40 years of professional derivatives experience and can streamline this process for you and your clients, allowing them to efficiently grow their wealth.

Contact us for a consultation.

 

 

This blog post is for informational or educational purposes only and is not intended as investment advice.  Any discussion of investment strategy or approach is intended only to illustrate investment concepts and in no case does the discussion represent Exceed Advisory’s investment performance or the results of any Exceed Advisory portfolio.  We provide investment advice only to clients and only after entering into an advisory agreement and obtaining information concerning individual needs and objectives. We think the information provided is accurate, but accuracy is not guaranteed. All investing in securities involves risks, including the risk of loss.

Tax Lessons Learned From Tesla

The past few years for Tesla (Ticker: TSLA) have been anything but mundane. Shares of the equity experienced a meteoric rise from mid-2019 to late 2022, with a trough-to-peak rally of over 3400% in a little over three years. However, after its parabolic ascent the shares declined by about 75% in a little over a year.

 

Opinions on the company are as polarizing as they come – some believe that it’s a cash-burning vortex destined for bankruptcy, while others are convinced Elon Musk can walk on water and TSLA is set to take over the world. Musk’s recent Twitter fiasco removed a lot of the sparkle from his image, and that shift in sentiment can be seen in Tesla’s recent performance.  There was always an embedded “Elon premium” in the shares, as believers shunned fundamentals because of the CEO’s rockstar image. Is it possible that there is now an “Elon discount?”

Early investors in the company experienced a financial windfall between mid-2019 and November 2021, but many were likely caught up in the hype, which would limit a potentially prudent taking of some profit. Aside from human emotions, the most likely reason that a buy-and-hold investor refused to reduce their TSLA position after its rapid rise was the associated tax liability with selling shares. Let’s look at a hypothetical situation involving an early investment in TSLA…

Assume a buy-and-hold investor with a $1M portfolio invested 10% of their capital in TSLA shares at an average price of $20 (split adjusted for today’s prices) at the end of 2018, and the remaining 90% of their capital was invested in a diversified market fund. For simplicity’s sake, in this example we’ll use the SPDR S&P 500 ETF trust (symbol SPY), an exchange traded fund (ETF) that aims to track performance of the S&P 500 index. So, on 1/2/2019 this hypothetical portfolio consisted of $100,000 in TSLA shares and $900,000 in SPY shares. The table below shows the performance of the Tesla and SPY positions, using end-of-year values. This illustration also assumes a 20% capital gains tax rate.

 

As you can see the Tesla position quickly grew into a substantial percentage of the total portfolio holdings. From the investor’s perspective, this is obviously a very good thing because it means that the TSLA position was appreciating rapidly. However, this rapid appreciation creates other problems associated with buy-and-hold investing.  Multiple studies have shown that holding a concentrated portfolio generally leads to underperformance. 1Nathan Sosner, “When Fortune Doesn’t Favor the Bold. Perils of Volatility for Wealth Growth and Preservation. ”The Journal of Wealth Management Winter 2022, jwm.2022.1.189; DOI: https://doi.org/10.3905/jwm.2022.1.189  2Bernt Arne Ødegard, “The diversification cost of large, concentrated equity stakes. How big is it? Is it justified?” Finance Research Letters Volume 6, Issue 2. https://doi.org/10.1016/j.frl.2009.01.003 3Baird’s Private Wealth Management Research, “The Hidden Cost of Holding a Concentrated Position. Why diversification can help to protect wealth.” https://www.bairdwealth.com/siteassets/pdfs/hidden-cost-holding-concentrated-position.pdf

In addition to the heavy concentration risk, the total portfolio volatility grew substantially. TSLA has a five-year monthly beta of 2.03, meaning that it’s more than twice as volatile as “The market.” As a result, total portfolio volatility grew by nearly 50 percent over the first three years. Elevated levels of volatility that lead to underperformance can be detrimental to risk-adjusted performance metrics like Sharpe and Sortino Ratios.

It’s easy to look back and wonder why an investor didn’t rebalance their portfolio after such a gigantic move higher by TSLA, but hindsight is always 20/20. At its peak at the end of 2021, the theoretical tax liability associated with the TSLA holding was approximately three times the initial investment amount, and nearly 30% of the initial portfolio value! Upon the liquidation of shares, this tax liability can be seen as an immediate loss of portfolio value.

Rapid ascents by companies like this aren’t anything new. History is littered with similar examples of companies that quickly rose to prominence, only to fall back to earth. A few that immediately come to mind are Yahoo, Dell Computer, Zoom, Meta, Netflix, Nokia, and Blockbuster Video. Generally speaking, companies that rise the most during bull markets may depreciate rapidly during market downturns. It’s imperative that investors harvest gains and periodically rebalance their portfolios in order to avoid substantial drawdowns.

The good news is that there are solutions to these common problems. Options are often (and rightly) viewed in a negative light among retail investors, as they can be very risky and lead to substantial losses. Options are complex and can be intimidating to even the most seasoned investor. What many people don’t realize, though, is that options can also be powerful tools for tax optimization and hedging within a portfolio. When correctly implemented, an option overlay strategy may completely eliminate tax liability on certain concentrated positions, while simultaneously hedging downside risk. There are of course transaction costs involved, as well as advisory fees in the case of an overlay strategy, but the ability to exit these positions tax neutrally while also reducing portfolio volatility can have a substantial positive effect on long-term capital appreciation.

If you or a client are dealing with how best to address the tax liability and downside risk concerns that often accompany concentrated positions, feel free to reach out to the team at Exceed Investments. Members of Exceed’s Portfolio Management Team have over 38 years of professional options experience and are well-versed in the tax code. These strategies can be tailored to fit specific investment goals and satisfy immediate needs. When executed properly, these option overlay strategies may reduce or eliminate tax liability, lower risk, and help you and your clients achieve their financial goals in an efficient manner.

 

Contact us for a consultation.

 

 

 

This blog post is for informational or educational purposes only and is not intended as investment advice.  Any discussion of investment strategy or approach is intended only to illustrate investment concepts and in no case does the discussion represent Exceed Advisory’s investment performance or the results of any Exceed Advisory portfolio.  We provide investment advice only to clients and only after entering into an advisory agreement and obtaining information concerning individual needs and objectives. We think the information provided is accurate, but accuracy is not guaranteed. All investing in securities involves risks, including the risk of loss.