A complex but tax-friendly approach to diversification

Combining a form of leverage with a "long-short" stock strategy can help highly concentrated clients diversify with bigger tax savings than using direct indexing, a new study found.

Variable prepaid forwards — loans paying as much as 90 cents on the dollar or more for a large chunk of stock with the equity as a collateral — defer potential taxes outside of pre-set dividends for a fixed term while providing the upfront capital to gain exposure to a wider variety of holdings, according to the study, a working academic paper published online earlier this year by Joseph Liberman and Nathan Sosner of asset management firm AQR Capital Management. Using a random sample of 100,000 returns over 20 years, the authors tested the use of variable prepaid forwards in "long-short" funds that generate short-term losses and gains over a longer period against the performance of increasingly popular direct indexing strategies.

Building index funds through the slices of stocks in their holdings rather than with a vehicle such as an ETF has won hundreds of billions of dollars worth of converts in recent years. The tax advantages of harvesting losses in those holdings to offset capital gains in the portfolios have proven integral to the movement. On the other hand, the findings of the paper suggested that a blend of variable prepaid forwards and long-short funds can avoid more capital gains and aid financial advisors and their clients in diversifying from a much-appreciated stock position in only a few years or less, according to Frank Remund, a wealth manager in the Boise, Idaho-based office of registered investment advisory firm Savvy Advisors.

"It could be a great tool for concentrated stock," Remund said in an interview. "You can get to where you want to go more quickly and not have to have it locked up for seven years."

READ MORE: How the ticking clock affects tax-loss harvesting

The higher prices for active management and elevated investment minimums, which can run into the millions for some of AQR's funds, could leave some of these strategies out of reach, though. 

Remund pointed out that company founders and executives, who are likely to be carrying large equity positions, often face restrictions on how much they can sell. In addition, if their holdings meet the criteria for the exemption for qualified small business stock, they could achieve similar objectives without "this rabbit hole" and the "added expenses" of the products, he noted.

"Low-basis stock investors can effectively diversify their portfolios by combining three innovations in the financial industry: VPF contracts, tax management in equity portfolios and long-short factor investing," the study said. "Individually, each of the innovations provides a benefit to a taxable investor pursuing sustainable wealth growth and preservation. However, their value is maximized when they are combined under an umbrella of a cohesive investment plan."

The authors of the study don't dispute that direct indexing brings notable tax advantages. But they question whether direct indexing would offset enough capital gains as part of a variable prepaid forward strategy to harness the most after-tax returns.

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"While the concept of investing a VPF prepayment in a direct-indexing strategy was a definite breakthrough two decades ago, recent advances in financial technology have created new opportunities for achieving far better wealth outcomes for low-basis concentrated stock investors," Liberman and Sosner write. "The problem with direct-indexing strategies is that they are quite limited in their ability to realize losses that could offset the gain recognized upon the VPF's maturity."

Instead, pairing the variable prepaid forwards with the "tax-aware long-short factor strategies" can give "the flexibility to tailor an investment profile that best fits their market outlook, tactical allocations, risk tolerance and overall wealth-planning objectives," they added.