Variable prepaid forwards for the rest of us
The basics of a common but complicated solution for hedging big stock positions
Variable prepaid forwards are a tool for hedging concentrated stock positions
The hand-wavey description of a variable prepaid forward (VPF) goes something like this…
A broker/dealer gives an investor money today, and the investor pledges some shares and agrees to deliver a variable quantity of those shares (or cash) in the future.
The investor is hedged since they’ve received cash that they can invest elsewhere, and they keep some upside potential. If structured properly, no tax is due when the VPF starts.
Rev. Rul. 2003-7 provides IRS’s clearest approval of a properly structured VPF.
What’s the big deal?
When the VPF starts, the investor receives cash, but does not recognize tax until expiration (typically 1-5 years).
What surprises many seeing a VPF for the first time is the size of the prepayment: Generally, 75%-90% of the fair market value of the shares.
Investors can roll the VPF without recognizing tax, assuming they structure the new prepayment properly.
Who would use a VPF?
VPFs are not for everyone:
The shares need to be publicly traded
Common, large-cap stocks need to have at least $1mm market value (though $3mm is the often-stated minimum, and $10mm is more common), and esoteric names might have higher minimums
The investor needs to be a qualified purchaser
What problem does a VPF solve?
There are three related reasons an investor might use a VPF:
The investor is bullish and wants to retain some upside
They want to hedge risk
They are tax sensitive and imagine a multi-year1 tax-aware exit
The VPF prepayment is not a loan
The prepayment from a VPF is not a loan. The prepayment amount implies the interest rate. This has several perks:
There is no risk of a margin call (there is with a collar)
The implied interest rate tends to be lower than SOFR
The implied interest rate is fixed (vs. portfolio margin, which floats)
Unlike a portfolio margin account, there are no periodic interest payments2
What do investors typically do with the prepayment cash?
The general idea is to use the prepayment cash to buy diversifying assets.
But for decades, the strategy has been to invest in tax-aware strategies that help defray the eventual tax due on VPF close.
Scott Welch and Cliff Quisenberry wrote an article in 2005 arguing for investing in an S&P 500 direct indexing strategy (Quisenberry was a research director at Parametric at the time, and the authors didn’t call it “direct indexing,” though that’s in effect what it was).
Their results show that a tax-managed use of VPF proceeds generally yields more after-tax wealth than a tax-oblivious direct S&P 500 investment, or selling, paying the tax, and diversifying.
It’s a toss-up, though.
The outcomes are close(ish) when comparing Tax Enhanced VPFs and the sell/diversify case.
So, let’s look at research showing a clear winner.
In AQR’s 2024 paper, Combining VPFs and Tax-Aware Strategies to Diversify Low-Basis Stock, they show that the cumulative after-tax return of VPF + direct indexing is essentially flat versus just selling the concentrated position upfront and reinvesting the proceeds (roughly consistent with Welch/Quisenberry 2005).
They go on to argue for using VPF proceeds in a tax-aware long/short separate account. The idea is that the long/short strategy can harvest tax losses that fully offset the capital gains eventually due on the VPF [see footnote #1 for additional discussion on this].
The one hiccup is that specific tax-aware long/short solutions may require a minimum position size so that managers are comfortable adding the extensions. This varies by manager and the stock the investor seeks to hedge3.
There’s quite a bit more ground to cover on this topic, but I’ll leave that to future work.
A simple package
A variable prepaid forward may seem complex (it is), but one logistical advantage is that everything fits into a single contract.
Alternatively, if an investor were to cobble together an option collar (short call, long put) in a portfolio margin account and borrow as much as possible, it would take a bit more effort to monitor.
This is just the beginning of my work on variable prepaid forwards. Stay tuned…
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“But but but… what about tax-aware long/short strategies like 250/150 and, hell, why not, 300/200? Those strategies can generate enough losses in a single year so that I could just sell the concentrated position and defray all the tax without bothering with the VPF stuff!”
There are a handful of issues with “being aggressive” that tax-aware long/short investors should consider…
AQR’s research shows that 250/150 generally takes more than 1 year to realize 100% in cumulative net capital losses. “RC 250/150 reaches a 100% CNCL [cumulative net capital losses] in less than two years and only about 10% of the vintages fail to realize a 100% CNCL after two years.” [Liberman, Joseph, Stanley Krasner, Nathan Sosner, and Pedro Freitas. 2023. “Beyond Direct Indexing: Dynamic Direct Long‑Short Investing.” The Journal of Beta Investment Strategies 14, no. 3 (Fall): 10–41.]
A plan relying on aggressive leverage also implies that the strategy is implemented near the beginning of the year, which may or may not be practical.
While many end wealth-owners are comfortable with high tracking error solutions (for example, AQR’s 250/150 solution aims for 6% tracking error, versus ~1% for a typical direct indexing portfolio), their wealth managers might not be comfortable with explaining tracking error if an alpha strategy underperforms.
There’s an argument that an investor is “married” to the leverage once they adopt it. In other words, if an investor adopts a 250/150 strategy, they would be “giving it all back” if they unwound to lower or no leverage. There are two problems with this argument:
AQR’s research shows that there’s a graceful way to deleverage a portfolio and still have cumulative net capital losses. See Exhibit 8 (Scheduled De-Risking of 250/150 Strategies, Panel A: Relaxed-Constraint (RC)) from the paper mentioned above:
“…the blue area signifies a pre-de-risking stage, the yellow area signifies a de-risking stage, and the green area signifies a post-de-risking stage.” Even if an investor must fully unwind to a no-leverage, long-only portfolio, a near-term tax-deferred strategy still has value. So, the “giving it all back” argument ignores the time value of money.
This is a non-exhaustive list of tradeoffs to consider. It’s nuanced. Every portfolio decision, especially those involving leverage and estate implications (like tax-aware long/short), needs a close look.
This is nuanced… if the VPF prepayment is invested in tax-aware long/short, and portfolio margin is complemented by short rebate, the interest rate payables start to look similar. But, again, portfolio margin floats, while VPF implied rates via prepayment is fixed.
Readers may be interested in AQR’s recent piece, which discusses managing concentrated positions with tax-aware long/short strategies.
You write the best letters on Substack. Well done, Brent!