Tax Aware

Making VPFs Work Harder for You

Topics - Tax Aware

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Making VPFs Work Harder for You

There is a range of solutions aimed at reducing the risk of concentrated stock tax-efficiently: completion portfolios, exchange funds, charitable giving, just to name a few. But for some investors, Variable Prepaid Forwards (VPFs) are a favorite. It’s not hard to see why—from the investor’s point of view, the VPF:

  1. Provides downside protection,
  2. Allows for some upside participation,
  3. Generates significant cash up-front,
  4. And defers recognition of the capital gain to a later date. 

Our latest paper looks at how investors can use #3—the up-front cash—to maximize the after-tax value of their investment portfolio. 

Two decades ago, it was cutting-edge for an investor to put that cash into a tax-loss harvesting strategy, such as Direct Indexing. The investor would collect the equity premium, while also realizing capital losses that would offset some of the capital gain realized at maturity of the VPF. 

But Direct Indexing has limitations. First, transaction costs and fees can create a pre-tax return drag compared to a passive index fund. Second, the tax losses it realizes tend to be fairly muted in the early years of the strategy and degrade toward zero in the years that follow. Those tax losses also have an unfortunate sensitivity to the market environment—they tend to be smaller when markets are up (i.e., exactly when you’d want them to be larger). 

Our paper finds long/short tax-aware factor strategies can be a significantly better choice for investing the VPF’s upfront cash proceeds than Direct Indexing. These strategies have been shown to be substantially more tax-beneficial than Direct Indexing, both in magnitude of tax losses and their consistency across market regimes. Importantly, these strategies generate pre-tax active returns at the same time as they deliver these tax benefits. Maybe even more uniquely, they don’t even have to be tied to an equity benchmark—which means investors could choose a benchmark that fits better with their investment goals.

This document is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein.

This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. Diversification does not eliminate the risk of experiencing investment losses. 

This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. Diversification does not eliminate the risk of experiencing investment losses.

The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.