Between 2 concentrated-stock strategies, a clear winner

For wealthy investors with concentrated holdings in appreciated stocks, one type of options contract tied to a loan is better than another "in nearly all circumstances," a new study found.

But financial advisors and clients seeking to tap into the tax advantages of a variable prepaid forward over a simpler, but less effective strategy called an options collar with a margin loan must be so-called qualified purchasers undertaking a complex transaction of at least $1 million, according to the study that has been accepted for publication in the Journal of Wealth Management later this year. 

Authors Brent Sullivan, the writer of the Tax Alpha Insider newsletter and blog, and two executives from San Francisco-based registered investment advisory firm Fort Point Capital Partners — Head of Derivative Solutions Roy Haya and Managing Partner Ralph Dryborough — posted the study in March and revised it last month.

The regulatory definition's requirement that "qualified purchasers" have at least $5 million in liquid net worth overall will render the report's conclusions as merely academic to most investors. But the discussion around such strategies is driving into an intersection with two important topics to a lot of advisors and clients: appreciated stocks with capital gains that will bring a tax hit upon realization and a growing menu of potential solutions to that problem. 

As an illustration of the value that many planners see with tax-focused investment strategies that add to the wealth management industry's traditional services, last month's first-ever Basis Northwest conference in Seattle drew 350 attendees, which is about seven times as many attendees as Sullivan, the co-organizer, had anticipated, he noted. So planners are getting more interested in strategies like variable prepaid forwards and options collars with a margin loan.

"It's definitely a niche solution, but it's a very powerful solution," Sullivan said of variable prepaid forwards. "There are meaningful differences between these two different approaches that look really similar on the surface but are quite different under the hood."

Advisors and clients are planning their next moves in an investing climate marked by roughly 15 years of bull equities in general and, more recently, the initial public offerings for SpaceX this month and plans for them in the future at OpenAI and Anthropic. So it pays for investors with appreciated stocks to embrace a "thoughtful combination" of strategies taking factors like their end goals, liquidity needs and risk tolerance into account, according to Shang Chou, who is the co-founder and managing partner of Dishmi Capital, a tax-focused alternative investment management firm and the other co-organizer of Basis Northwest. 

Advisors should know that their "tax advice is going to be invaluable" in a time of social media noise around the IPOs and a rush to sell products to investors, Chou said.

"When you're a hammer, everything looks like a nail. The reality is that Wall Street is driven by product sales," he said. "As an investor, as a shareholder in one of these concentrated stock positions, you do want to be intentionally patient. … A very skilled planner or advisor can help you figure out, 'what is the right combination?'"

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How the strategies work, or don't work

In weighing the benefits of the two strategies discussed in the paper, the authors pointed out that they both provide "downside protection and day-one liquidity in exchange for capped upside." 

In a variable prepaid forward contract, the investor pledges the concentrated stock to get a loan called a prepayment under the obligation to transfer certain amounts of shares or cash upon maturity, with a floor and ceiling value threshold in the terms. With an options collar and an accompanying margin loan, an investor also gets that liquidity upfront through a pairing with a long put at lower value and a short call at a higher one. In either case, investors trying to hedge against their concentration risk and get liquidity from their portfolios without a tax hit from capital gains can achieve those two goals, the authors write.

"The economic difference between the two solutions can be explained by character degradation (the deferral of an option loss into a stock basis adjustment that, when recovered as reduced long-term gain, yields less after-tax value per dollar than a current offset against short-term income), phantom income (a current tax liability with no corresponding net economic gain), and financing spread," Sullivan, Haya and Dryborough wrote. "In nearly all circumstances, we conclude that the variable prepaid forward is a structurally more efficient alternative."

The main distinctions stem from the fact that the latter "bundles the hedge and a prepayment in a single contract," while the options collar and loan "subjects each option leg to position-by-position gain-or-loss testing" that brings that phantom income, according to the study. The "operational simplicity" for investors who are "fully committed to delivering shares at maturity" and operating with a lower minimum transaction size through standard brokerage platforms makes the collar and margin loan more accessible, the authors write. But the structure of the variable prepaid forward gives it the edge in most cases.

"The VPF avoids phantom income entirely, and its integrated netting substantially reduces character degradation," the authors wrote. "An investor who holds external capital losses can offset the collar's phantom income, but doing so diverts losses that could otherwise shelter gains elsewhere; the VPF avoids this cost entirely, preserving the investor's loss inventory for more productive use."

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Buyer and advisor beware

As options experts with experience executing many types of strategies, Haya and Dryborough acted as the "ruthless" technical reviewers in the writing process for the study, Sullivan noted. They knew going into it that the variable prepaid forward "is just a tighter vehicle," but the numbers from the calculations in the study provided further evidence, he said. With more retail investors getting access to options trading in recent years, they're getting more sales pitches for collars with margin loans. 

But there is "almost no reason" to do that if they can use the variable prepaid forward strategy instead, according to Sullivan. "It's pretty clear — if you're eligible for this product, it's like almost hands-down better."

In "this big wave of democratization and innovation that's sweeping over the wealth world," advisors and their clients will likely be hearing more about these two strategies, other complex vehicles like box spreads and Section 351 exchanges or any number of other approaches, Chou said. As a former startup founder earlier in his career, he's now trying to help educate more advisors and investors about how "IPOs and wealth creation events are amazing things and filled with euphoria" that often turn into a "rollercoaster" of stock values and accompanying tax implications, he said. 

"The first time it happened, I like to say I made every mistake in the book," Chou said. "It's a very complicated decision-making process that we try to help folks work though."