Diversifying Low-Basis Stock by Combining Variable Prepaid Forwards and Tax-Aware Strategies

As an investment advisor for almost 30 years, one of the most common situations I’ve been asked to address is related to investors’ heavily concentrated position—concentrations of 50%-80% have not been unusual—in an individual stock (typically the stock of their employer). This is a mistake because while holding a concentrated position is the surest way to create a great fortune, it’s also the surest way to lose one. And given that investors are on average highly risk averse (the pain of a loss is much greater than the joy of an equal size gain), this is not an attractive proposition.

Given the widely known benefits of diversification, why do investors hold such concentrated positions? Behavioral economists have identified the following reasons for the failure to diversify:

• Confusing the familiar with the safe. Familiarity breeds overconfidence, leading to an illusion of safety.

• Overconfidence: For example, employees are often overconfident regarding the outlook of their own firm.

• Recency bias.

• Investors with large gains (which can create a concentrated position) make the mistake of believing they are playing with the house’s money.

· Treating the likely as certain and the unlikely as impossible.

· The endowment effect—valuing an owned object higher than its market value.

While these behavioral mistakes can lead investors to hold concentrated positions, another major issue is often the desire to avoid paying large capital gains taxes. There are several strategies that can be used to minimize the tax problem: donating appreciated shares to charities; the use of an exchange fund (a pooled investment vehicle structured as a partnership, where multiple individuals contribute their concentrated stock positions in-kind to the fund and receive a proportional share of the overall fund in return); variable prepaid forwards (VPF); and combining VPFs with direct indexing (creating a portfolio that mimics a market index but allows for tax-loss harvesting) and also long-short, tax-aware strategies (taking long positions in stocks that, according to a factor-based model, are expected to outperform and short positions in stocks expected to underperform).

What is a VPF?

A variable prepaid forward is a contract where an investor borrows money against the value of their stock. They receive cash upfront and agree to deliver shares of the stock at a future date. This allows the investor to diversify their holdings without immediately triggering a taxable event. The gain is realized on settlement.

Research Findings

Joseph Liberman and Nathan Sosner, authors of the February 2025 study “Combining Variable Prepaid Forwards and Tax-Aware Strategies to Diversify Low-Basis Stock,” explored combining variable prepaid forward (VPF) contracts with tax-aware (TA) strategies in order to both diversify low-basis stock and improve after-tax wealth accumulation. Their analysis simulated the following investment scenarios: holding the concentrated stock, selling the stock and investing the proceeds in a market index fund, entering a VPF contract (with a 100% floor and a 120% ceiling) and investing the VPF prepayment in a market index fund, and entering a VPF contract and investing the VPF prepayment in a TA strategy. For each scenario, they utilized 100,000 randomly drawn 20-year return histories. For consistency, the same set of 100,000 simulated histories for a given investment was used across all scenarios involving that investment.

Key Findings

• Investing VPF proceeds in an index fund generally doesn’t outperform selling the stock upfront and investing the proceeds in the index fund. Using direct indexing instead of an index fund fares only slightly better—direct-indexing strategies have limited ability to offset VPF settlement gains, adding value only when managed at a cost of less than 30 basis points. The real value of gain deferral offered by the VPF was observed when the VPF was combined with long-short strategies.

• Compared to direct indexing, the TA long-short factor strategies realized significantly higher net losses than direct-indexing strategies, allowing the investor to offset a larger fraction of the VPF settlement gain. They can also generate pre-tax profits from the factor strategies.

• Combining VPFs with TA long-short factor strategies led to better long-run after-tax wealth compared to all other scenarios, including continuing to hold the stock, fully selling the stock upfront, and combining a VPF with an index fund or a direct-indexing strategy.

Based on their findings Liberman and Sosner concluded that combining a VPF with TA long-short factor strategies leads to significantly better long-run after-tax wealth outcomes compared to other alternatives like direct indexing or a market index fund.

Investor Takeaways

Concentration brings both the opportunity for great returns and the agony of disasters. For investors who have a relatively low marginal utility of wealth (which is true of most high-net-worth individuals, the very ones who tend to have concentrated portfolios) and thus should be risk averse (having already ‘won the game’ by achieving sufficient financial wealth to maintain a more-than-acceptable lifestyle), having concentrated positions is an imprudent risk.

We reviewed a long laundry list of behavioral biases that result in the failure to diversify. Behavioral biases are irrational. Thus, they should be resisted, something that is easier said than done. However, the first step in avoiding them is to be aware of the biases – and now you are. Knowledge is the armor that can protect you from biases.

If you find yourself holding a concentrated position, don’t just sit there, trapped into inaction by behavioral biases. Act. Or one day you might find that you have turned a large fortune into a small one. The good news is that now there are investment strategies that can be used to minimize the tax impact. Liberman and Sosner showed that low-basis stock investors can effectively diversify their concentrated portfolios by combining three financial innovations: variable prepaid forward (VPF) contracts, tax-aware equity portfolio management, and long-short factor investing. For investors looking to diversify low-basis stock in a tax-efficient manner, this approach offers a promising solution.

Larry Swedroe is the author or co-author of 18 books on investing, including his latest, Enrich Your Future: The Keys to Successful Investing.