Investing in Exchange Funds

Investment strategiesExchange funds: Benefits and risks for diversifying concentrated stock positions

Key things to know

  • Exchange funds are a private investment fund designed for long-term investors with concentrated stock positions to diversify their portfolio and reduce taxes.

  • You can contribute your concentrated stock to a fund in exchange for ownership of an equally valued diversified portfolio of securities without triggering any current tax consequences.

  • There may be specific requirements that you must meet to either qualify as an accredited investor1 or qualified purchaser.2

Many investors hold heavily concentrated positions in their portfolio. And whether due to emotions or tax concerns, investors too often avoid rebalancing their concentrated holdings.
Over time, however, a disproportionately large stock position introduces substantial risk to a portfolio. If that concentrated position declines in value, it can have a pronounced negative impact on an investor’s overall portfolio.

Exchange funds offer a potential solution. 

Investors that use exchange funds seek to achieve long-term, after-tax returns that track the overall market as measured by indexes like the S&P 500 Index.

What is an exchange fund

An exchange fund, also known as a swap fund, is a private investment fund designed for long-term investors with concentrated stock positions to diversify their portfolio and reduce taxes. Exchange funds could be particularly beneficial for executives who hold a substantial amount of their employer’s stock, individuals who have inherited assets from a family business, or investors with very large gains in a particular stock. 

“Whether you’ve acquired stocks through a merger or acquisition or simply saw huge stock growth, there are a number of scenarios where an exchange fund may make sense,” says Natalie Burke, senior research analyst for public markets due diligence with the U.S. Bank Asset Management Group. “It’s all built on the simple idea that a diverse portfolio has inherently lower risks than a concentrated one.”

How do exchange funds work?

With an exchange fund, investors choose to contribute their concentrated stock to a fund in exchange for ownership of an equally valued diversified portfolio of securities without triggering any current tax consequences. Exchange fund managers pool contributed securities from many investors.

Investors that use exchange funds seek to achieve long-term, after-tax returns that track the overall market as measured by indexes like the S&P 500 Index. These funds are required to invest at least 20% of portfolio holdings in “qualifying assets.” These are investments that are neither stocks nor bonds that trade on a public market. Exchange funds must meet this requirement in order for the transfer to individual investors to be considered non-taxable, per federal tax code.

This requirement is often met by purchasing illiquid private real estate investments, such as multi-family residential, office or industrial properties. Typically, funds target established properties in major U.S. markets with consistent cash flows.

Who can invest in exchange funds?

To invest in an exchange fund, investors may be required to qualify as an accredited investor1  or qualified purchaser.2 And depending on the fund, one or more acceptable securities with a combined value ranging from $500,000 to $1 million must be contributed in exchange for fund shares. Cash contributions are not permitted, and not all stocks will be accepted into an exchange fund. There’s typically a list of stocks approved within a fund’s investable universe, which is always subject to change.

Accepted securities typically must be listed on common U.S. and foreign exchanges. Restricted stocks of publicly traded companies are eligible for acceptance, but the timing of commitments should be coordinated with the company’s compliance procedures. Exchange funds typically cannot accept mutual funds, master limited partnerships (MLP), business development corporations (BDC), exchange-traded funds (ETF), real estate investment trusts (REITs) or any securities that issue a Schedule K-1.

“Exchange funds have a level of complexity and unique requirements,” Burke says. “As asset managers, we can walk you through them and help you determine if they’re a good fit for your portfolio.”

What are potential benefits of exchange funds?

If you meet the requirements, exchange funds can potentially help you overcome serious challenges:

  1. Diversification. The primary benefit of an exchange fund is that investors swap their concentrated holding of a stock for a professionally managed, diversified portfolio. This may help reduce risk and volatility.

  2. Minimized tax impact. Contributions of appreciated stock to an exchange fund are generally not taxable under current federal tax law.

  3. Tax-sensitive investment management. Exchange funds seek to minimize and defer shareholder taxes. This is accomplished by owning primarily low-yielding securities and stocks whose dividends can qualify for favorable federal income tax treatment. In addition, the funds typically limit portfolio turnover to avoid passing along taxable capital gains to investors.

  4. Positioning for greater returns. Because no tax is due on the transaction, investors can keep the full value of the contributed security working for them. This creates the potential to generate greater portfolio appreciation over time before taxes are due.

  5. Effective estate planning. Under current law, if the exchange fund is still held at the investor’s death, beneficiaries, through an intra-family transfer of wealth, can take advantage of the stepped-up cost basis at death benefit. However, proposed legislation could change that.

What are potential risks of exchange funds?

While exchange funds offer plenty of benefits, they also carry risks:

  1. Equity market risk. Assets in an exchange fund remain subject to stock market risk. Performance is expected to be highly correlated to broader equity markets.

  2. Potential opportunity cost. While diversification may reduce risk, it’s possible the diversified portfolio of stocks will underperform an investor’s original holding.

  3. Liquidity restrictions. Exchange funds are intended for long-term investors. Once an investor contributes a stock, there are restrictions on liquidity for seven years. While shares may generally be redeemed daily or monthly, investors redeeming during those seven years are likely to first receive the original shares they contributed instead of a diversified basket of stocks. And early redemptions are subject to a redemption fee. 

    Shareholders redeeming after seven years may receive a diversified basket of liquid securities selected by the manager. Distributions are generally not taxable to the redeeming shareholder until the distributed securities are later sold.

  4. Real estate investment risks. The qualifying asset component (for example, private real estate investments) of an exchange fund typically has very limited liquidity and may detract from performance in certain market environments such as the 2008 financial crisis.

  5. High fees and expenses. There are numerous fees and expenses associated with an exchange fund, including but not limited to those associated with advisory, distribution, shareholder servicing, redemption, selling commissions, interest, and borrowing costs.

  6. Tax risks. Contributions to exchange funds are not taxable under current tax law, but legislation could change that. Also, corporate events may trigger taxable events. Any gains generated by the stock prior to the time it was contributed to the exchange fund ultimately will be applied in the future when the investor sells exchange fund positions.

  7. Suitability. Exchange funds are a long-term, complex solution for investors with significant holdings that include an oversized position in equities. An exchange fund may not be the most appropriate choice for everyone.

Weighing the pros and cons of exchange funds

Exchange funds offer investment diversification and tax-deferral benefits for those with concentrated stock positions. They may be a good option if you’re a long-term investor looking to reduce exposure to a concentrated, low cost-basis stock.

“Using an exchange fund could help you avoid selling stock and, as a result, considerable taxes, or avoid having to borrow against your position and purchase a diversified portfolio,” Burke says. “It can be an elegant, though complex, solution for the suitable investor.”

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Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio. Diversification and asset allocation do not guarantee returns or protect against losses.

Investments in exchange funds are available to investors who meet “Qualified Purchaser” qualifications. While exchange funds provide diversification, they will not protect against broad market declines. Investors must remain in a fund for at least seven years before redeeming shares, and those who leave prematurely may face penalties and only receive their original shares back. For additional details about various risks associated with these types of investments, investors are encouraged to review the offering materials, including the Private Offering Memorandum with their tax and legal advisors.

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  1. Accredited Investor: For individuals, the requirement is generally met by a net worth that exceeds $1 million (excluding primary residence and any related indebtedness), income in excess of $200,000 (individually)/$300,00 (jointly with spouse) in the two most recent years with an expectation of the same in the current year, or individual has a Series 7, 65 and/or 82 securities license(s). Relying on joint net worth or income does not mean securities must be jointly purchased. For entities (including trusts, non-profit corporations exempt under Section 501(c)(3), LLCs, LLPs, corporations, etc.), the requirement is generally met if the entity has assets in excess of $5 million (assuming the entity was not formed for the specific purpose of acquiring the securities offered), or when all of the entity owners are accredited investors. Please refer to Rule 501 under the Securities Act of 1933 for the complete definition. 

  2. Qualified Purchaser: For individuals, the requirement is generally met when the investor owns (individually or jointly) $5 million or more in investments. Relying on joint ownership of investments does not mean securities must be jointly purchased. For entities (including trusts), the requirement is generally met if the entity owns $25 million or more in investments; the entity owns $5M or more in investments AND it is owned by two or more natural persons who are related as siblings/spouse; or all beneficial owners of the entity are each Qualified Purchasers. Please refer to Section 2(a)(51) of the Investment Company Act of 1940 for the complete definition. 

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