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.
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.”
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.
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.”
If you meet the requirements, exchange funds can potentially help you overcome serious challenges:
While exchange funds offer plenty of benefits, they also carry risks:
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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