Demystifying Exchange Funds: An Overlooked Way to Manage Concentration Risk

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A key responsibility for financial advisors is helping clients manage risk in their investment portfolios. For clients with highly appreciated concentrated stock positions, this can be especially challenging.

Whether clients have accumulated company stock through an employee compensation plan or simply held a single stock that appreciated significantly, a concentrated position exposes them to outsized risk if that one company struggles. As Larry Swedroe wrote last year, fortune doesn’t always favor the bold.

However, selling appreciated stock to diversify will trigger capital gains taxes, which can take a huge bite out of assets as well as returns. This leaves many investors feeling stuck between two suboptimal choices. Should they hold onto the risk, or pay a large tax bill?

It may be hard to convince clients to diversify when that option also increases their tax liabilities for the next year. Thankfully, there is a third option that can provide a tax-efficient path to diversification: exchange funds.

By allowing investors to diversify immediately while differing capital gains taxes, exchange funds provide a differentiated solution to the concentration dilemma.

But exchange funds are poorly understood and underutilized by many financial advisors and their clients. Having managed exchange funds for two decades – and advised investors who struggle with concentrated positions – I’ve seen the difference exchange funds can make. I believe advisors who fully understand the mechanics and benefits of exchange funds can deliver significant value to their clients.

Here are the key things advisors don’t always know about exchange funds.

How exchange funds work

At their core, exchange funds are quite simple. Multiple investors contribute stock to a pooled fund. In return, each investor receives shares of the fund equal in value to the stock they contributed. The fund is structured to be diversified in its allocations, often tracking a broad market index.

By exchanging their single stock for fund shares, each investor achieves instant diversification. And crucially, under current tax law, the exchange that allows them to diversify is not treated as a taxable event. The investor’s cost basis carries over to their fund shares, and they can defer taxes until they eventually sell.

To qualify for tax deferral, tax regulations also require that at least 20 percent of an exchange fund be invested in illiquid “qualifying assets,” like real estate.

After a seven-year “socialization period” required by the tax code, investors can redeem their fund shares and receive a basket of the stocks held in the fund. There is no taxable event until the redeeming investor sells some or all of the stocks in the basket, which allows them to continue deferring taxes (or strategically realizing gains).

Benefits for clients

The primary benefit of exchange funds is clear. Investors can diversify a concentrated position without triggering a significant tax bill.

Given that many investors’ most highly appreciated assets are in a single stock or a small handful of stocks, avoiding tax drag can be game-changing. Here’s an illustration of how an investment in an exchange fund would compare to diversifying and selling if an investor liquidated after seven years:

But the benefits go beyond tax efficiency.

Psychologically, taking the first step to diversify can be difficult for investors who have grown attached to their “winne” stock. Exchange funds ease this mental barrier by keeping the investor involved in the markets and not forcing them to the sidelines.

Exchange funds are also a uniquely flexible tool. Since investors can redeem a basket of individual stocks after seven years, they retain control over when to realize gains. This can provide estate planning benefits, for example, since heirs receive a step-up in cost basis.

What to look for in an exchange fund

Like any investment product, not all exchange funds are created equal. Advisors should look for:

Meaningful diversification across the fund’s holdings to ensure risk reduction;
Low fees and expenses, since fund expenses can eat into investment returns over time; and
A strong portfolio management team with a deep understanding of tax-efficient management.

Misconceptions to correct

In speaking with advisors and clients, I often hear a few common misconceptions about exchange funds:

“Don't investors need to be ultra-high net worth?” While early exchange funds had very high minimums, newer providers like Cache have made the strategy more accessible. Minimums are now as low as $100 thousand and eligibility extends to all accredited investors.
“Can’t investors just sell over time to spread out the tax hit?” Selling gradually is certainly an option, but it still triggers a tax liability. Exchange funds allow investors to diversify first, then decide when or if to realize gains. Selling to diversify also keeps the investor exposed to the same single stock risk, albeit a risk that diminishes slowly over time.
“What if the other stocks in the fund underperform the investor’s original holding?” This is certainly possible, but it misses the point of diversification. The goal is to reduce risk, not maximize returns.

The bottom line for advisors

For advisors with clients holding concentrated positions, exchange funds can be a powerful arrow in the quiver. By helping investors diversify tax-efficiently, they solve a problem for which good solutions are scarce.

Of course, exchange funds are not right for everyone. They require a long-term investment mindset, and they’re not a magic bullet for generating outsized returns. But for the right client, they can be an excellent way to prudently manage a key risk.

As with any complex planning topic, advisors will need to educate clients and correct misconceptions about how exchange funds work. If you’d like to learn more, I helped put together this detailed resource as well as a list of providers. For those willing to put in the effort to fully understand this strategy, exchange funds can be a major value-add.

After all, financial advisors are primarily tasked with helping their clients, and exchange funds deserve a place in that toolkit.

Michael Allison is the Investment Strategist at Cache, which offers products for concentrated portfolios, including a streamlined exchange fund for modern advisors. He also founded New Lantern Advisors, which merged with Investment Research Partners, LLC, where he continues to serve as Strategist and Portfolio Manager. Michael previously spent over 20 years at Eaton Vance, helping build an industry-leading $40 billion exchange fund franchise.

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