Exchange Funds: One Way to Reduce Concentrated Stock Risk

When diversifying your investment portfolio, the baseball strategy of swinging for singles and doubles instead of home runs comes to mind. Having too much exposure by way of a concentrated position — the equivalent of banking on home runs to win — can increase the risk of your overall portfolio.

A concentrated position refers to having a significant portion of your overall portfolio allocated to one single investment, typically a particular stock. Usually, once a single stock position reaches 10% or more of your portfolio, its risk begins to intensify.

Using an exchange fund can be one way to reduce your risk, providing protection in case a significant investment ends up performing poorly.

What is an exchange or swap fund?

An exchange fund — also called a swap fund — allows you to substitute or replace a concentrated stock position with a diversified basket of stocks of the same value, reducing portfolio risk and putting off tax consequences until later.

Oftentimes, company executives may end up heavily invested in their employer’s stock. Some companies may require that senior managers have a certain percentage of stock ownership to align their interests with that of the company. Even without a shareholding requirement, key employees' portfolios can become concentrated in their company’s stock through employee equity compensation benefits, such as stock options or RSUs.

Besides being a company executive, there are other reasons you may have ended up with a concentrated stock position. It could be that one stock has significantly outperformed others within your portfolio over time and now represents a disproportionate share of your portfolio. Or, perhaps you’ve inherited a family business or some other long-standing investment holding.

Instead of having to sell shares to diversify your portfolio and pay out the associated capital gains taxes, which can be hefty, employing an exchange fund could be a potential solution. Even restricted stocks are sometimes eligible for exchange funds.

» Worried about taxes? Consider strategies to reduce capital gains tax

How an exchange fund works

An exchange fund aggregates the concentrated stock positions of many investors, creating a diversified collection of stocks that mimics an underlying, broad-based stock market index. You can swap your concentrated position for a partnership interest or share of the exchange fund, avoiding a taxable event and providing you with tax-deferred growth instead. Exchange funds are held for seven years before you have the option to redeem your shares in the fund, typically for shares in the stocks held in the portfolio.

Exchange funds typically reinvest capital gains and dividends. A taxable event occurs once you redeem your partnership shares in the fund, with your cost basis of the fund being the cost basis of the concentrated stock that you handed over (the amount you paid to purchase the stock originally).

Benefits of exchange funds

Diversification

The main reason to use an exchange fund is for diversification. Spreading your investment dollars across a wide range of assets can help you reduce volatility and investment risk, so that no one asset has an outsize impact on your overall investment portfolio. An exchange fund helps you replace a concentrated position with a diversified one.

Tax deferral

Another benefit of exchange funds is postponing your tax liability. Some concentrated stock positions have become sizable due to the stock’s appreciation over time. This means that the stock would have accumulated large gains and selling shares to diversify would likely generate a significant tax burden. Depending on your tax situation, it may make financial sense to delay paying taxes to another time or leave your partnership shares behind to heirs since they will benefit from having a step-up in cost basis (heirs are able to adjust the cost basis of an asset to the fair market value at the time of inheritance).

» Looking to save on taxes? Learn more about tax-efficient investing and charitable giving

Drawbacks of exchange funds

Accredited investors

Typically, exchange funds are structured as private placement limited partnerships, or limited liability companies, which means that usually only accredited investors with over $5 million in net worth can participate. They also have high minimum investment requirements, often $500,000 (or more) worth of shares in the stock being exchanged. Exchange funds are not registered securities, so they don’t need to follow the SEC’s requirements for information disclosure.

Liquidity

Exchange funds usually require that you hold on to your partnership shares for at least seven years before redemption (completing the swap of your concentrated position into a basket of stocks) without penalty. Seven years is a long time to wait and could present an issue if your financial circumstances change and you need access to your investments during that time. Redeeming partnership shares early could mean a return of your concentrated stock rather than shares of the diversified fund you were seeking.

Qualifying assets

Exchange funds give you the ability to swap your stock for the fund’s partnership shares tax-free. To maintain eligibility for this preferential tax treatment, exchange funds are required to keep a 20% minimum of total gross assets in certain illiquid qualifying investments to help minimize portfolio volatility. Often, these qualifying investments might be commodities or real estate, which can potentially be riskier than traditional stock holdings.

» Compare the differences of investing in stocks vs. real estate

Fees

With any investment, your costs matter. Exchange funds may charge an upfront sales charge as well as ongoing investment management fees.

Is an exchange fund right for you?