Personal Finance

Not many individual investors are familiar with exchange funds (even though it’s a well-known tool among advisors) and whether they make sense for investors with low-basis stock. Every investor situation is different and there are multiple exchange funds in existence, so the below should not be considered advice or relied upon to make an investment decision. However, I am familiar with exchange funds and can provide some education around the topic.

What is an Exchange Fund?

To start, I should note that an “exchange fund” is not an “exchange-traded fund” (ETF). Exchange funds are private funds and typically organized as a 3(c)7 fund, which means that they are only available to “qualified purchasers.” To qualify as an qualified purchaser, individuals must own at least $5 million of investments (or $25 million if the investor is an entity) (see my post on the topic here). Minimum investments are often set in the $500,000 to $1,000,000 range. Fund purchases and redemptions are typically made “in-kind,” which means that investors contribute shares (instead of cash) to buy the fund and receive shares of stock (instead of cash) to exit the fund.

How Does An Exchange Fund Work?

Exchange funds represent a diversification strategy where an investor can exchange shares of a single stock for shares of the exchange fund. In other words, an investor can exchange an individual stock for a basket of stocks. Investors who stay invested for at least seven years can generally elect to receive a diversified basket of stocks when they redeem from the fund (holding periods of less than seven years are often redeemed with the same stock that was contributed, although the dollar value of the redemption may be less favorable).

Why Would An Investor Use An Exchange Fund?

Assume an investor owns $100 of a stock with a cost basis of $20. Rather than selling the stock, realizing $80 of capital gains, paying tax on the capital gains, and then re-investing the post-tax proceeds, an exchange fund investor could contribute the $100 of stock to the fund and receive $100 of fund shares. Rather than selling stock (and paying tax) in order to raise cash and then diversify, the exchange fund investor is able to diversify without creating a taxable event.

Why Wouldn’t an Investor Use an Exchange Fund?

I should note that exchange funds are not a good solution for every situation. Below are just a few situations where an exchange fund would not make sense:

• Investors who need cash and/or liquidity should not invest in an exchange fund, as the investor is simply trading one investment for another (with the maximum benefit realized after seven years). Exchange funds are diversification strategy, but cannot help with unlocking liquidity.

• Although exchange funds represent a way to defer tax, the capital gain remains embedded in the investments. The capital gain and tax liability is “transferred” from the single stock to the exchange fund and possibly to the redemption basket of stocks (if/when the investor exits). Thus, those who want to diversify and defer taxes may find value in an exchange fund. However, the funds do have expenses and costs, so these must be weighed against the benefits of the tax deferral.
• Lastly, there is the issue of ability to invest. Typically, investors must be “qualified purchasers” and able to deliver at least $500,000 to $1 million of stock. Generally only “large cap” stocks can be contributed and the fund must have capacity for that specific stock.

Exchange funds can be a good solution for investors whose wealth is concentrated in low-basis stock positions. Nonetheless, I encourage investors to work with their advisor, accountant, and attorney in order to determine if an exchange fund is an appropriate strategy.

CDs and Treasuries are two popular vehicles for investors to maximize returns without taking much (if any) credit risk. The average American is probably more familiar with CDs even though Treasuries are a better vehicle for most people. Learn why below:

CD stands for certificate of deposit and are issued by banks. There are two main types of CDs. Traditional CDs are typically advertised to a bank’s clients and potential clients. Brokered CDs are distributed through brokerages and investors can purchase them at issuance or trade them.

Treasuries are refer to bonds issued by the US Treasury. Treasury bonds, notes, and bills are all the same thing and the different words are used to denote the term of the bond at issuance (bonds are long-term, notes are intermediate, and bills are short-term). This article focuses on shorter-term maturities since CD are generally shorter-term.

Safety

CDs

Both CDs and Treasuries offer government guarantees, although the terms and entities are slightly different.

CDs and other types of bank accounts are typically insured by the Federal Depot Insurance Corporation (FDIC), which insures up to “per depositor at each insured bank and savings association.” Those with more than $250,000 can use multiple registrations and/or multiple banks to obtain a higher amount of protection (in aggregate).

The FDIC is essentially an insurance plan that banks pay into to protect their customers in case the bank fails. If there were massive numbers of bank failures that overwhelmed the FDIC’s ability to make depositors whole, the FDIC’s website states two contingency plans:

• Plan A would be to draw on a line of credit with the US Treasury. Essentially get a loan from the Treasury.
• Plan B is that the FDIC is backed by the full faith and credit of the US government (which is another way of saying the Treasury would cover any shortfall). This is probably true, but I imagine it would require congressional approval which could be politically fraught.

However, no FDIC insured deposits have been lost due to bank failure since the FDIC was established in 1933.

Treasuries

Treasuries are not insured in any way. So there is no dollar limit, since there is no insurance in the first place.

The US Treasury says it will pay back principal and interest and people accept that (although it gets a little dicey every time there is a debt-ceiling standoff in the US). That being said, I would argue that Treasuries are theoretically safer than CDs since the Treasury backs the FDIC. Of course, you should not park money in Treasuries if there’s a chance that the US will sanction you, as Russia learned in 2022 (the US simply confiscated their Treasuries, which are of course just digital assets sitting on ledgers in the Treasury computer system).

I suppose there is a scenario where the US government defaults (due to a debt ceiling battle or something else) and Treasury payments don’t get made while banks still honor CD payments. This seems unlikely to me, but I suppose it is theoretically possible.

Liquidity

Treasuries are generally accepted to be the most liquid asset in the world. It is generally very easy and low cost to buy or sell Treasuries.

CDs are a slightly different story. CDs offered by banks directly to consumers are generally illiquid. Investors typically buy a CD for a certain term directly from the bank and there is often an early withdrawal penalty. Brokered CDs are issued by banks through brokerages and investors can buy them at issue or trade them on a secondary market. So brokered CDs are relatively liquid, but not to the same extent as Treasuries. I would personally never buy a CD from a bank, although I would consider a brokered CD.

Rates

This does not always hold true, but Treasuries generally yield the most, followed by brokered CDs with traditional CDs generally yielding the lowest. Of course there is a range, so the highest yielding brokered CD may exceed Treasury rates (as an example). One thing to look out for with traditional CDs are limits on how much can be deposited. The rate may be higher for the first $10,000 (as an example) and lower on any additional amounts.

Taxes

Treasuries have much more favorable tax treatment than CDs. Both Treasuries and CDs generate interest income, which is taxed at ordinary income tax rates. However, Treasuries are exempt from state and local tax, which can be quite high in places like California or New York City. For residents in high tax states or cities, using Treasuries over CDs is probably a no-brainer for taxable accounts.

Other Considerations

i have recommended CDs to some people in the past if their state tax rate is low, don’t need the liquidity, and are older and just more comfortable with CDs. Sometimes it is better to keep retirees in their comfort zone than push them outside their comfort zone, in my opinion. I’m a big proponent of only investing in things that one understands. However, I recommend Treasuries much more frequently than CDs.

“Do you have any financial advice for new parents?”

A handful of friends have asked this question in the past week. The question often relates to childcare expenses or college savings plans, but I usually advise new parents to prioritize the below items before anything else:

• Buy enough term life insurance to provide for your family if you and/or your spouse die prematurely. There’s no “right” amount, so ask yourself what you would want covered if you passed. Your salary of x years? Your spouse’s salary so he/she wouldn’t have to work for y years? Childcare expenses for z years? Payoff a mortgage? College tuition? Other expenses? Add those numbers up and go get some quotes.
• Establish an estate plan, including a revocable living trust and will. The will should appoint a guardian for your children if you pass away while they’re still minors, although the courts do have the final say. The will also directs what to do with assets that were excluded from the trust (or forgotten to be put in the trust, which I see very often!). The trust should help avoid probate for assets placed within it and provide for supervision of the assets for the benefit of the children.

Buying insurance and establishing an estate plan are simple steps, but each does require some time and money. Fortunately, each item can be a one-time decision, which may be a relief for new parents who are completely overwhelmed!

In my experience though, insurance agents are hungry for business and often provide speedy and over-the-top service. And unless there is some complexity, my observation is that most attorneys can draft an estate plan within a couple days of an initial meeting.

These two steps might not optimize your financial life, but they may protect your kids against the worst outcomes.

Frequently Asked Questions (FAQs)

Many of my friends are having kids these days, which means I’m being asked about 529s more than anything else. Below are just a few of the common questions:

• Should I open a 529?
• Which company should I use?
• How much should I contribute?

My answer to all of the above is:

• Are you properly insured?
• Is your estate plan in order?

If not, my advice is generally “Go get properly insured and engage an estate planning attorney. Before investing money for an uncertain future, invest to protect your family should anything unexpected happen.”

The above is educational and is NOT legal or financial advice. Every situation is different and I’m not an insurance agent or an attorney.