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.