Blog Exchange Fund – To Diversify Appreciated Securities

By Cowles Liipfert and Don Wells

Some investors have a large ownership position in one or two highly-appreciated stocks and would like to diversify to reduce the risk of concentrated investments. Selling shares of that stock would incur large capital gains tax, which they would like to avoid.

An Exchange Fund, sometimes called a “swap fund,” is an arrangement among concentrated shareholders of different companies, which pool their various shares into a partnership or LLC, thereby enabling them to diversify their portfolios without selling shares.

Do not confuse Exchange Funds with Exchange Traded Funds (ETFs). Despite the similarity in names, ETF’s are almost polar opposites of Exchange Funds. ETFs allow frequent trading, whereas Exchange Funds anticipate long holding periods, without trades for their members ..

Exchange Funds are created for the mutual benefit of investors with large positions in various companies, who also wish to diversify without incurring capital gains tax.

Several investors pool their respective shares into a partnership or LLC, and each investor receives a pro-rata share of the Exchange Fund. Each investor owns a portion of the Exchange Fund that contains a portfolio of different stocks, thereby accomplishing the desired diversification.

Exchange Funds must retain control of what stocks are contributed to the Fund and the participants who contribute their stocks, to ensure that the fund’s portfolio Is sound and that the investors have similar interests.

Consequently, Exchange Funds often require participants to have minimum liquidity of $5 million and also to go into a lock-up period – typically seven years – during which they cannot transfer their shares to someone else.

The complicated creation of an Exchange Fund requires a temporary period of time in which the Exchange Fund is put together, but at some point-when enough shares have been contributed – the Fund closes as to new shares, and the investors receive shares in the Fund, based on the value of their respective contributions to the Fund.

There are other ways to diversify family wealth while reducing capital gains tax, none of which is appropriate for everyone, such as (a) through charitable remainder trusts; (b) by offsetting gains with losses in other assets, and (c) by giving highly-appreciated assets to lower-income family members. Between annual exclusion gifts and annual lifetime gift tax exclusion gifts, you can transfer a lot of value to family members, but with gifting, you lose access to the gifted securities, in case you ever needed such access.

Up to 80% of the assets in an Exchange Fund may be in stocks, but the rest must consist of illiquid investments, such as real property investments. One alternate investment could be valuable artwork, for example.