Some wealthy investors facing concentration risk and possible capital gains taxes from highly appreciated stocks could find their exit ramps with an exchange fund.
An exchange fund is a partnership where many investors pool their concentrated holdings, resulting in a diversified basket of shares. At least 20% of the collective vehicle is required to hold certain qualifying illiquid assets. Exchange funds have been around for decades as a tax-deferral and concentration wind-down strategy. But the continuing bull appreciation in stocks is drawing more investors to exchange funds, a "cousin" method
A newer crop of direct-to-consumer products aimed at solving appreciated, concentrated holdings — coupled with the "explainability" of exchange funds compared to, say, a tax-aware long-short vehicle — is accelerating the investments, Sullivan said. Without those types of strategies, investors remain locked into capital gains that pose taxes upon realization, while in the meantime exposing their portfolios disproportionately to possible volatility in just one asset.
"You get diversified instantly — when the fund closes, you are diversified," Sullivan said. "A lot of people really like how fast it is."
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The nuts and bolts of exchange funds
He and other experts point out that Section 721 of the tax code and other rules require financial advisors and their clients to retain their investment in an exchange fund for at least seven years. Technically, however — and depending on asset management firms' guidelines — investors could redeem their original shares earlier for an extra fee. Some exchange fund managers enable investors to borrow against their holdings in the vehicles, which frequently use real estate to satisfy the illiquid asset requirement. One exchange fund called Craft Pod invests in private jets as its illiquid holding while offering clients chartered flights at an hourly rate.
After the seven years are up, investors may redeem their diversified holdings in the fund, with their tax basis in the original concentrated stock at the same value as the date they contributed it into the exchange pool. Further capital gains are absorbed across the whole group of investors in the exchange fund, with the diversification allowing for exposure to losses that may also offset that appreciation. Investors continue deferring the capital gains and accompanying taxes for the entire time.
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One of the companies leading the charge
Many advisors and investors with concentrated, appreciated stocks see exchange funds as "a way for them to remove some of that risk and get broader exposure across the equity market," said Aaron White, head of investor solutions at asset management startup Cache. The firm's vehicles have amassed more than $1.25 billion in client assets two years after launching its first exchange fund. Any accredited investor with at least $100,000 worth of stocks to contribute could invest in Cache's exchange fund, which carries an annual advisory fee between 0.40% and 0.95% for up to $1 million and 0.6% for anything above that amount (with wholesale discounts for advisors). But the company charges no sales, commissions or performance fees, and the fund's fees drop to 0.25% after seven years.
And, in addition to the diversification of the vehicle for their clients' portfolios, an exchange fund gives advisors "looking to differentiate themselves" from the competition a helpful tax savings strategy to mention to prospective customers, White noted. Since there is "a huge interest in just tax-aware investing in general," Cache is on a "mission" to educate more investors about methods like exchange funds, he said.
"Exchange funds have been used by the ultrawealthy to diversify tax efficiently for generations," White said. "I have calls every day with advisors that are learning about exchange funds for the first time."
