The risk is clear: If you stock takes a hit, it can have an exaggerated impact on your portfolio. However, you don't want to sell the position to diversify because of the potential negative tax implications.
If you are holding onto a great company like Apple or Amazon, you may not worry about riding a big position in the company but what happens if the future looks more bleak. In our area, we have seen many companies like Lucent Technologies and Lehman Brothers go from Wall Street darlings to bankruptcy.
Enter the Exchange Fund
Exchange Funds or “Swap Funds,” are private placement limited partnerships or LLCs. An Exchange Fund allows an investor to “exchange” highly appreciate stock(s) for shares in a fund of many pooled stocks that correlate with an index like the S&P 500 or Russell 1000.
Benefits of Diversification
The biggest benefit is allowing an investor to swap individual stock for a diversified stock fund without triggering any tax consequences. They will still have market risk but will remove the individual risk of a single company. Diversification can be an important part of maintaining wealth over the long term.
Who are Exchange Funds for?
The Exchange Funds are limited to accredited investors with at least $5 million in investible assets. Minimums are $500,000 in a single or multiple stocks.
Currently there are just two firms creating exchange funds: Goldman Sachs and Eaton Vance.
The other caveat is that the fund has to be willing to accept your stock. For example, if the fund has too much Apple stock, it won't be willing to accept anymore.
There are a few potential downsides to Exchange Funds.
First off, to legally function as a partnership, exchange funds must invest at least 20% of assets in illiquid investments, typically real estate. Therefore, it isn't a pure stock portfolio.
Secondly, there are fees for management of the fund. This can eat into long-term returns.
Thirdly, there is also a 7-year wait if you want to redeem the shares as portfolio. Also, some exchange funds are illiquid for 7 years. At Goldman Sachs, they allow early redemption but at a cost of 1% in the first 3 years but they allow you to redeem.
Finally, you need to work closely with your CPA. The original basis is assigned to the basket of stocks you received. It is crucial for your CPA to be involved throughout the process to ensure proper record keeping and tracking.
Exchange Funds offer diversification and tax-deferred investing without triggering capital gains tax in a concentrated position. For those who qualify and are looking to diversify concentrated low basis stock, they are definitely worth considering.
We can help clients decide if it is a right fit and also have a relationship with Goldman Sachs to give accredited investors access to the Exchange Fund. If you want to learn more and see if it the right fit for you, please contact us.
Header photo from Unsplash by Natalie Rhea