Tax alpha and diversification via exchange funds

When a client holds a concentrated position in one stock, it often means something has gone really well for them. Whether they’ve earned the stock as compensation or invested well, that one company’s performance has likely had a huge impact on their life. 

However, it also subjects them to concentration risk, and there’s a good chance you’ll advise them to diversify.

Yet selling and diversifying exposes clients’ portfolios to tax drag, while alternative investment options like separately managed accounts with tax-loss harvesting can typically offset modest gains. Tax-loss harvesting can also take a long time to have an impact. 

Exchange funds, on the other hand, can help clients diversify right away while deferring capital gains taxes indefinitely as long as they stay invested in the fund.

How do exchange funds work?

I discovered exchange funds after Uber’s IPO in mid-2019. As a longtime employee at the company, I’d watched my wealth grow on paper for years. Once I was free to sell my stocks, however, I was shocked by the potential tax bill I faced.

Exchange funds, I learned, offered an effective solution to all of the challenges I faced. By pooling concentrated stocks from multiple investors, an exchange fund creates a diversified investment that approximates an existing index and allows clients to defer capital gains taxes. (Note that the IRS rules require 20% of the fund to be invested in an illiquid asset like real estate.) 

After seven years, clients can withdraw a diversified basket of stocks from the fund. No capital gains taxes are due until the client sells the stocks.

READ MORE: The most wonderful time of the year, for tax-loss harvesting

A hypothetical tax benefits scenario

In addition to reducing concentration risk immediately, an exchange fund can also provide tax alpha.

To understand the tax benefits of exchange funds, it can be helpful to look at an example of when the strategy might be most beneficial. Imagine a client who is an executive and longtime employee at Apple whose stock compensation had ballooned in value over the years:

• Concentrated stock value: $2,000,000
• Cost basis: $200,000
• Annual family income: $750,000
• Tax filing status: Married filing jointly
• Long-term capital gains rate: 39.4% (in the highest California state tax bracket, including federal, net investment income and state taxes)
• Annual return of a diversified investment, before fees: 10%
• Exchange fund management expense annual fees: 0.5% 
• Annual fees of comparable index fund: 0.2%

To sell and diversify, this hypothetical client would have to pay almost $696,000 in taxes upfront. Diversifying with an exchange fund doesn’t trigger a taxable event, so an exchange fund approach would start with a higher principal amount.

READ MORE: 3 tax tricks financial advisors can use for risky, overweight portfolios

After the seven-year investment period, this delta would grow to almost $1.3 million — and the excess principal would continue to compound until the client ultimately sells the stocks they withdraw from the fund.

Of course, assets from the exchange fund will carry their original cost basis, which means the client would still have a large tax bill to pay when they liquidate the basket of stocks they receive. 

However, the exchange fund strategy would still leave the client with an additional $300,000 if they liquidated all their assets after seven years. That’s over 2.3% per year in additional returns — provided the performance of the exchange fund mirrors the performance of its benchmark index. 

Who are exchange funds best suited for — and who’s eligible?

General investment risk aside, it is important to understand that exchange funds require a minimum seven-year investment horizon, and that they involve liquidity risk, real estate market risk, credit risk and tax law risk.

Therefore, a client should only participate if:

1. The client holds an appreciated, publicly traded stock.
2. The client doesn’t need liquidity for seven-plus years.
3. The client is an accredited investor or qualified purchaser, depending on the fund. 
4. The client has $100,000 or more to contribute.
5. The exchange fund needs your client’s stock.

READ MORE: Secrets of S&P 500 index funds: They’re not all alike

Regarding the last three points, requirements can vary from provider to provider. Traditional providers may require participants to be qualified purchasers and to contribute $1 million or more in stocks to join a fund. Because all exchange funds are benchmarked to an existing index, they may only be open to taking some stocks. 

Overall, exchange funds offer advisors an alternative, potentially better way of managing their clients’ concentrated positions. Instant diversification and deferred gains can make it a very useful tool as investors try to convert an appreciated stock into enduring wealth.