Exchange Funds
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TL;DR There’s an investment vehicle called an “exchange fund” that can help investors who hold large positions in their company stock diversify without triggering taxes, but it is important to understand the benefits and risks before making an investment. An exchange fund might make sense for you if you are highly concentrated in one company’s stock or have highly appreciated stock that would be subject to large capital gains taxes if you sold your shares. The fund pools your shares with other concentrated shareholders to try and match the allocation of an index. While these were historically subject to high minimums of $500K - $1M, and high eligibility requirements of $5M+ in investment assets, a newer entrant called Cache that has opened exchange fund participation to Accredited Investors with minimums of $100K. Since there is a significant lockup period (~7 years), you should only pursue this option if you want to diversify and do not have liquidity needs in the short-to-mid term. Whether your concentrated position comes from stock-based compensation, long-term holdings, or inheritance, navigating the right approach to diversification is crucial to protecting and optimizing your wealth.
What is an exchange fund?
An exchange fund is a limited partnership (most commonly organized as an LLC) that takes concentrated shareholders of different companies and pools their shares within the limited partnership. This pooling of assets allows each investor to “exchange” their large holding of a single stock for units in the partnership without triggering taxable gain, as the tax code treats contributions to specifically structured partnerships as a non-taxable event. Exchange funds thus provide investors with an easy way to diversify their holdings while deferring capital gains taxes, though there are notable risks that we dive into below.
Usually, exchange funds try to approximate a variety of indices like the Nasdaq-100, S&P500, and Russell 3000, though the success of that diversification depends on which concentrated stocks were contributed to the fund. An important thing to note is that in order to contribute to the fund, a fund must be actively accepting your company’s specific stock at the time. Funds will restrict the types of stock that may be contributed if those stocks will put the fund out of balance against its targeted index.
For a deeper dive into exchange funds, join Compound and Cache for a Compound Conversation — Everything You Need to Know About Managing a Concentrated Position.
Who is this for and why would I want to use one?
Exchange funds may be an attractive option for people who have significant ownership of a company’s stock, so long as all the pros and cons are fully considered.
For example:
- Sally has $2M worth of Company X’s stock. She wants to diversify but doesn’t want to pay the capital gains taxes that get triggered when you sell stock. Instead, she puts $500k worth of the stock in an exchange fund. That stock sits in the exchange fund and is invested in that benchmark index. Sally is shielded from experiencing the volatility of a single stock. Additionally, Sally has invested a full $500K into the diversified fund rather than a smaller post-tax amount if she had sold her stocks to diversify. When the 7-year lockup period ends, Sally gets a basket of stocks back with the same cost basis as the shares she originally contributed to the fund, which she can either sell, keep in the fund, or contribute to a new exchange fund. If she chooses to sell them, she will pay long-term capital gains.
- By deferring capital gains taxes, Sally had more principal to invest than she would have if she sold her stocks to diversify. If her cost basis was $0 and her state and federal capital gains rate was 35%, then a 10% annual return would have a much bigger impact with an exchange fund:
Simulated results for illustrative purposes only. Effective capital gains tax rate: 35%. Initial cost basis: $0. Investment Term: 7 years. The growth rate of 10.5% is hypothetical, gross of fees, 10% net rate of return assumed, and used to illustrate the benefits of potential tax deferral. Exchange Funds require a 7 year hold period to recognize the tax benefits. Sell and reinvest also assumes a 10% net rate of return. State or other taxes may still apply.
Use the Exchange Fund Calculator at the end of this article to create a personalized comparison.
Some things to keep in mind:
- You need to be at least an accredited investor to use an exchange fund. Individuals need to make an annual income exceeding $200k (or $300k for a household), or have a net worth that exceeds $1 million in order to reach accreditation. With many funds, you will need to be a qualified purchaser, which requires having at least $5M in investments. This depends on the fund.
- Depending on your company policy, you may or may not be restricted from contributing your stock. Many larger companies like Apple, Nvidia, Microsoft, Tesla, and Amazon have favorable policies toward employee participation in exchange funds. Just like employees are able to sell their stock during an open window, these companies allow contributions to an exchange fund.
- There is typically an investment minimum (~$100k). You can combine stocks to meet that minimum as long as the fund accepts the combined stocks you wish to contribute. (i.e. you can combine Facebook and Google stock to reach the minimum.)
- You won’t get to participate in the long-term growth of one company’s stock. Since you’re diversifying out of your concentrated position, you won’t experience the upside if that one company’s stock greatly appreciates. So carefully consider if you are bullish on that particular company’s growth for the next ~7 years while also considering the concentration risk in your portfolio and determining the allocation to diversify away and reduce risk in your portfolio.
- They are private. Exchange funds are private investments like VC funds or PE funds. They do not trade publicly, but they are subject to regulatory requirements like any private fund, such as regular NAV reports and comprehensive audits.
- They usually don’t just contain stock. Tax law requires that 20% of the exchange fund be held in illiquid assets called “qualifying assets,” which the manager selects to enable the tax-deferred exchange. Most often, these are real estate assets.
What are the downsides of using an exchange fund? There are a few.
- There’s a seven year holding period for your stock. The typical lockup period is seven years, as required by tax law. So, once you transfer shares to the fund, you won’t own shares of that company directly anymore; you will own shares in a fund for at least seven years. Only pursue this option if you don’t need the funds in the near term. Some exchange funds might let you borrow against your partnership units.
- Your taxes are not eliminated, they’re deferred. This deferral helps you compound your investments off a larger base, but you will eventually pay taxes when you sell your shares. Thus, you diversify right away, while being in control of when you liquidate your investments, perhaps when you are in a lower tax bracket.
- You may owe taxes while you participate in the fund. Certain investment income, like dividends or mandatory corporate actions, would trigger tax implications for the investors in the fund. Though exchange funds do not rebalance through stock sales, you may be allocated gains if this option is pursued by the fund managers.
- You have limited ability to choose what you get back. If you put in Google stock, you don’t get to choose Google stock on the way out after the lockup period. Most funds typically redeem a portfolio of 15 - 25 stocks from the fund, at the discretion of the fund manager.
- There are management and early withdrawal fees. You’ll have to pay management fees (~1%) and sales fees (~1.5% - 2%) on top of any taxes owed. Some exchange funds charge higher management fees than others, so do your research when selecting a fund. There’s also a separate fee of ~1-3% for taking your funds out early.
- Taxes might go up (or down). Taxes might go up in the future (meaning it may be advantageous to pay any taxes you owe today rather than in 7-10 years) or they might go down. But it’s impossible to predict.
Bottom Line
You’ve done a great job picking the right company to join or invest in, and the company’s stock has done incredibly well since then. This appreciation has caused you to become heavily concentrated, and you now want to reduce your risk by diversifying into other securities. Exchange funds allow you to do that without triggering taxes from a sale. If you foresee your company experiencing lots of growth, outperforming the diversified index on a risk-adjusted basis, this strategy might not make sense for you. However, if your portfolio is highly concentrated, then contributing to an exchange fund may be the most efficient way to diversify for you. Just be sure to fully weigh all the pros and cons.
Compound and Cache are teaming up for a Compound Conversation on February 19th, 2025 at 2pm ET / 11 am PT. Join us live to learn Everything You Need to Know About Managing a Concentrated Position.
This calculator is provided by Cache and let’s you see how selling and diversifying compares to a tax-deferred exchange fund.