I was recently approached by client whose broker had pitched him the idea of using exchange funds to diversify his holdings and he wanted my second opinion. If you are an employee of a major technology company, you've likely been approached with the same idea. Before you decide to diversify with exchange funds, it's important to understand what they are.
What Are Exchange Funds?
Exchange funds are private placement limited partnerships or limited liability companies (LLCs) designed specially for investors with concentrated positions in highly appreciated stocks to help them diversify without triggering taxes. (For more, see: 4 Ways to Diversify a Concentrated Stock Position.)
How Do Exchange Funds Work?
Investors transfer shares of their concentrated stocks to the fund in exchange for an equal value of units of the fund. These transfers are not taxable since they are considered partnership capital contributions under the tax law. There are a few caveats to the law though: investors have to stay in the fund for a minimum of seven years and the fund must invest 20% of its capital in illiquid assets.
- They are a legitimate way to defer taxes.
- They are more diversified than holding on to one concentrated stock.
- They simply defer (not eliminate) your taxes.
- They are not very diversified since they are formed by volunteer contributions of highly appreciated stocks.
- They are expensive to participate in. There is typically a 1% to 2% front load, and ongoing expenses of 1% a year.
- You can’t take your money out for seven years.
- These funds are unregistered private placement investment vehicles outside of Securities and Exchange Commission (SEC) oversight. You have no idea what’s going on within them and whether any of their reporting is true. This is called asymmetric information risk. The parties who have more information (fund originators and managers) are prone to take advantage of the parties who have less information (fund investors.)
- There is the 20% illiquid asset requirement, and you have no control if the managers play with it to benefit themselves. This is called agency risk (or moral hazard.) The parties who are in control are prone to take advantage of the parties who are not in control.
- You never know what you’ll get when you redeem the fund since instead of money, the fund will give you shares of stocks in the fund as well as the illiquid assets required by law that collectively have the same basis as the stocks you originally transferred.
- The fund poses challenges for record keeping.
- You have to pay taxes when the managers sell other people’s highly appreciated stocks in the fund.
- Tax filing is difficult because after redemption you will end up with a bunch of unfamiliar stocks and illiquid assets with unknown basis (since you did not buy them yourself).
Many people who call themselves financial advisors in the U.S. are brokers who are not legally required to put your interests first. Their job is to make transactions happen so they can collect fees and commissions from both sides. So, if you have been pitched a exchange fund by a broker or an insurance agent, make sure you get a second opinion. (For more from this author, see: Why Hedge Funds Do Not Belong in Your Portfolio.)