What Is an Exchange Fund?

An exchange fund, also known as a swap fund, is an arrangement between concentrated shareholders of different companies that pools shares and allows an investor to exchange their large holding of a single stock for units in the entire pool's portfolio. Exchange funds provide investors with an easy way to diversify their holdings while deferring taxes from capital gains.

Exchange funds should not be confused with exchange traded funds (ETFs), which are mutual fund-like securities that trade on stock exchanges.

Key Takeaways

  • Exchange funds pool large amounts of concentrated shareholders of different companies into a single investment pool.
  • The purpose is to allow large shareholders in a single corporation to exchange their concentrated holding in exchange for a share in the pool's more diversified portfolio.
  • Exchange funds are particularly appealing to concentrated shareholders who wish to diversity their otherwise restricted holdings.
  • They also appeal to large investors who have highly appreciated stock that would be subject to enormous capital gains tax if they sought to diversify by selling those shares to purchase others in the market.

How Exchange Funds Work

The exchange fund takes advantage of the fact that there are a number of investors in a similar position with a concentrated stock position who want to diversify. So, in this type of fund several investors pool their shares into a partnership, and each investor receives a pro-rata share of the exchange fund. Now the investor owns a share of a fund that contains a portfolio of different stocks—which allows for some diversification. This approach not only achieves a measure of diversification for the investor, it also allows for the deferral of taxes.

Because an investor swaps shares with the fund, no sale actually occurs. This allows the investor to defer the payment of capital gains tax until they sell the fund's units. There are both private and public exchange funds. The former deals with companies that are not publicly traded, providing investors with a way to diversify private equity holdings. The public funds offer investors portfolio shares containing publicly traded firms.

Exchange funds are designed to appeal primarily to investors who previously focused on building concentrated positions on restricted or highly appreciated stock, but who are now looking to diversify. Typically, a large bank, an investment company, or other financial institution will create a fund that will have a certain size and blend that it is targeting for in terms of the stock that is contributed.

Participants in an exchange fund will contribute some of the shares they hold, which are then pooled with other investors’ shares. With each shareholder that contributes, the portfolio becomes increasingly diversified. An exchange fund may be marketed toward executives and business owners, who have amassed positions that typically are centered on one or a handful of companies. Participating in the fund allows them to diversify those heavily concentrated positions on stocks.

Exchange Fund Requirements

Exchanged funds may require the potential participants to have a minimum liquidity of $5 million cash to join and contribute. Exchange funds will also typically have a seven year lock-up period to satisfy the tax deferral requirements, which could pose a problem for some investors.

As the fund grows, and when enough shares have been contributed, the fund closes to new shares. Then, each investor is given interest in the collective shares based on their portion from the original contributions. The shares in the fund moved to the exchange fund are not immediately subject to capital gains taxation.

If an investor decides they wish to leave an exchange fund, they will receive shares drawn from the fund rather than cash. Those shares will be dependent on what has been contributed to the fund and is still available. Up to 80 percent of the assets in an exchange fund can be stocks, but the rest must be made up of illiquid investments, such as real estate investments.