Exchange Fund

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 large capital gains taxes 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 there being a number of investors in similar positions: holding concentrated stock positions and wishing to diversify. Several investors pool their shares into a partnership, and each 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, but 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 taxes until the fund's units are sold. There are both private and public exchange funds. The former provides investors with a way to diversify private equity holdings, while the latter offer 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, investment company, or other financial institution will create a fund, targeting a certain size and blend 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 to it, 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 of stocks.

Exchange Fund Requirements

Exchanged funds may require 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, 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.

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