I worked at the same company for almost 20 years, and I’m highly concentrated in appreciated stock. Selling even a portion would create a huge tax bill, but I know I need to diversify. Are exchange funds a good option?
Why Concentration Is a Real Risk
Whether the concentrated position is in a volatile tech company or a stable, low beta stock, the problem is the same. A single stock portfolio carries significantly higher volatility than a diversified one.
For many long-tenured employees, the barrier to diversification is the tax bill. Selling highly appreciated shares can trigger millions in capital gains, which pushes people toward the “just keep holding it” trap. Exchange funds were designed as a possible solution.
How Exchange Funds Actually Work
At a high level, an exchange fund pools concentrated stock positions from many investors into one diversified partnership.
Imagine three people each contribute five million dollars of concentrated stock. Instead of each person holding one risky position, the partnership now holds a pool of three stocks worth fifteen million. Each partner owns a slice of the diversified pool rather than their single security.
After a mandatory holding period of seven years, the investor redeems their interest and receives a basket of individual stocks designed to approximate a broad market index. The tax bill is deferred, not eliminated, because the basis is carried into the newly received shares.
This is where the strategy starts to get more complex.
Why the IRS Requires Non-Public Assets
A pure stock-for-stock swap would be a taxable event. Exchange funds rely on an exception in the tax code that allows contributions of publicly traded securities to a partnership only if the partnership contains at least 20 percent in non-public assets.
This means exchange funds must hold private investments alongside the pool of contributed stocks. The non-public portion is often real estate, but can also include private equity, private credit, or specialty assets. These assets introduce different risk, different liquidity, and different valuation assumptions.
This is the first major footnote that investors often miss.
Key Issues to Evaluate Before Using an Exchange Fund
1. Seven-year lockup
You cannot exit early. If flexibility matters, this can be a dealbreaker.
2. Low basis complexity at redemption
You eventually receive a basket of stocks with very low cost basis. The tax deferral is helpful while the assets grow, but future planning becomes more complicated.
3. Provider acceptance and minimums
Exchange funds often require high minimum contributions and may reject certain stocks if they already hold too much of them.
4. Tracking error
The fund may target the S&P 500, but the mix of contributed stocks and the non-public assets can lead to meaningful deviations from the index. Always review the tracking error before committing.
5. Loss of liquidity and control
This is a partnership structure. You lose the ability to vote your shares, sell early, or adjust the underlying mix.
Are Exchange Funds Worth It?
They can be. For an investor with significant concentration and long investment horizons, exchange funds offer a rare opportunity to reduce single-stock risk without triggering an immediate tax hit.
But “too good to be true” often comes with footnotes, and exchange funds are full of footnotes. Before moving forward, compare them to the alternatives:
• Simply selling and paying the tax
• Layering in charitable giving strategies
• Using structured solutions like collars
• Gradual multi-year selling
• 10b5-1 plans
• Gifting strategies if estate planning is a priority
For the right investor, an exchange fund can be an elegant solution. For the wrong investor, it becomes a multi-year illiquid partnership that complicates future planning.
This post is adapted from a recent episode of the Scholar Wealth Podcast. For more perspective on managing concentration risk and evaluating exchange funds, listen to the full episode here.