The Diversification Wormhole: Exchange Funds (Swap Funds)
The Diversification Wormhole: Exchange Funds (Swap Funds)
Stuck with $10M of a single stock? Selling triggers a massive tax bill. Borrowing adds risk. How to swap your concentrated position for a diversified portfolio tax-free.
Executive Summary
- The Concentration Trap: Executives often hold 90% of their net worth in their own company’s stock. It’s high risk. But selling to diversify means handing 30%+ (Fed + State) to the IRS. You are effectively “locked in” by taxes.
- The Solution (The Pool): An **Exchange Fund** is a private partnership where qualified investors “pool” their stocks. You contribute $5M of Apple. Someone else contributes $5M of Google, another puts in Amazon. The fund now holds a diversified basket.
- The Exit (Tax-Free): Under current tax law, contributions to a partnership are tax-free. If you stay in the fund for **7 years**, you can withdraw your share of the *diversified basket* (not your original Apple stock) without triggering capital gains tax. You achieved diversification with zero tax leakage.
The 20% Illiquid Rule
Regulatory Hurdle: To qualify as a partnership (and not a taxable investment company), the fund must hold at least 20% of its assets in “qualifying illiquid assets” (usually Real Estate or Commodities).
👉 Reality: This means your returns will be a blend of the stock market (80%) and real estate (20%). It adds a layer of asset class diversification but makes valuation complex.
Mechanic: The 7-Year Swap
Simulation: Tech Executive’s Dilemma ($5M Single Stock)
| Feature | Direct Sale | Exchange Fund |
|---|---|---|
| Tax Impact | Immediate (Year 1) | Deferred (Indefinitely until exit) |
| Liquidity | High (Cash T+2) | Low (7-Year Lock-up) |
| Cost Basis | Resets (Less Capital) | Carries Over (Original Basis) |
“Diversification is the only free lunch in finance, but taxes usually eat that lunch. Exchange Funds allow you to keep the lunch and the tax savings, provided you have the patience to wait 7 years.”