A client whose portfolio is highly concentrated in a single large holding with sizable embedded capital gains presents a multilevel challenge for a financial advisor. On the one hand, continuing to hold the security exposes much of the client's portfolio to the risks inherent in investing in a single company. On the other hand, selling the security in order to diversify may trigger significant capital gains and incur a sizable tax bill, leaving less for the client to reinvest. And while some investors can diversify gradually over time to at least dampen the tax consequences of selling, that might not be an option for someone who is already in a high tax bracket, or whose concentrated position is so sizable that it would take several years or more to diversify their portfolio to an acceptable level.
One option that has gained prominence in recent years to solve for this challenge is the exchange fund, which combines multiple areas of the tax code to allow investors to achieve some level of diversification while deferring the recognition of capital gains. In a nutshell, an exchange fund operates as a partnership to which multiple investors contribute individual highly appreciated securities and, after a seven-year holding period, each investor can withdraw a pro rata share of the entire 'basket' of securities within the fund without recognizing capital gains. And over the past several years, as the runup in technology stocks has created concentrated stock wealth for numerous investors – such as employees of technology companies who are compensated in company stock – exchange funds have been marketed as a solution to provide instant diversification with full deferral of capital gains.
However, there are caveats relevant for advisors when evaluating whether an exchange fund might help their clients achieve their goals. For example, the seven-year holding period –which is a requirement for the exchange fund to achieve tax deferral for all its participants – creates a significant restriction for clients who may need liquidity during that time frame. Additionally, the requirement for the exchange fund to hold at least 20% of its assets in illiquid investments, typically non-traded real estate funded by debt incurred by the fund in order to avoid selling any of the contributed securities, raises questions about the risks involved in adding such a high allocation to illiquid alternative assets – especially given the cost of borrowing to invest in those assets.
Also, because the concentrated securities that many investors are trying to diversify away from are disproportionately made up of technology stocks (since those have been the top overperformers in recent years), many exchange funds are consequently concentrated in technology and other high-growth sectors. Meaning that, while the fund might be diversified enough to eliminate investors' single-company risk, investors may still be subject to a significant amount of 'single-sector' risk. That is, if they can find a fund that will take their securities, as investors who are concentrated in certain popular holdings like Apple and Amazon might face long waiting lists for exchange funds with room for them.
The key point is that strategies like exchange funds don't eliminate tax on diversifying out of concentrated holdings – they merely defer it. Unless the investor doesn't plan to use the portfolio funds during their lifetime, they'll need to pay the tax at some point. Which means that when evaluating an exchange fund, advisors can ask whether it's worth taking on the additional risk – both in terms of illiquidity and the risks of the investments within the exchange fund itself –just to delay a tax bill that will eventually come anyway, or whether it's better to sell and take the tax hit now rather than risk even greater losses if the portfolio is misaligned with the client's needs?
