Exchange funds vs. direct indexing for large stock positions

Which strategy should you use to diversify a concentrated position in your portfolio?

Srikanth Narayan
Founder and CEO

Christopher Lange
Head of Investments

Enter exchange funds and direct indexing
Consider these seven factors
So… exchange funds or direct indexing?

(Update Mar 2026 - Read our comparison on how exchange funds and tax-aware long/short can be used for diversifying large stock positions)

A concentrated position (more than 10% of your net worth in a single stock) can be a good problem to have. It means something has gone really well for you – whether you’ve invested in the right companies or earned stock compensation from them. However, it also means you’re subject to concentration risk that can take your net worth on a roller coaster ride.

Diversifying your portfolio helps reduce your risk, but you might balk at the giant tax bill you would incur if you sold. Fortunately, there are several investment strategies designed to help you diversify tax-efficiently.

Enter exchange funds and direct indexing

In this post, we compare two popular strategies that might come up when you research diversifying a large stock position – exchange funds and direct indexing. Both are sophisticated vehicles, so weighing the pros and cons to choose the best strategy can be complex.

That’s why we did the homework for you.

Exchange funds

Exchange funds work by pooling together stocks from multiple investors into a communal fund. The fund accepts stocks in specific quantities to achieve a target investment objective, typically resembling the composition of a diversified index fund like the Nasdaq-100 Index or the S&P 500 Index. In exchange, each participant gets a pro-rata share of the fund.

No capital gains taxes are triggered when the fund is created, so an investor’s entire principal can grow without being subject to tax drag. After seven years, investors may choose to redeem their share in the fund for a diversified basket of stocks without paying capital gains taxes. No taxes are due until the basket of stocks is eventually sold, which can result in a significant performance advantage over time.

Since it is logistically challenging to assemble a group of investors with a set of stocks that’s weighted exactly the same as an index fund, exchange funds approximate the composition of their target index through various quantitative measures, resulting in a certain "tracking error".

Direct indexing

Direct indexing works by purchasing the entire basket of stocks that makes up a diversified index fund (instead of ETF or Mutual Fund shares). As stocks in the index naturally fluctuate, it presents opportunities to offset the gains of some stocks with losses from others through a technique called "tax-loss harvesting".

By passing tax losses back to the investor, direct indexing can offset some of the tax burden they incur when selling off their concentrated position. As those harvested losses accrue over time, it allows the investor to diversify more and more of their concentrated position.

A significant cash infusion is typically required to initiate the program – or some of the concentrated positions must be sold (and taxes paid) upfront. When selling stocks to harvest losses, the investor cannot immediately repurchase them due to Wash Sale rules, so the composition of a direct index portfolio will not always match the target index. This situation also leads to tracking error, which can be significant if a rapidly rising stock is sold and can’t be repurchased.

Consider these seven factors

So, which approach is right for you? Both direct indexing and exchange funds have benefits and drawbacks for diversifying a concentrated position. Choosing the best strategy really depends on your investment outlook, your liquidity needs, and your risk tolerance. Here’s a closer look at the factors that may affect your decision.

1. The cost of diversification

An exchange fund allows for a transition to a diversified basket without triggering taxes. When you hold a stock with significant appreciation, whether in percentage or absolute dollar value, diversification would mean a giant tax bill. As a rough rule of thumb, we suggest that exchange funds have strong benefits when your stocks have appreciated 50% or more.

On the other hand, a direct indexing program generates tax losses to offset gains on individual stocks. Using tax losses to offset gains could be beneficial when using a direct index as an alternative to a traditional index fund because it generates tax alpha that is shown to improve after-tax returns by around 1% per year.

However, it may not be the optimal strategy when trying to diversify a stock that has appreciated significantly. Investment losses, regardless of how they are marketed, are generally undesirable. For example, a position with $1M in capital gains would require $1M in capital losses to offset the tax burden. In this case, while an investor avoided the taxes on $1M in gains, they also experienced $1M in actual losses.

Takeaway: Exchange funds are more effective when you hold stocks with significant gains, while direct indexing may be more suitable for offsetting smaller gains or when the long-term nature of an exchange fund is a concern.

2. Time required to diversify

An exchange fund diversifies an investor’s portfolio immediately upon investment. A direct indexing program diversifies a single-stock exposure by selling away the concentrated position as tax losses are harvested. Depending on the extent of built-in gains and the size of the index portfolio, it could take several years or decades to generate enough losses to offset the gains in your concentrated position.

Takeaway: Exchange funds diversify you upon participation, immediately reducing your exposure to the concentration risk in your portfolio. Direct indexing could take years or decades to achieve the same result.

3. Liquidity constraints

Exchange funds are a long-term investment product. The current tax code requires at least a seven-year holding period before an investor is able to redeem a diversified portfolio. Direct indexing programs can be initiated and wound down upon investor request, but exiting early also means you could still hold a concentrated position.

Takeaway: Exchange funds require a seven-year commitment, and liquidity before the end of that period is limited. Direct indexing offers flexible liquidity.

4. Capital needed to diversify

With an exchange fund, all you do is contribute stock to a communal fund alongside other investors. You can invest an amount that you feel comfortable with, and no additional capital is necessary. However, a direct indexing program requires sufficient capital to create a portfolio that offsets the gains in your concentrated stock position.

Takeaway: Exchange funds do not need any additional capital infusion, whereas direct indexing needs substantial cash contribution to get started.

5. Options for a target index

Each exchange fund is formed with a specific index in mind, while a direct indexing program can be customized around any investment preferences.

Takeaway: Exchange funds are limited to well-known indices while direct indexing offers high flexibility.

6. What happens at redemption

Exchange funds distribute, without triggering taxes, a diversified basket of stocks upon redemption. Direct indexing programs usually distribute the set of stocks bought to replicate the index and have limited tax-loss harvesting potential.

Takeaway: In both cases, you receive a basket of stocks upon redemption, but tax-loss harvesting opportunities differ.

7. Overall tax advantage

The tax advantages depend on your financial situation and investment outlook. Exchange funds can help you diversify while deferring taxes. Direct indexing produces a tax alpha of ~1% every year on average.

Takeaway: The overall tax advantage from an exchange fund is substantial for high earners who hold significantly appreciated stock positions, while direct indexing's tax benefits may vary.

So… exchange funds or direct indexing?

If you have a large stock position that you’d like to diversify, it is worth doing your due diligence on these options. Hopefully, our article sheds light on how you should be thinking about it.

Summary table

Exchange funds are a passive investment vehicle designed to provide diversified exposure. They do not guarantee higher returns than their underlying stocks, and they are likely to fluctuate with market conditions. It is still possible to lose principal when you participate in an exchange fund.

If you’d like to see whether you’re eligible for an exchange fund, our other strategies for managing large stock positions, or ask more detailed questions, we’d be happy to talk.