# How do exchange funds work? The ultimate guide Everything you should know before investing in one. [Srikanth Narayan](https://usecache.com/author/srikanth-narayan) Founder and CEO [Christopher Lange](https://usecache.com/author/christopher-lange) Head of Investments ## The history of exchange funds Exchange funds are nothing new. In fact, they have been around in some form since the tax code established [Section 351 Exchanges](https://www.irs.gov/pub/irs-drop/rr-03-51.pdf) in the 1930s. The tax code also includes provisions for "like-kind" exchanges, and you might have heard of the [1031 Exchange](https://heinonline.org/HOL/LandingPage?handle=hein.journals/smulr22&div=55&id=&page=), which was created in 1954 to allow real estate investors to defer taxes when exchanging property. Who offers exchange funds? Today, exchange funds are offered by prestigious investment firms like Goldman Sachs and Morgan Stanley. Institutionally, they have been available since the 1960s, and they started to become more widespread after Eaton Vance (now part of Morgan Stanley) [obtained an IRS ruling](https://www.govinfo.gov/content/pkg/CPRT-94JPRT69124/pdf/CPRT-94JPRT69124.pdf) in 1975 that clarified the conditions under which they are allowed. ## What rules apply to exchange funds, and who can participate? ### Investor Eligibility Exchange funds are private funds for sophisticated investors who are capable of understanding their benefits and risks. As such, they are only available to [Accredited Investors](https://www.sec.gov/education/capitalraising/building-blocks/accredited-investor) – which means individuals who earn: 1. Over $200,000 per year or 2. Couples earning over $300,000 per year, or 3. Households with a net worth over $1 million (excluding the value of their primary residence) ### Stock Eligibility Traditional exchange funds accept stocks that allow them to achieve the right balance to meet their investment objectives. That means there can be a supply and demand problem when stocks you hold are oversubscribed because too many other investors want to bring in the same stocks. ### Fund Structure Each fund is structured as a limited partnership (usually a Delaware LLC). Each contributing shareholder receives a pro-rata share of the entire portfolio in the form of fund shares. ### Holding period The current tax rules mandate that each investor remains in the fund for seven years before they can withdraw a tax-deferred basket of stocks from the fund. Early withdrawal can result in the loss of that tax deferral, and you may incur fees or penalties with your fund provider. ## Timeline: How an exchange fund works Unlike an ETF or mutual fund, exchange funds are not ready for investment continuously. They open to contributions at periodic intervals when sufficient diversity of demand exists. ## How fund participation works Once the fund is set up, there are a few notable milestones before you can redeem your shares in the fund for a tax-deferred basket of stocks. ### Lock-up period The pool of stocks in an exchange fund is carefully weighted to achieve certain investment goals. Premature redemptions can throw off that balance and hurt your fellow investors. ### 7-year holding period If you want to receive the benefits of an exchange fund, you have to commit to it. Redemption requests after the lockup but before the seven-year mark are satisfied by distributing some or all of your original contribution back to you. ### Redemption After seven years, you can request to withdraw your share of the fund. The fund manager will distribute a diversified basket of 20 to 25 stocks that match your ownership percentage, and your cost basis from the stock you initially contributed will carry over. ## What makes exchange funds effective for certain investors? Exchange funds are for sophisticated investors with a concentrated stock position and a long-term time horizon for their investments. If you are all of those things, here are some simple examples of the diversification and tax advantages you might experience. ### The benefits of tax deferral: When you defer taxes, the money you would have paid in taxes remains invested and working for you in the market. ### The benefit of reducing concentration risk: It can be a great feeling when you’re sitting on a pile of company stock that is increasing in value every day. However, moving out of a concentrated position may also improve your returns over time. ### Tax planning advantages: Instead of being forced to liquidate your concentrated position when you still have high income and an unfavorable tax bracket, exchange funds provide diversification today and let you control when you liquidate your stock (if at all). ### Estate planning advantages: Exchange funds can even provide significant estate planning benefits for certain investors. Upon your death, the current tax code allows your heirs to withdraw the diversified basket from a fund on a stepped-up basis. ## What are the risks of an exchange fund? Exchange funds can help you in lots of ways, but they’re not for everyone. ### Liquidity considerations Exchange funds are a long-term investment. Period. ### Tax considerations There’s a chance that tax laws might change in the future, which may impact the favorable tax treatment of an investment in an Exchange Fund. ### Investment considerations 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. ## How much should investors like these invest in an exchange fund? When you contribute to an exchange fund, you don’t have to contribute all of your concentrated position. It’s quite common to use a variety of tools to diversify. ## How do you learn more? If there’s one thing all the investors in the examples above have in common, it’s that they have a long investment horizon and a large holding in at least one stock. Feel free to set up a quick call with our team, or take a closer look at [our modern exchange fund products](https://usecache.com/product/exchange-funds).