# What is an Exchange Fund? Pros and cons investors should know If you’ve accumulated a lot of stock in one company, you’ll eventually face some tough tradeoffs. You could sell the stock to diversify your holdings, but it might mean incurring a big tax bill. Or you could hang onto the stock, but you’d have to ride the daily rollercoaster of having your net worth tied to one asset. Exchange funds give you the best of both worlds. They let you diversify your portfolio **and** defer a considerable tax bill. It’s simpler than you may think. In a few minutes, you’ll know everything you need to know about exchange funds and how they can help you build a healthier portfolio. ## **What is an exchange fund?** Exchange funds take stocks from multiple investors and pool them into a single fund, giving each investor a stake in the fund. As an investor, they allow you to diversify your holdings without selling stock and triggering a taxable event. Exchange funds are not new; they’ve been used to reduce concentration risk tax-efficiently since the 1930s. Until recently, however, these funds have only been available to ultra-wealthy investors through white-shoe investment banks. They are also known as swap funds because they allow investors to “swap” a concentrated position in one stock for a diversified portfolio. A typical exchange fund consists of stocks contributed by its investors and at least [20% of “qualifying assets”](https://usecache.com/companion/why-exchange-funds-hold-real-estate-the-20-qualifying-asset-rule-explained)(like real estate) that are required by the tax code. Exchange funds are often structured to target a particular investment objective, like well-known market indexes. For example, the [Cache Exchange Fund](https://usecache.com/) is designed to approximate the long-term performance of the Nasdaq-100 index. ## **How does an exchange fund work?** Let's look at an example to show how an exchange fund can benefit investors. Imagine there are four long-time employees of tech companies who have earned highly appreciated stock: _We used a small number of investors here to make this example simple, but exchange funds typically include a much larger portfolio that’s designed to meet an investment objective._ Now, imagine that these investors pooled their holdings to create an exchange fund. If they participated in an exchange fund together, they would be able to defer capital gains taxes while diversifying away from their appreciated positions. Instead of individual stocks, each investor would own a share of the fund that’s proportionate to their initial contribution: The tax benefits of exchange funds come from [Section 721 of the Internal Revenue Code](https://www.law.cornell.edu/uscode/text/26/721), which allows investors to defer the recognition of a taxable gain or a loss when they contribute stocks to a partnership. As long as certain conditions are met (like holding at least 20% of the fund in qualifying illiquid assets), no taxes are triggered when stocks are contributed to an exchange fund. Stocks are merely swapped for ownership in the fund, and each investor’s cost basis remains the same. And each investor’s share of the fund remains the same, regardless of the performance of the stock they contributed. They are now invested in that fund instead of the underlying stock. To receive tax-deferred treatment, the current tax code requires investors to hold their investment in the fund for seven years before they can withdraw their diversified basket of stocks. And when it comes time to sell those stocks, the initial cost basis will still apply. That means, for example, that Andrea’s $100,000 cost basis would ultimately be used to calculate her capital gains. ## **Exchange fund requirements** Exchange funds have a number of specific requirements which investors must meet to contribute publicly traded stocks and benefit from tax deferral. These are the key rules applicable to exchange funds: ### Be an accredited investor Investors in exchange funds must meet the SEC criteria of being an accredited investor to participate in an exchange fund. To qualify by income, one needs to have an annual income of $200,000 or more over the previous two years with a reasonable expectation that they will maintain this income, or a requirement of $300,000+ in income jointly with a spouse. Alternatively, investors can be accredited if they have a net worth of $1 million or more, excluding their primary residence from this calculation. Most exchange funds also require investors to be a Qualified Purchaser, mandating that they have an investment portfolio of $5 million or more. ### Meet the minimum contribution Traditional exchange funds typically require a contribution of $500,000 to $1 million in publicly-traded stock. Cache, a modern exchange fund, only requires $100,000 in contributions. ### Contribute eligible assets With the Cache Exchange Fund Investors must contribute publicly-traded stock to participate in the exchange fund. For most exchange funds, private stock cannot be contributed. ### Holding period To take full advantage of the tax benefits of an exchange fund, investors must hold shares in the exchange fund for at least seven years. If investors withdraw from the fund early, they may receive back the original public stock rather than diversified shares. Penalties may also apply for early redemption. ## **What are the benefits of an exchange fund?** By helping you take your winnings off the table without triggering capital gains taxes, exchange funds can help you: **Diversify your holdings and reduce risk** Upgrade from a concentrated portfolio (more than 10% of your net worth in a single asset) to a diversified portfolio that’s carefully built around an investment objective. All stocks move up and down, but it’s less likely for a basket of stocks to lose most or all of their value than it is for stock in one company to underperform significantly. Keep in mind that diversification does not guarantee investment returns and does not eliminate risk. **Limit tax drag** When you realize capital gains on your stock and pay taxes on them, you are left with less money to invest. This concept is called tax drag. It can hinder the long-term growth of your portfolio. An exchange fund lets your initial investment continue to appreciate by deferring taxation. **Choose a new path** A concentrated position is often the result of hard work, smart decisions, and good luck. Understandably, you can get emotionally attached to the one stock that drives your portfolio. Exchange funds eliminate a lot of the excuses for keeping all your eggs in one basket by delaying taxation and reducing volatility. **Minimize the risk associated with your employer** If you work at a company and hold a concentrated position in that company’s stock, you are exposed to that company’s business risk in two different ways. Diversifying your holdings reduces the risk to your finances if the company faces business challenges. **Optimize your tax rate** Instead of being forced to liquidate when you’re in a high tax bracket, exchange funds let you diversify today and maintain control over when you liquidate your stock (if at all). **Improve estate planning** Exchange funds can provide significant estate planning benefits for certain investors, too. Under the current IRS code, your heirs could be able to withdraw a diversified basket on a stepped-up cost basis. ## **A closer look at the tax benefits of exchange funds** To really understand the tax benefits — and how tax drag can impact your portfolio — let’s return to our example. Recall that Andrea has earned $330,000 of Apple [stock as equity compensation](https://usecache.com/companion/equity-compensation-types), with a cost basis of $100,000. Here’s a hypothetical comparison between selling her Apple stock (and paying effective capital gains tax of 37.1%) versus contributing her stock to an exchange fund: This illustration shows what happens at the starting point of the investment. With the sell-and-diversify strategy in Scenario 1, you put fewer dollars to work. While market risk is inherent to investing, the seven-year holding requirement leaves ample time for compound interest to work its magic on the larger asset pool in Scenario 2. At the end of the seven year holding period, participating in an exchange fund puts Andrea about 35% ahead of where she would have been if she paid capital gains taxes before diversifying. And if she were to hold onto the exchange fund for longer than seven years, the power of compound interest could keep the performance gap growing. ## **Who are exchange funds for?** So, is an exchange fund right for you? It depends on your financial circumstances and whether you meet the eligibility criteria. Here are four key considerations: #### **1. Do you hold a concentrated position in one or two stocks?** Exchange funds can be a great way to diversify your investment portfolio if a lot of it is rooted in a single stock – especially if the stock has appreciated significantly. Are you looking for a way to reduce your risk in a tax-efficient way? And are you willing to hold the investment for at least seven years? Then an exchange fund could be a good fit for your portfolio. #### **2. Who is eligible for an exchange fund?** To be eligible for a modern exchange fund (like the one Cache offers), you must meet the [SEC’s definition of an accredited investor](https://www.sec.gov/education/capitalraising/building-blocks/accredited-investor), which means you must have one of the following: - Over $200,000 in annual income OR - Over $300,000 in annual income, when combined with a spouse or partner OR - Over $1,000,000 in net worth (individually or with a partner), excluding the value of your primary residence Some traditional [exchange fund providers](https://usecache.com/companion/exchange-fund-providers) require exchange fund participants to meet the higher threshold of being a “qualified purchaser” with over $5,000,000 in investments. #### **3. What’s the minimum contribution to an exchange fund?** Most traditional exchange fund providers require you to contribute at least $500,000 to $1,000,000 worth of a given stock to participate in their funds. The more modern [Cache Exchange Fund](https://usecache.com/exchange) allows contributions as low as $100,000. #### **4. What’s your timeline?** An investor should both intend and have the financial stability to commit for at least seven years when they decide to participate in an exchange fund.