Skip to main content
Closely Held Businesses

Diversifying a Concentrated Stock Portfolio through Exchange Funds

By June 26, 2017No Comments

Do you hold a large concentrated position in low basis stock? Do you want to diversify that position without incurring the significant capital gains tax from selling the stock? Click the link to continue reading about Partnership Exchange Funds and if they will work for you!

The key to a good investment portfolio is a well-balanced and diversified selection of stocks and bonds that can protect against market volatility, corporate scandals and bubble bursts. This can be difficult to achieve if all of your equity is tied up in a singular position. Many executives and successful business owners find themselves in this situation. They have a disproportionate amount of a single equity investment that has very low basis. There are several ways to manage this predicament including: selling the stock, hedging the stock with options to try and mitigate any potential losses, or contributing to an exchange fund.

Selling the stock outright may be the easiest and quickest way to diversify the portfolio, but can result in significant tax. Hedging the stock with options is another can hedge against market fluctuations, but ultimately keeps the investor locked in that concentrated position. An exchange fund however, will allow the investor to bypass incurring capital gains and diversify the concentrated stock position.

An exchange fund is a partnership or limited liability company created by a large financial institution that allows multiple investors to contribute separate concentrated stock positions to the partnership in order to create a diversified portfolio held by the partnership. The investor owns a percentage of the partnership exchange fund in which they will share in earnings and losses. After a predetermined amount of time, the partners are allowed to liquidate their investment in the partnership, but instead of receiving the original stock contributed, they receive a “slice” of all the stock owned by the partnership. This creates a more diversified portfolio for the partner. Because it was a contribution to and distribution from a partnership, there is no gain or loss that is recognized by the partner, and the basis owned in those distributed assets is the same as the investors basis in the stock they originally contributed.

For instance, Investor A holds a concentrated position of 50,000 shares of Corporation A with a basis of $5,000 and fair market value of $500,000. If Investor A were to sell their position, they would recognize a gain of $495,000 which could have significant tax consequences. If on the other hand they contribute their 50,000 shares to a partnership exchange fund, and in return receive a diversified portfolio, they could hold that diversified portfolio and not have to recognize the large gain until they sell the stocks in the new portfolio.

Although an exchange fund can successfully diversify a portfolio and defer taxes, an investor should consider several limitations before contributing to a fund. The first consideration is that not everyone can contribute to exchange funds since the funds themselves are unregistered securities. The investor in an exchange fund needs to be classified as a “qualified investor” which means they must have a net worth of at least $1 million dollars (not including their primary residence) or earned income that exceeded $200,000 in each of the prior two years. Also, since most funds are looking for a wide variety of investors to diversify the portfolio, they can require each investor to contribute a minimum of $1 million in stock.

This contributed stock must also meet certain market capitalization and industry criteria in order to be considered by the fund manager as a good investment for the overall portfolio. Exchange funds are also required to hold at least 20% of illiquid investments which may limit returns in a bull market, but, conversely, can offer more diversification and protection in bear markets. Another side effect of the illiquid investments in the portfolio are that getting shares and cash out of the fund are often difficult on short notice, and can result in fees associated with early withdrawal (exchange funds often require a minimum investment period of seven years before being able to withdraw the diversified holding).

There are many pros and cons related to exchange funds, but they are often a much overlooked option for investors who are highly concentrated in a single equity position.

If you have any questions or need help determining if exchange funds are the right strategy for you, please contact your L&B professional at 858-558-9200.

Leave a Reply

SafeSend - a safe and easy solution for your tax engagements! Learn More >>
+