How executives use exchange funds to diversify without selling

For executives and founders who get rich from a single stock, it’s sometimes possible to have too much of a good thing.

While the boom in tech stocks could mean a windfall for employees at high-flying companies, tying up too much of your net worth in a single stock is risky. Some advisors stick to a 10% rule of thumb; This means that no single stock or asset should make up more than 10% of a portfolio.

“This represents both the greatest risk and the greatest opportunity for the client,” said Rob Romano, head of capital markets investor solutions at Merrill.

Founders and longtime employees looking to diversify their portfolios may face high capital gains taxes when they sell long-held stocks to reinvest. Instead, they can donate their shares to an exchange fund (not to be confused with ETFs).

Exchange funds, also known as exchange funds, pool the shares of more than one investor who purchases shares of the partnership or shares of the fund. After a designated lock-in period (usually seven years), investors can redeem their shares for a diversified basket of stocks equal to their share in the fund.

While stock funds became mainstream in the 70s, they have become more popular recently as the stock market delivers strong returns, especially with the rise of artificial intelligence.

Eric Freedman, chief investment officer of Northern Trust’s asset management unit, said many publicly traded technology companies are increasing equity compensation to compete with new AI startups for talent.

Stock market funds typically hold 80% of their assets in stocks and aim to mirror benchmark indices such as: S&P 500 or Russell 3000. The remaining 20% ​​is required by the Internal Revenue Service to be held in non-securities assets; real estate is the most popular option.

Steve Edwards, senior investment strategist in Morgan Stanley’s wealth division, said he is seeing clients increasingly use exchange funds as a wealth transfer strategy.

“What exchange funds help us with is narrowing the range of outcomes because a single stock will have such a wide range of outcomes,” he said. “Imagine being 70 years old and owning a great stock, but then it turns into a dumpster fire and you don’t actually get to pass on the inheritance you were hoping for to your heirs.”

Still, getting customers to hedge their bets is often a difficult proposition, Edwards said.

“People remember the blessing that stocks have provided them and their families, and they anticipate that blessing to continue,” he said. “What we find in our research and studies is that stocks that perform better actually tend to underperform in the future.”

He said clients often take some chips off the table by investing only a portion of their shares in a stock market fund.

Exchange funds only accept accredited investors who are valued at more than $1 million or have earned more than $200,000 in income in the last two calendar years.

The lock-in period also comes with fine print: If an investor uses the money before seven years, he loses the tax benefit and could incur high fees. Rather than buying a diversified basket of stocks, the investor typically buys back their original shares up to the value of their shares in the fund.

Scott Welch, chief investment officer at multifamily office Certuity, said he recommends against exchange funds because of the lock-in period. There are more flexible ways to reduce risk, such as collars, variable prepayment futuresor Tax loss harvesting with long and short positionshe said. If the client’s primary goal is liquidity, borrowing against equity is another solid option.