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An exchange fund, also known as a swap fund, is an
investment vehicle An investment fund is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group such as reducing the risks of the investment by a significant percentage. These advantages inc ...
that allows investors with large stock positions to pool their stocks into a single fund, diversifying their holdings without triggering a taxable event. Given its dependence on the IRS Tax Code, it is a mechanism specific to the
U.S. The United States of America (USA), also known as the United States (U.S.) or America, is a country primarily located in North America. It is a federal republic of 50 states and a federal capital district, Washington, D.C. The 48 contiguous ...
, first introduced as early as 1954 with the passage of 26 U.S. Code ยง 721 though the practice traces back to the 1930s through other tax provisions. The primary benefit of this arrangement is to diversify a large stock position without triggering a " taxable event". Note that the
tax A tax is a mandatory financial charge or levy imposed on an individual or legal entity by a governmental organization to support government spending and public expenditures collectively or to regulate and reduce negative externalities. Tax co ...
is not avoided, just deferred. Deferring taxes avoids tax drag, as the money lost to taxes remains invested in the market, letting the portfolio compound from a larger base, which could create a significant advantage with time. When the diversified holdings are eventually sold, tax will be due on the difference between the sales price and the original cost basis of the contributed stock.


Detailed structure and eligibility

* Fund Structure: Exchange funds are structured as private funds, much like hedge funds or private equity funds. Regulations require that the investors be limited to sophisticated investors, typically
accredited investors An accredited or sophisticated investor is an investor with a special status under financial regulation laws. The definition of an accredited investor (if any), and the consequences of being classified as such, vary between countries. Generally, ac ...
. Each investor is thus a limited partner in fund. * Investor Eligibility: Most exchange funds only service qualified purchasers with at least $5 million in investible assets, with minimum investments of $500,000 to $1M at firms like Eaton Vance and Goldman Sachs. Newer entrants like Cache are making them available to
accredited investors An accredited or sophisticated investor is an investor with a special status under financial regulation laws. The definition of an accredited investor (if any), and the consequences of being classified as such, vary between countries. Generally, ac ...
with minimums of $100,000. * Fund holding requirements: To qualify for a tax-deferred exchange, an exchange fund needs to hold at least 20% in qualifying illiquid assets like real estate or commodities at each closing. * Liquidity: As per the current IRS code, investors are able to redeem a diversified portfolio without triggering taxable gains after a seven-year holding period. Before seven years, investors can only redeem their own stock back, but at the lower of the value of the contributed stock or their fund ownership.


Benefits and risks

* Exchange funds diversify an investor's concentrated position, reducing the overall risk in their portfolio. * Exchange funds provides significant tax alpha, since the entire principal is invested in the diversified portfolio, rather than the smaller post-tax base. A larger asset base should theoretically compound faster. * Exchange funds help investors overcome several biases that can discourage them from diversifying a concentrated position (such as the anchoring bias that occurs when a stock loses value). * Exchange funds are suitable for long-term investors only, as investors must plan to hold it for at least seven years to receive the tax benefits. * Risks associated with exchange funds include liquidity risks, investment risks, tax law risks, leverage risks, and others.


Providers

Historically, exchange funds have been offered primarily by two major investment firms, specifically for their ultra-wealthy clients.
Morgan Stanley Morgan Stanley is an American multinational investment bank and financial services company headquartered at 1585 Broadway in Midtown Manhattan, New York City. With offices in 42 countries and more than 80,000 employees, the firm's clients in ...
(through
Eaton Vance Eaton Vance Corp. is an American investment management firm based in Boston, Massachusetts. It is one of the oldest investment companies in the United States, with a history dating back to 1924. Through five primary investment affiliates, Eaton V ...
) is a prominent provider of these funds.
Goldman Sachs The Goldman Sachs Group, Inc. ( ) is an American multinational investment bank and financial services company. Founded in 1869, Goldman Sachs is headquartered in Lower Manhattan in New York City, with regional headquarters in many internationa ...
offers exchange funds as well. Newer entrants like Cache offer exchange funds that are more accessible to a broader range of investors.


Regulatory and Policy Questions

Exchange funds became popular after Eaton Vance obtained a private ruling from the IRS in 1975 allowing their use. The U.S.
Securities and Exchange Commission The United States Securities and Exchange Commission (SEC) is an independent agency of the United States federal government, created in the aftermath of the Wall Street crash of 1929. Its primary purpose is to enforce laws against market m ...
has investigated the use of these arrangements with reference to the potential for
market abuse In economics and finance, market abuse may arise in circumstances in which investors in a financial market have been unreasonably disadvantaged, directly or indirectly, by others who: * have used information which is not publicly available (inside ...
by directors not disclosing their effective divestment in stocks for which they are privy to sensitive market information. In addition, there is general public policy disagreement whether tax revenue that is generated from exchange funds and other
like-kind exchanges Under Section 1031 of the United States Internal Revenue Code (), a taxpayer may defer recognition of capital gains and related federal income tax liability on the exchange of certain types of property, a process known as a 1031 exchange. In 197 ...
should be deferred or avoided. Many holders of appreciated positions may elect to hold the concentrated position and borrow against it rather than sell and pay the associated capital gains tax, which results in
deadweight loss In economics, deadweight loss is the loss of societal economic welfare due to production/consumption of a good at a quantity where marginal benefit (to society) does not equal marginal cost (to society). In other words, there are either goods ...
to the economy. Proponents argue that exchange funds help with this significant deadweight loss as holders of appreciated stock can diversify and liquidate their positions, re-injecting this capital into the economy. Opponents argue that exchange funds only serve a narrow slice of the population. For example, public figures like politician
Mitt Romney Willard Mitt Romney (born March 12, 1947) is an American businessman and retired politician. He served as a United States Senate, United States senator from Utah from 2019 to 2025 and as the 70th governor of Massachusetts from 2003 to 2007 ...
and businessman Eli Broad have been identified as using exchange funds to reduce their tax obligations. Regulatory filings indicate that it is a frequently used strategy by high-ranking corporate executives.


References

{{DEFAULTSORT:Exchange Fund Investment