Founders turn to exchange funds to diversify concentrated stock wealth

Company founders and early employees sitting on massive stock holdings are increasingly looking for ways to spread out their wealth without getting hit by hefty tax bills, according to financial advisors at major wealth management firms.

The recent surge in technology stocks has created fortunes for workers at successful companies. But having most of your money tied to a single company’s performance can be dangerous. Many financial advisors recommend that no single investment should represent more than 10% of someone’s total wealth.

Rob Romano, who leads capital markets investor solutions at Merrill, described the situation facing these clients as a double-edged sword. “It represents both the biggest risk and biggest opportunity for that client,” he explained.

How exchange funds help avoid tax hits

People looking to spread their investments around typically face large capital gains taxes when selling stock they’ve owned for years. Exchange funds, which shouldn’t be mixed up with ETFs, offer a different approach.

These funds, sometimes called swap funds, work by combining stock from different investors into one pool. Contributors get a stake in the fund based on what they put in. After sitting in the fund for a required period, usually seven years, investors can take out a mix of different stocks worth the same as their share of the fund.

The concept dates back to the 1970s, but these funds have become more popular lately as markets continue climbing, driven largely by excitement around artificial intelligence.

Eric Freedman, who oversees investments at Northern Trust’s wealth management operation, said publicly traded tech companies are handing out more stock-based pay to keep up with hot AI startups competing for workers.

These funds typically hold 80% of their money in stocks and try to match major market indexes like the S&P 500 or Russell 3000. The Internal Revenue Service requires the other 20% to be in non-stock assets, with real estate being the most common choice.

Steve Edwards, a senior investment strategist at Morgan Stanley’s wealth division, said more clients are using these funds as part of their estate planning.

“What exchange funds are helping us to do is to narrow the range of outcomes because a single stock will have a very wide range of outcomes,” Edwards said. “Imagine you’re 70 years old, and you have a stock that’s been amazing, but then it becomes a dumpster fire and, essentially, you are not able to pass to your heirs the legacy that you were hoping to.”

Challenges and alternative strategies

Getting wealthy clients to protect themselves isn’t always easy, Edwards noted.

“People remember the blessing the stock has been to them and their family, and they’re extrapolating forward that the blessing will continue,” he said. “What we found in our research and our work is that stocks that have outperformed actually tend to underperform more in the future.”

Most clients only put part of their holdings into exchange funds rather than everything, Edwards added.

These investment vehicles come with restrictions. Only accredited investors can participate, meaning people worth over $1 million or earning more than $200,000 annually for the past two years.

The seven-year waiting period also has catches. Anyone who pulls out early loses the tax advantage and might face large penalties. Instead of getting a variety of stocks back, early exits typically just return the original shares up to the value of what they own in the fund.

Scott Welch, chief investment officer at Certuity, a multi-family office, said he steers clients away from exchange funds because of the lengthy lockup. He points to more adaptable options like collars, variable prepaid forwards, or tax-loss harvesting with long and short positions. For clients mainly worried about having cash available, borrowing money using their stock as collateral works better, he said.

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