September 22, 2023

One Way to Reduce Concentrated Stock Risk is to Invest in Exchange Funds

One Way to Reduce Concentrated Stock Risk is to Invest in Exchange Funds

The baseball technique of hitting singles and doubles rather than home runs comes to mind when diversifying your investment portfolio. Having too much exposure through a concentrated position — the equivalent of relying on home runs to win — might increase the total threat of your portfolio. A concentrated position is when you commit a large chunk of your whole portfolio to a single investment, usually a stock. When a single stock investment makes up 10% or more of your portfolio, the risk involved with it generally rises. One approach to limit your risk is to use an exchange fund, which provides insurance in the event that a large investment underperforms.

What is an exchange or swap fund?

An exchange fund, often known as a swap fund, enables you to swap a concentrated stock position with a diversified basket of equities of equal value, decreasing portfolio risk and delaying tax effects. Executives are frequently seen to be substantially involved in the shares of their companies. To align their interests with those of the firm, some corporations may require top executives to possess a particular number of shares. Employee equity compensation advantages, such as stock options or RSUs, can concentrate important employees’ portfolios in their company’s shares even if no shareholding need exists.

You may have wind up with a concentrated stock holding for a variety of reasons other than being a corporate leader. It’s possible that one stock in your portfolio has beaten others and now accounts for a disproportionate number of your portfolio. Using an exchange fund instead of selling stocks to diversify your portfolio and paying the significant capital gains taxes that come with it might be a realistic choice. Even limited equities may be eligible for exchange funds on occasion.

How an exchange fund works

An exchange fund combines the concentrated stock positions of several investors to produce a diversified collection of shares that matches a wide stock market index. You can exchange your concentrated position for a partnership interest or a share of the exchange fund, which avoids a taxable event and instead provides you with tax-deferred gains.

Capital profits and dividends are frequently re-invested by exchange funds. When you redeem and sell your partnership shares in the fund, the cost basis of the fund is equal to the cost basis of the concentrated stock you handed over, which is a taxable event (the amount you paid to purchase the stock originally).

Benefits of exchange funds


The key reason to invest in an exchange fund is to diversify your portfolio. By distributing your investment funds among a number of assets, you may minimize volatility and investment risk by guaranteeing that no single item has an excessively big impact on your whole portfolio. An exchange fund can help you diversify your portfolio by replacing a concentrated position with a more diversified one.

Tax deferral

Another advantage of exchanging funds is that it allows you to postpone your tax burden. Because of the stock’s long-term gain, certain concentrated stock investments have grown rather large. This implies the stock would have amassed huge profits, and selling shares to diversify would almost certainly result in a big tax bill. Depending on your tax circumstances, it may be more cost-effective to postpone paying taxes or transfer your partnership shares to heirs, who will benefit from the cost-basis step-up.

Drawbacks of exchange funds

Accredited investors

Exchange funds are often formed as private placement limited partnerships or limited liability corporations, which implies that only authorised investors with a net worth of at least $5 million are eligible to invest. Because exchange funds are not registered securities, they are exempt from the SEC’s information disclosure rules.


Before you may redeem without penalty, most exchange funds need you to keep on to your partnership shares for at least 7 years. 7 years is plenty of time to wait, and it may be problematic if your financial situation changes throughout that period and you want access to your investments. Early redemption of partnership shares might result in the return of your concentrated stock instead of the diversified fund shares you were hoping for.

Qualifying assets

Exchange funds allow you to exchange your stock for the partnership shares of the tax-free. Exchange funds must hold a least of 20% of overall gross assets in specific qualified investments to preserve eligibility for this favourable tax treatment, which helps to reduce portfolio volatility. Commodities or real estate are frequently used as qualifying assets, as they are more illiquid and riskier than standard stock holdings.

Is an exchange fund right for you?

Exchange funds are one of the many techniques to manage concentrated stock ownership. While exchange funds can help spread the investing risk of a single stock holding, you’ll still have to deal with the highs and lows of the stock market. Your diversified partnership shares might outperform or underperform your single stock holding. Seeking the assistance of a financial or wealth expert can help you balance your alternatives and determine whether or not employing an exchange fund is a good plan for you.

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