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Key takeaways

  • Exchange funds are a private investment that diversifies single-stock concentration while deferring taxes on the initial contribution.

  • Eligibility, liquidity constraints, and fees make them best for long-term, high-net-worth investors.

  • Benefits rely on fit and execution; private real estate sleeves add diversification but introduce liquidity and performance trade-offs.

Many investors hold heavily concentrated positions in their portfolio. And whether due to emotions or tax concerns, investors too often avoid rebalancing their concentrated holdings.

Over time, however, concentration raises portfolio risk because a single stock’s decline can materially damage overall wealth. Exchange funds offer a potential solution to diversify while also deferring taxes.

"Using an exchange fund could help you avoid selling stock and, as a result, defer a large tax liability. It can be an elegant, though complex, solution for the suitable investor."

Natalie Burke, co-head of public markets manager research, U.S. Bank Asset Management Group

What are exchange funds?

An exchange fund, also called a swap fund, is a private investment fund designed for long-term investors who want to diversify concentrated stock and manage taxes. Exchange funds can be particularly beneficial for executives who hold a substantial amount of their employer’s stock, individuals who have inherited family business assets, or investors with very large gains in a single stock.

“Whether you’ve acquired stocks through a merger or acquisition or simply saw huge stock growth, there are a number of scenarios where an exchange fund may make sense,” says Natalie Burke, co-head of public markets manager research with U.S. Bank Asset Management Group. “It’s all built on the simple idea that a diverse portfolio has inherently lower risks than a concentrated one.”

How do exchange funds work?

With an exchange fund, you contribute appreciated stock to the fund and receive an equally valued interest in a diversified portfolio, typically without triggering current taxes. Exchange fund managers pool contributed securities across investors who seek to achieve long-term, after-tax returns that broadly track the overall market often measured against indexes like the S&P 500.

Regulations require funds hold at least 20% of portfolio holdings in “qualifying assets.” These assets are neither publicly traded stocks nor bonds so that the transfer to individual investors qualifies as non-taxable, per federal tax code. Funds often meet this requirement by purchasing illiquid private real estate investments, such as multi-family residential, office or industrial properties. Typically, funds target established properties in major U.S. markets with consistent cash flows.

Who qualifies to invest in exchange funds?

To invest in exchange funds, eligibility often requires accredited investor 1 or qualified purchaser 2 status. Depending on the fund, you may need to contribute one or more acceptable securities with a combined value ranging from $100,000 to $1 million in value in exchange for fund shares. Cash contributions are typically not permitted, and each fund maintains an approved list of eligible stocks that can change over time.

Accepted securities are usually those listed on common U.S. and foreign exchanges. Some funds may accept restricted stocks of public companies, but commitment timing must align with the issuer’s compliance procedures. Exchange funds generally do not accept mutual funds, master limited partnerships (MLP), business development corporations (BDC), exchange-traded funds (ETFs), real estate investment trusts (REITs) or any securities that issue a Schedule K-1.

Burke notes, “Exchange funds have a level of complexity and unique eligibility requirements. As asset managers, we can walk you through them and help you determine if they’re a good fit for your portfolio.”

What are the potential benefits of exchange funds?

If you meet the requirements, exchange funds can potentially help you overcome serious challenges.

Diversification

You swap a concentrated holding for a professionally managed, diversified portfolio to reduce single-stock risk and overall volatility.

Minimized tax impact

Under current federal tax law, contributing appreciated stock is generally not taxable at time of transfer.

Tax-sensitive investment management

Exchange funds seek to limit shareholder taxes by favoring low-yielding securities, emphasizing qualified dividends for favorable federal income tax treatment, and keeping portfolio turnover to avoid distributing taxable capital gains.

Positioning for greater returns

Because the contribution does not trigger tax, your full pre-tax value remains invested, potentially enhancing long-term appreciation before taxes ultimately come due.

Effective estate planning

If you still hold the fund at death, beneficiaries may benefit from a stepped-up cost basis under current law.

What are potential risks of exchange funds?

While exchange funds offer plenty of benefits, they also carry risks.

Equity market risk

Fund performance remains tied to broader stock markets; diversification does not eliminate market risk.

Potential opportunity cost

A diversified stock portfolio may underperform the original concentrated stock.

Liquidity restrictions

Exchange funds target long-term investors. For the first seven years, redemptions often return your original contributed stares rather than a diversified portfolio and may incur redemption fees. After seven years, redemptions typically deliver a diversified set of liquid securities chosen by the manager. The IRS generally defers taxation on in-kind distributions until you sell the distributed securities.

Real estate investment risks

The qualifying asset sleeve, commonly real estate, has limited liquidity and can detract from performance in certain market environments such as the 2008 financial crisis.

High fees and expenses

Expect multiple fees and expense layers, including but not limited to advisory, distribution, shareholder servicing, redemption, selling commissions, interest, and borrowing costs. Evaluate net-of-fee return expectations

Tax risks

Contributions to exchange funds are not currently taxable, but laws can change. Also, corporate events may trigger taxable events. Embedded gains up to the contribution date carry forward and generally apply when you sell the positions received from the fund, meaning exchange funds do not eliminate capital gains tax liability, but rather defer it while reducing concentration risk.

Suitability

Exchange funds are complex and best suited for long-term investors with significant, low-basis equity concentration. They are not appropriate for everyone.

Weighing the pros and cons of exchange funds

Exchange funds diversify concentration and defer taxes for investors seeking a more balanced equity portfolio. They provide an alternative to selling and realize gains or borrowing against a position to buy a diversified portfolio.

As Burke summarizes, “Using an exchange fund could help you avoid selling stock and, as a result, defer a large tax liability. It can be an elegant, though complex, solution for the suitable investor.”

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Disclosures

  1. Accredited Investor: For individuals, the requirement is generally met by a net worth that exceeds $1 million (excluding primary residence and any related indebtedness), income in excess of $200,000 (individually)/$300,00 (jointly with spouse) in the two most recent years with an expectation of the same in the current year, or individual has a Series 7, 65 and/or 82 securities license(s). Relying on joint net worth or income does not mean securities must be jointly purchased. For entities (including trusts, non-profit corporations exempt under Section 501(c)(3), LLCs, LLPs, corporations, etc.), the requirement is generally met if the entity has assets in excess of $5 million (assuming the entity was not formed for the specific purpose of acquiring the securities offered), or when all of the entity owners are accredited investors. Please refer to Rule 501 under the Securities Act of 1933 for the complete definition.

  2. Qualified Purchaser: For individuals, the requirement is generally met when the investor owns (individually or jointly) $5 million or more in investments. Relying on joint ownership of investments does not mean securities must be jointly purchased. For entities (including trusts), the requirement is generally met if the entity owns $25 million or more in investments; the entity owns $5M or more in investments AND it is owned by two or more natural persons who are related as siblings/spouse; or all beneficial owners of the entity are each Qualified Purchasers. Please refer to Section 2(a)(51) of the Investment Company Act of 1940 for the complete definition.

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Investment and insurance products and services including annuities are:
Not a deposit • Not FDIC insured • May lose value • Not bank guaranteed • Not insured by any federal government agency.

U.S. Wealth Management – U.S. Bank is a marketing logo for U.S. Bank.

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U.S. Bank and its representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation.

The information provided represents the opinion of U.S. Bank and is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific investment advice and should not be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation.

U.S. Bank does not offer insurance products but may refer you to an affiliated or third party insurance provider.

U.S. Bank is not responsible for and does not guarantee the products, services or performance of U.S. Bancorp Investments, Inc.

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Diversification and asset allocation do not guarantee returns or protect against losses.

Factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness.

Exchange-traded funds (ETFs) are baskets of securities that are traded on an exchange like individual stocks at negotiated prices and are not individually redeemable. ETFs are designed to generally track a market index and shares may trade at a premium or a discount to the net asset value of the underlying securities.