Exchange Funds: A Tax-Smart Way to Diversify Concentrated Stock
Exchange funds overview
A tax-smart strategy for investors with highly concentrated stock positions
For some investors, a large portion of their wealth is tied up in a single stock, often from years of employment at a public company or an early investment that performed well. While this can create significant wealth, it also introduces risk: if too much of your portfolio depends on one company, your financial future may move with that company’s stock price.
Exchange funds can be one way to diversify without immediately selling and triggering large capital gains.
Why This Matters
It’s common to see clients hold highly appreciated stock long after it stops fitting their portfolio. Maybe it’s a long-term winner from their employer or a legacy position inherited years ago. The real issue isn’t the investment itself, it’s the tax bill that comes with selling it.
Say someone owns $1 million of a single stock with a $200,000 cost basis. If they sell, they’ll realize $800,000 in long-term gains. This gain means roughly $190,400 in taxes (23.8% combined capital gains and Net Investment Income tax), before factoring in any state taxes.
That’s enough to make anyone hesitate, but keeping the position has its own risks. Concentrated stock creates volatility, especially if that company or sector falls out of favor. Over time, a single stock can go from being a career-maker to a portfolio drag.
What Is an Exchange Fund?
An exchange fund allows investors with large, appreciated stock positions to contribute their shares to a professionally managed partnership in exchange for ownership in a diversified pool of stocks contributed by other investors.
The key benefit is that you’re not selling your stock - you’re exchanging it for a diversified portfolio. That means you don’t recognize capital gains when you contribute your shares.
You’ll typically stay invested for about seven years, after which you can redeem your fund shares for a diversified basket of stocks. You still owe taxes eventually when you sell those new shares, but you’ve deferred the gain, and in the meantime, your portfolio isn’t riding on one stock anymore.
Who They’re For
Exchange funds are designed for investors with:
Highly appreciated, publicly traded stock (often $250,000 or more in a single name)
A long-term time horizon - typically seven years or more
No immediate need for liquidity
An interest in managing taxes proactively rather than reactively
Historically, exchange funds were limited to investors contributing $1 million or more, with offerings from large institutions like Goldman Sachs and Eaton Vance (Morgan Stanley).
However, newer entrants like Cache are making exchange funds more accessible. Many allow contributions as low as $100,000, opening the door to a broader range of investors.
The Tax Benefit in Numbers
Using the earlier example, if your $1 million stock grows at 7% annually, and you sell today, you’re left with about $800,000 after tax to reinvest.
If instead you contribute to an exchange fund, you can invest the full $1 million, and let it compound tax-deferred. After seven years at the same 7% rate, that’s roughly $1.6 million - more than $300,000 more than if you’d sold and reinvested after paying taxes upfront.
Deferral doesn’t eliminate taxes, but it gives your money more time to grow before paying them. It can also create opportunities to sell in a lower tax bracket later, or pass shares to heirs who receive a step-up in basis.
What to Watch Out For
Exchange funds can be an elegant solution, but they’re not for everyone.
Keep in mind:
They’re illiquid during the holding period
You’ll likely receive a basket of stocks at the end, not cash
Diversification depends on the fund’s composition
Fees and fund minimums vary
The Bottom Line
For investors sitting on a large, appreciated stock position, exchange funds can offer a powerful way to diversify while deferring taxes, giving your portfolio a chance to grow without the immediate hit of capital gains.
They’re not a perfect fit for everyone, but for those with the right profile, they can bridge the gap between tax efficiency and risk management in a way that few other tools can.