A reader of this blog posted a question recently about exchange funds, inquiring, like any savvy consumer, as to whether or not there’s a catch of some sort with this type of product. I’ll try to give a thumbnail sketch on exchange funds and their advantages and disadvantages. Warning: for novice investors, this discussion will focus on a somewhat specialized and complex part of investing. If you’re not facing the challenge of a concentrated position in a low-basis asset, then this discussion may not be applicable to you.

The demand for exchange funds arises out of a problem facing many taxable high-net worth investors: how to address a concentrated position that creates excessive risk in a portfolio but would trigger capital gains in order to sell the asset and diversify. Such a situation can commonly arise due to an entrepreneur or executive receiving stock (through acquisition, grants or options) in a single company that represents a high percentage of an individual’s wealth. For example, newly-minted dot com millionaires might be worth $20 million in stock of a company that bought their firm, which might comprise 100% of their portfolio.

Investors in such situations have usually faced the choices of 1) selling the stock and paying the capital gains,  2) using derivatives such as variable pre-paid forwards to alleviate temporarily some of the extra risk, 3) continuing to hold the stock and just bearing the extra risk or 4) contributing the stock to an exchange fund, and receiving a more diversified holding in return. These choices provide various advantages and disadvantages. Selling the stock can offer a great way to diversify instantaneously, and for a high-volatility stock the upfront tax penalty is usually more than worthwhile. Derivatives tend to be a very expensive way to diversify, though they’re very popular with brokers since they can generate so much profit for those selling them. Continuing to hold the stock avoids the pain of an immediate tax penalty, which is less of a problem for less volatile stocks than for high-flyers.

Exchange funds provide a unique tax treatment for investors with concentrated positions since they allow for the contribution of undiversified assets and then the withdrawal of more diversified assets, typically seven years later. The advantage lies in the ability to defer capital gains while achieving some level of diversification. The disadvantages include 1) the high fees, both initial placement fee and ongoing annual fee, 2) the lack of liquidity, i.e. tying up funds for up to seven years, 3) the lack of control of the other assets in the fund and extent of diversification (based on what actually gets contributed rather than what’s necessarily ideal), 4) the requirement that exchange funds hold 20% in illiquid assets, which is fine if that fits your asset allocation and a problem if it doesn’t.

Even with all of those disadvantages, exchange funds can still be beneficial for investors with high tax rates and a long time horizon who will not be liquidating the assets in question for a long time, if ever. The sooner an investor might sell, the less advantageous an exchange fund will be, even if it’s selling beyond the typical seven-year holding period. Furthermore, the lower an investor’s tax rate, the less advantageous will the fund be.

To answer the blog reader’s question, you should be careful about the high fees in an exchange fund and the true diversification achieved, but the tax advantages can be real nonetheless, especially if you face a high tax rate. This discussion applies to a situation faced by a typical high-net worth taxable investor, and may not apply to all situations. Please seek specific advice on tax or portfolio issues you may face. As a bit of further disclosure, Eaton Vance, one of the leaders in exchange funds and mentioned by the blog reader, owns a competitor of my employer, so if you’re a truly cynical skeptic, you might need to take that fact into account. Unfortunately for consumers, the investment industry has acted in a way that makes some cynical skepticism a healthy thing.