Exchange Funds

 Basic Meaning

An exchange fund is a partnership in which the partners each contribute highly appreciated stock in order to achieve diversification and defer the tax liability.  In the exchange funds no sale in fact occurs as the investor swap shares with the fund and by doing so capital gain tax incidence does not arise and payment of tax is deferred.

Brief History

Eaton Vance offered its first exchange fund in 1961 and, as of the spring of 2004, has approximately $16 billion assets in this niche.2 Other providers include the investment banks, since they often take companies public and their clients are seeking a way to diversify their concentrated stock risk without paying capital gains taxes. The investor retains his cost basis in the exchange fund shares, so this should be considered a tax deferral rather than a tax minimization option. To qualify for a tax-free exchange, the investor’s stock must remain in the fund for at least seven years. For the fund to satisfy regulatory requirements, at least 20 percent of assets must be maintained in “qualifying assets,” which are typically real estate investments.

How it Works

The investor may hold shares longer than seven years, and some funds have almost a perpetual inclination. An investor who redeems shares may be given a select group or basket of stocks or a pro rata distribution of shares held by the fund. The portfolio construction process may exclude certain types of stocks, depending on the manager’s acceptance criteria. Therefore, the investor may have to check with several providers to determine if they will accept the concentrated holding. As with all portfolios, there is investment risk and a component of active management. Therefore, the exchange fund may achieve a return different from the most common stock benchmarks. In the case of Eaton Vance, it manages its exchange funds in conjunction with its Tax-Managed Growth Fund, which has a history of never having distributed any capital gains.

Holding period and Penalties

Investors and their advisers need to understand the various provisions of the fund they are considering, as there may be early-withdrawal penalties or adverse tax consequences if the seven-year holding period cannot be satisfied. Fees on exchange funds typically run about 1 percent or slightly less annually.

The exchange fund may offer estate planning advantages. If the investment in the exchange fund is intended to be a gift, it is likely a meaningful discount to the face value for tax purposes can be achieved. From time to time, exchange funds have come under the scrutiny of legislators and regulators. Most recently, it is the SEC is trying to determine if corporate insiders were using them to reduce their exposure without sending a signal to investors.